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 to explain 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.

Not one year, every year
The simple fact is that dividend investing has stamina and has been shown to outperform the market over the long haul. It's also not going to pass quietly into the night as the next big thing comes along. That's because the types of companies that tend to pay dividends happen to be stable, high-quality large caps. Investors who stick to their guns with dividends over the long haul will be well-rewarded for doing so.

That's why dividend investing is the way I invest in my own portfolio, and it's how I recommend 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 case for dividends
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 companies like Mercury General (NYSE: MCY  ) , AJ Gallagher (NYSE: AJG  ) , Altria (NYSE: MO  ) , and Chevron (NYSE: CVX  ) -- all of which are solid businesses that pay shareholders and trade for below-average earnings and free cash flow (FCF) multiples -- but speculatively back the truck up on Baidu.com (Nasdaq: BIDU  ) at 59 times forward earnings and no FCF or companies like Conexant Systems (Nasdaq: CNXT  ) or Level 3 Communications (Nasdaq: LVLT  ) that don't even have the numbers to generate multiples? No thanks.

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 from 1980 through 2004. During this period, S&P 500 dividend-payers beat nonpayers by 2.7 percentage points 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 you have to pay taxes on dividends in the year that you receive them, 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 though you'll pay tax on the income you receive, there is a benefit to taking that cash up front: no inflation effect.

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.

Some of you will recall that I recently promised to share how one could find solid dividend-payers of one's 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 Emmertcan pick Waldo out of a crowd in five seconds flat, every time. He's also the lead analyst of Motley Fool Income Investor. Mercury General and AJ Gallagher are two of his newsletter's recommendations. Try it for 30 days via the Fool's guaranteed no-risk free trial. Mathew does not own shares of any company mentioned. Fool disclosure rules arehere.


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