The Worst Stocks to Own

Fans of Seinfeld are familiar with Festivus, a made-up holiday in which participants gather 'round an aluminum pole and take turns sharing how the other participants have disappointed them throughout the year.

Market? This Festivus is for you. Between the predicted recession, the collapse of the credit market, and prior transgressions from Enron and Worldcom, disappointment abounds.

While avoiding all investing disappointment is impossible -- humans, managers, and investors alike do make mistakes -- knowing some universal traits of bad stocks can help you avoid the bad and move toward the good with six promising stocks you may want to consider.

Back to the cold aluminum pole
While stocks disappoint us in myriad ways, there are some commonalities I've gleaned from both my hedge fund days and my work as an advisor to the Motley Fool Income Investor newsletter.

How can you disappoint me, corporate management? Let me count the ways:

1. Poor strategic moves: This should speak for itself, but if you see one blunder after another, it may be time to fly the coop. If you see corporate officers dumping shares, fly faster.
2. A case of the over-smarts: It's much easier to believe you have a great idea than to actually have one. Especially if it's off the balance sheet.
3. Managerial egomania: Supervoting shares, bold acquisitions, optimistic buybacks of pricey stock, and hoarding cash can signal a managerial team that overestimates its talent. I've read that four out of five acquisitions don't work out, and managements often stockpile cash with the delusion that they've got good uses for it. Often, they don't.
4. Low operational returns: The point of a business is to earn a profit. While a business barely covering its cost of capital (or equity) is still adding value, having a nice, hefty return cushion not only protects against trouble but enhances lucre in the good times.
5. Inferior market share: Sure, we love when an underdog has his day, but all too often, second-rate, late-to-the-party competitors tend to stay that way. I'm less strict on this point, but I much prefer to invest with the No. 1 or No. 2 company in the market.

Buy a dividend stock and call me in the morning
There's a simple antidote to many -- though not all -- of these ills besides the obvious move of watching for signs of this misbehavior and getting out when you see them.

The secret antidote is embarrassingly simple: Dividends. Say what?

To begin with, dividend stocks outperform the market. Wharton professor Jeremy Siegel found that, from 1872 to 2003, a full 97% of equity returns came from dividends -- specifically, reinvested dividends. Only 3% came from the original principal.

Dividends are also built-in protection from the corporate money-squandering endemic to this age: Maintaining a payout forces management to pick and choose only the very best projects. That's smart because it saves a ton of corporate waste.

All of that hits your bottom line as a dividend investor: Rob Arnott and Clifford Asness found that stocks paying the highest dividends actually had the highest earnings growth over the following 10 years!

I used Capital IQ, an institutional stock screener, to unearth six stocks with returns on equity above 10%, paying out more than 2.5%, and with market caps in excess of a billion dollars. While these aren't recommendations, they are starting points for further research.

If dividends sound like they're worth a deeper look or you'd like to see which ones we recommend, snatch up a free, 30-day guest pass and poke around my Motley Fool Income Investor service. You can kick the tires all you want. It's beating the market by seven percentage points and has more than 70 actively tracked recommendations.

James Early owns no stocks mentioned in this article. Bank of America and JPMorgan are Income Investor recommendations. The Motley Fool has a disclosure policy that does not disappoint.