As the author of a stock newsletter, one of the most common questions I receive is this: "How do you find good stocks?" They get right to the point, don't they? Many readers say they employ screening tools to find good stocks, but they often find it difficult to determine the best criteria for which to screen. To that end, they're looking for a magic bullet that will produce the greatest investment results.
Though I generally don't subscribe to the magic bullet theory, in this case finding great stocks might be just that easy. With complete honesty, I can tell you that if I could screen for just one thing to find the best returns in the market, I would screen for dividends, hands down.
I've often said that dividend-paying companies tend to beat the market over time -- with lower risk than nonpayers, to boot. To me, that should be every investor's goal.
I've always had a handful of statistics at the ready to support my dividend assertions, and generally folks have found them to be fairly compelling. However, thanks to one incredibly hardworking professor, we now have incontrovertible proof that boring and stodgy outperforms hot and fresh nearly every time. How? Well, most often through the power of dividends.
A good read
I recently read a book that contains some of the best research I've ever seen as an investor. You'll find some of the best investment lessons that you could ever learn in professor Jeremy Siegel's latest book, The Future for Investors. It's required reading for anyone who truly wants to beat the market and create real wealth.
You may remember Siegel as the author of Stocks for the Long Run, which established equities as the greatest wealth-building investment of all time. Similarly, The Future for Investors establishes the reason behind much of that outperformance: dividends and the incredible importance of reinvesting them over time.
Boring will make you rich
It's no coincidence that Altria (NYSE: MO ) (the parent of Philip Morris and Kraft Foods (NYSE: KFT ) ), not IBM (NYSE: IBM ) , is the best-performing stock among the original S&P 500 companies. But wait, you say, I thought technology was supposed to outperform the boring stuff. Not quite. Time and again in Siegel's research, boring also means better in terms of stock performance, and what could be more boring than getting a check for spendable cash every three months in the form of dividends?
Frankly, I have no idea which company is going to be the next Microsoft (Nasdaq: MSFT ) , but that's just not necessary to be a great investor. I simply have to pick the highest-quality, dividend-paying companies trading at the best prices, reinvest those dividends whenever possible, and in all likelihood, I'll demolish the market averages over the long haul.
Sure, you might hit one out of the park every so often, but most of us won't, and what then? The fact is that picking a winning stock goes way beyond picking a winning product. I talk to people every day who absolutely love products such as TiVo (Nasdaq: TIVO ) or Sirius Satellite Radio (Nasdaq: SIRI ) , but it's anyone's guess as to whether these businesses are truly going to make money for shareholders one day.
The cards are certainly stacked against investors here. As Siegel points out in his research, the fact is that companies like this have to make a whole heck of a lot of money to be successful investments because they're typically so darn expensive. This is what he refers to as "The Growth Trap." In other words, investors think they must buy high-growth stocks in order to beat the market, when in fact those companies are least likely to outperform because they're already trading at such expensive prices. In that case, results have to be positively stellar in order for them to trade higher, and that typically won't continue forever.
There's a better way: Incredibly boring old-economy companies that pay dividends -- such as railroads and consumer products firms -- consistently outperformed the latest technology companies with higher earnings growth in Siegel's research, and they did so with less risk (i.e., in terms of volatility).
Some people say that volatility doesn't matter because they're investing for the long term, and thus won't need the money until some point in the future. But many of us can't say exactly when that point will be, and it does have a way of creeping up on you. The bottom line is that lower volatility means there's a greater chance that your money will be there when you need it, no matter when that turns out to be. And because dividends give you reduced risk while still allowing you to beat the market, you've found your magic bullet.
Though I can't say that my figures cover quite as extensive a period of time, the results I've generated in Motley Fool Income Investor have, thus far, borne this out. Since I began writing this dividend-stock newsletter more than two years ago, the S&P 500 has produced a total return (i.e., including dividends) of 13.54%. My portfolio of 56 dividend payers, on the other hand, has generated a total return of 15%.
That may not sound like a very wide margin, but consider that we've managed to outperform the market while undertaking significantly less business risk, experiencing lower volatility, and enjoying a dividend yield of 4.6% -- more than twice the yield offered by the S&P 500. And we've done this during a period when we're not supposed to outperform at all. Consider that, historically speaking, this conservative strategy is expected to lose to the S&P during bull markets, such as the one we've been experiencing since 2003.
Though our 15% average isn't bad in its own right, there are certainly standouts among the portfolio, and ironically some of my best performers could also be considered my most conservative. For example, quality water utility California Water is up nearly 60% since its recommendation just over two years ago. And Texas electric utility TXU (NYSE: TXU ) is up 74% in only one year. Overall, a quarter of our recommendations are up more than 30%, and a third are up more than 20%.
All told, I think that's a fairly strong showing for a conservative, boring portfolio. Again, you're just not supposed to put up performance figures like these with stodgy dividend payers in a bull market, or so the story goes. But as we've seen, the story is often wrong. Learning that lesson early will help you build real wealth over your lifetime and allow you to sleep better along the way.
This commentary was originally published on June 13, 2005. It has been updated.
Mathew Emmert isn't as boring as he seems. He's making his subscribers a fortune as the chief analyst ofMotley Fool Income Investor. He owns shares of Altria and Microsoft, disclosure of which is an ironclad requirementat the Fool. Microsoft is an Inside Value recommendation. TiVo is a Stock Advisor recommendation. Kraft is an Income Investor recommendation.