The Stock Screaming "Buy Me!"

How much money could you make if you found out what really drives equity returns?

Ned Davis Research gave that question a closer look. It studied the period from 1972 to 2006, capturing the era of "fiat" money that followed the United States' departure from the gold standard. The researchers found that bifurcating stocks by one simple factor made an enormous difference.

That single factor: whether a stock pays a dividend.

Ned Davis found that from 1972 to 2006, S&P stocks that didn't pay a dividend returned a measly 4.1% annualized. Dividend payers, meanwhile, returned a whopping 10.1% annually!

Keep reading for six dividend samurais
To put this power to work for you, I've got six stock ideas below, based on a special screen.

As a former hedge fund analyst, director of research and analysis for The Motley Fool, and now co-advisor for the Motley Fool Income Investor newsletter, I've read a lot of academic studies in my day, and believe me, a six-percentage-point difference is absolutely enormous. It leads to a powerful yet simple conclusion: If you're a stock investor, you'll profit by being in dividend stocks.

Finding just one great dividend stock -- the stock that should be screaming "Buy me!" -- can mean an early retirement, not to mention a wealthy one.

But how do you find that one stock?

How to make a fortune in the modern era
Let's consider an actual stock -- Mr. X -- whose identity will remain a secret for a moment. Mr. X isn't glamorous. He wouldn't seem to have a lot going for him. Most people don't even like his product. He's in constant litigation.

But Mr. X has a magic potion: compounding dividends.

If you had put $1,000 into this stock -- it's a real stock, remember -- in 1980 and sold just last fall, you would have $47,000 in principal gains. That's nice. But if you had reinvested the dividends, you would have $213,000!

Who is Mr. X? Altria.

But don't go calling your broker just yet. The thing is, Altria has probably had its day in the sun. It may well be a decent investment, but it's no longer screaming, "Buy me!"

The challenge is finding the next Altria -- the next big dividend winner -- with returns so large you can buy the castle in Malibu instead of the condo in Cleveland come retirement (but only if you want to).

It's out there today, and it's screaming, "Buy me!" -- but you have to be listening. Toward that end, I'd like to share two must-haves I've learned:

Must-have No. 1: Strong operational returns. The whole point of a business is to turn lead into gold -- to take capital and create even more capital. If return on equity (ROE), return on assets, and return on capital look anemic, investors' returns likely will be, too.

Must-have No. 2: A growing dividend. This signals more than just larger checks in the here-and-now. It signals a dividend-friendly board, which can mean the difference between a cash-monger and a cash-sharer as the years tick by.

There are pitfalls to watch out for in dividend investing. Don't lose your nest egg by falling through one of these trapdoors:

Trapdoor No. 1: The dividend double-take. I remember when my friend got stood up, left holding a dozen roses in a restaurant full of expectant onlookers. You might not have expectant onlookers, but you don't want a company that ditches its dividend. Look for a payout ratio of less than 80% for most companies. Math whizzes will want to replace net income with free cash flow in the formula, something I do in finding stocks for my newsletter, too.

Trapdoor No. 2: Closet debt. ROE is great, and rightfully loved by investors ranging from your next-door neighbor to Warren Buffett. But companies know a dirty little trick: Load up on debt, and your ROE soars. That can be great, but don't take that check at face value. The company may have just gotten a lot riskier. Next time you see ROE spike, check to see if the debt has done the same.

The six dividend samurais
For some starting-point ideas, here are six stocks with ROE in excess of 10%, debt-to-capital ratios below 50%, free cash flow payout ratios of less than 80%, dividend yields greater than 1.5%, and payouts that have grown in the past year:

Stock

Yield

LTM ROE

Dividend
Growth (YOY)

Abbott Labs (NYSE: ABT  )

2.7%

23.8%

10.3%

AmBev (NYSE: ABV  )

3.6%*

16.1%

93.7%

Nucor (NYSE: NUE  )

1.7%

28.4%

104.9%

Hasbro (NYSE: HAS  )

2.1%

24.1%

30.8%

Fortune Brands (NYSE: FO  )

2.5%

13.7%

7.8%

Gap (NYSE: GPS  )

1.9%

18.9%

26.6%

Data from Capital IQ, a division of Standard & Poor's. *From adr.com.

The above stocks come from a statistically advantageous group, but I believe my co-advisor Andy Cross and I have found a whole lot more. Follow this special link, which gives you a month-long guest pass to our Motley Fool Income Investor newsletter, and you'll get our very latest -- and very best -- stock ideas for beating the market.

Here's my promise: Take a free guest pass, and you'll find at least one stock you love within the Income Investor service. The service is beating the market by eight percentage points since we opened for business.

This article was first published Sept. 12, 2007. It has been updated.

James Early doesn't own any stocks mentioned. Hasbro and Gap are Stock Advisor recommendations. Gap is also an Inside Value selection. The Motley Fool has a disclosure policy.


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