Why Dividends Rule the Market

At the end of this article -- after warning investors to avoid long-term bonds at their current yields -- I said that dividend-paying stocks offered a better alternative for most investors who had money to put to work in this market. I also promised to come back this week to explain exactly why that's so. Lo and behold, I'm keeping my word. It may seem like a rarity among financial analysts these days, but we Fools do delight in breaking the mold whenever possible.

So let's get down to business -- specifically, dividend business. Certainly, dividend-paying stocks are back in vogue, and many pundits are jumping on the payout bandwagon without knowing exactly why they're coming along for the ride. Indeed, I've seen several articles lately offering up the recent performance of dividend stocks as the Holy Grail of investing. While that description may apply, hyped-up short-term performance isn't why it applies.

Some marketing materials have gone as far as to say that you should be buying dividend-paying stocks because a single dividend-oriented ETF -- the iSharesDow Jones Select Dividend Index (NYSE: DVY  ) -- outperformed the S&P 500 (AMEX: SPY  ) last year.

Again, that sounds great. And it may seem that I have little to complain about as everyone rushes to embrace my beloved dividend-investment strategy, but a single year? Puh-leeze. Dividend payers have been pounding non-dividend payers since the S&P 500 began tracking stocks nearly eight decades ago, and these guys want to talk about one measly ETF over a single stinking year?

That's not exactly a compelling argument for betting my family's future on a single style of investing. But leave it to Wall Street to take the perfect lifetime investment strategy and make it sound like the latest fad.

Not one year, every year
As much as I'm enjoying this short-term performance, there's simply very little statistical significance in a one-year return. Indeed, over such a period you can't really say beyond a shadow of a doubt that dividends were responsible for that return. Perhaps the quality, stable large caps that just happen to be the types of companies that pay dividends were simply back in vogue themselves. Who knows?

More importantly, who cares? Again, what they should be talking about are the reasons that this strategy has whooped up on the indexes for ages now. Dividend investing has stamina. It's not going to pass quietly into the night as the next big thing comes along. Sure, sometimes it will get more attention in the press, sometimes less, but those who stick to their guns over the long haul will be well rewarded for doing so.

I don't have to talk myself into coming to work every morning to write about dividends. This is the way I invest because I believe in it with every fiber of my being. It's how I invest my own portfolio, and it's how I recommend that my friends, family, and you invest yours. From 20-year-old cousins to mothers to grandmothers, dividends are a great screening tool for everyone, and I wouldn't be the advisor of Motley Fool Income Investor if I didn't truly believe that.

The plain truth is that dividend stocks tend to outperform the market over the long haul, and they often do this while suffering far less volatility, which means there's a greater chance that your money will be there when you need it.

Yeah but...
When I've talked about this in the past, some have said, "Sure, dividend stocks outperformed over the past 70 years because times were different during most of that period -- companies used to pay out much larger dividends. I'll bet your numbers don't hold true for the modern market."

While that's a notable point, these folks are always surprised to hear that dividend outperformance has actually been even more pronounced since 1980. During this period, S&P 500 dividend payers beat non-payers by 2.7% per year. It may not sound significant, but trust me when I tell you that this difference can equal hundreds of thousands of dollars in extra investment gains over time.

The next complaint always involves taxes. While it's true that taxes must be paid on dividends in the year that they're received, this seems a fair trade-off for the up-front return and additional safety, flexibility, and growth offered by dividend payers.

Beyond that, consider that taxes on dividends are lower than ever before and are now equivalent to the tax rate on capital gains (i.e., 15%). Finally, though you'll pay tax on the income you receive, there is a benefit to taking that cash up front: no inflation impact. This advantage is almost never discussed, but consider that all of your returns from capital gains are coming at some point in the future, and are therefore being whittled away by the corrosive effects of inflation.

In the case of dividends, however, because you're receiving some of your return right now, this portion of your return is not affected by inflation, and can be used to buy goods and services in today's dollars. Better yet, successful companies tend to increase their dividends year in and year out at rates that far exceed the rate of inflation, providing added protection to your future income stream.

The Foolish bottom line
Of course, these are just a few of the reasons that I love this strategy, but there are many more, such as additional downside protection in bad markets, more fiscally responsible managers, and what I refer to as the ability to have your cake and eat it if you want to -- meaning you can take the income now or reinvest it for the future.

Looking for an income boost? In another recent article, I explained how General Electric (NYSE: GE  ) , Johnson & Johnson (NYSE: JNJ  ) , and PepsiCo (NYSE: PEP  ) could generate 20%, 30%, and even 50% dividend yields for their owners. Now that's a nice payday. Not good enough? Even more recently, I explained how investors could turn just $3,000 into an annual income of more than $8,700.

There truly is something for everyone in the dividend universe. For instance, dividend reinvestment plans can be a great way to get your kids and grandkids started in the stock market. I began my own investing career via such plans, purchasing a single share of three separate companies and building them over the years through dividend reinvestment and modest monthly cash payments. (Actually, very modest cash payments, as necessitated by my status as a lowly, ramen-noodle-eating college student -- those were the days.)

But one of the most convincing arguments for dividend stocks right now is simply valuation. It's amazing to me, but high-quality dividend payers remain some of the cheapest investments in the market, while the valuations of second-, third-, and even fourth-tier companies rocket into the stratosphere.

Though prices are higher everywhere, I'm consistently shocked that so many investors keep falling for the same old tricks. I mean, really, ignore a company like Newell Rubbermaid (NYSE: NWL  ) that trades at 14 times earnings and 10 times free cash flow (FCF), but back the truck up on Google (Nasdaq: GOOG  ) at 129 times earnings and 75 times FCF? No thanks. In investing, boring is a good thing, so I'll stick with my dividends.

Some of you will recall that I recently promised to share how one could find solid dividend payers of their own, and I did just that in this article. Of course, if you determine that you don't have the time or inclination for such activities, we're happy to dig up the best dividends in the market for you each month in the pages of Income Investor.

Fool on!

This article was originally published on Jan. 31, 2005. It has been updated.

Mathew Emmert can pick Waldo out of a crowd in five seconds flat, every time. He's also the senior investment analyst of Motley Fool Income Investor. Try it for 30 days via the Fool's guaranteed no-riskfree trial. Mathew owns shares of GE and PepsiCo, though he wouldn't touch Google at this price, despite his love of a good search. The Fool isinvestors writing for investors. Fool disclosure rules are here.


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