What Every Portfolio Needs

Growth investors and value guys have opposing views of the world. Some folks are loath to take too big a gamble with their investments while others espouse the concept that you've got to risk big to win big. But from newbies to grizzled veterans, the daring to the cautious, there's one category of investments that should be in every portfolio.

Dividend-paying stocks work for you.

Dividends are time-tested, reliable, punctual, and put money in your pocket. Reinvest them and watch them increase your stake in a value play. Use dividend payers to hedge against the volatility of the more aggressive stocks you believe in. If you're young, let the magic of compounding build your nest egg. If you're nearing retirement, use dividend income to pay your bills.

The power of dividends is proven. Consider the case of Sears (Nasdaq: SHLD  ) . Over the course of a recent 20-year period (namely, 1978 to 1998), Sears delivered a 9% return without dividends. With dividends, that return rose to 20%. That's an 11% difference. Let's say you graduated from college in the late '70s and wanted to throw some of those first hard-earned paychecks into the market. Without dividends, a $2,000 investment in Sears in 1978 would've turned into $11,208.82 in 20 years. Respectable, to be sure. But with dividends, that same $2,000 in 1978 turned into $76,675.20 two decades hence.

And I'm not simply cherry-picking the shiniest investment vehicle in recent history. Putting the power of dividends in your portfolio is a proven market-beating strategy. If you'd invested $50,000 in the S&P 500 -- i.e., just in the overall market -- 10 years ago, you'd be sitting on $143,500 today. With dividends, that figure increases to $176,500. What would you do with an extra $33,000?

Those are the kinds of outsized gains analyst Mathew Emmert goes after in his Motley Fool Income Investor newsletter service. And consistent with those above numbers, Income Investor recommendations are outperforming the S&P 500 by nearly 8% since its August 2003 inception, and that doesn't even count reinvestment of the dividends.

Here's what we know
While pumping up your returns, dividends also transmit information about management's expectations regarding company prospects. Increases and initiations are a positive sign; reductions are a bad sign. Think about that classic American company, Johnson & Johnson (NYSE: JNJ  ) . J&J has had 42 consecutive dividend increases -- a statistic that underlines its market-beating returns over the past 25 years.

To use Mathew's words, dividends are "the best predictor" of so many other features and traits of a business. For one, dividends indicate a profitable business. But the dividend isn't simply a "sign." There's that little matter of the dividend being cash -- cash that you can either (1) take as a quarterly income to spend on necessities or luxuries, or (2) reinvest to enlarge your stake in the company through a dividend reinvestment plan (DRiP).

This decision, of course, depends on your investment time frame and strategy.

Not-so-risky business
Managing risk is crucial in any portfolio, and dividends help investors achieve that goal. As Mathew says, "The beauty of the dividend is market outperformance with lower risk."

Skeptical? Well, let's put that statement under the lights. Do reliable dividend-paying companies "outperform"? Yes. In 2004, dividend payers in the S&P 500 outperformed non-payers 18.35% to 3.65%. Do reliable dividend payers carry less risk? Yes. Because the dividends Mathew looks for are paid from free cash flow, his recommendations are less risky. (What's more risky: A profitable company or an unprofitable one?)

Yet dividend-paying companies are slowly going the way of the pocketwatch. The number of companies paying a dividend today is about one-fourth that of the mid-1950s. Also, dividend payers are becoming more industry-specific. Approximately 75% of companies in the oil and gas sector pay a dividend today (BP (NYSE: BP  ) , for instance, pays an excellent dividend), while 0% of firms in the airline sector pay them. Which makes sense when you consider that.

Cash is king
Here's a staggering stat for you: Of the nearly 10,000 publicly traded companies on the U.S. markets, about one-third currently report negative earnings.

Read that again. Now take a deep breath.

The Income Investor approach does not stalk glamorous growth stocks. Satellite radio may be an innovative technology, but it's not a safe haven for your money. No cash flow? No earnings? Half a business plan? Then there's no chance it will sneak into Mathew's portfolio. "There are a lot of 'half' businesses trading at 'whole' prices," he says. That math just doesn't add up.

Companies with free cash flow pay dividends, buy back shares, and reinvest in the business. In other words, cash creates shareholder value, and dividends indicate cash. But let's be clear: Not all dividend-paying companies are surefire bets. Some companies even try to manipulate investors by taking on debt to pay or increase a dividend (which is why Mathew always looks for dividends that are paid from money the business actually generated).

The universal language
Aside from yielding solid, predictable returns, Income Investor recommendations cover every corner of the market: common stocks, real estate investment trusts (REITs), master limited partnerships (MLPs), and preferred stocks.

Mathew scours the market looking for cash-rich companies in every time zone. His four most recent recommendations are businesses operating outside the United States, from South America to Asia. And one of his biggest gainers to date is French oil giant Total SA (NYSE: TOT  ) -- the stock is up nearly 30% since he picked it.

Why doesn't the market recognize the brilliance of dividend payers and bid up their prices? For one, dividend payers are often boring. Companies like Bank of America (NYSE: BAC  ) are solid dividend payers that sometimes fly under the radar. And when's the last time you heard someone waxing poetic about dividend-payers ConAgra (NYSE: CAG  ) or Cadbury-Schweppes (NYSE: CSG  ) over martinis? I'll venture a guess: never.

Making money is never boring
The case of California Water illustrates exactly what the Income Investor strategy is all about. The company had no Street coverage, a relatively small market cap (about $450 million), and a 4.7% yield. As a largely regulated water utility, its business model was stable. And California Water was undervalued by the market despite its dividend-paying fundamentals. The company is up 33% since Mathew's October 2003 recommendation and has been paying investors along for the ride.

Investing is about earning money that will support you and your family, generate income, subsidize utility bills, and pay for those umbrella drinks at the beach. You're a step closer to those goals in day 1 of dividend investing. If you can build a portfolio today, down the road you can turn off that "reinvest" feature and let the spigot open.

Dividend-paying stocks make money. Period. For that simple reason, they are what every portfolio needs.

If he could, Mathew Emmert would eat and sleep dividends. Since he can't, he just dreams about them. Put Mathew in your corner by signing up for a free 30-day trial of Income Investor. In addition to the two monthly recommendations, you'll have access to all back issues as well as a lively community of discussion boards; special members-only feature articles; and advice, FAQs, and tax tips for dividend investors.

Brian Richards wishes he'd reinvested the $4.18 dividend check he received on a quarterly basis as a kid. Instead, he bought gum. Brian does not own shares of any company mentioned in this article. The Fool has a strict disclosure policy.


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