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 $52,000 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 likely 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 are likely to 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 trap doors:

Trap door 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.

Trap door 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 whether 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 85%, dividend yields of 1.5% or greater, and payouts that have grown in the past year:

Stock

Yield

LTM ROE

Dividend Growth (YOY)

Debt/Capital

Norfolk Southern (NYSE: NSC  )

1.9%

15.2%

39.2%

40%

Staples (Nasdaq: SPLS  )

1.6%

18.5%

13.8%

6%

General Dynamics (NYSE: GD  )

1.7%

20.3%

24.5%

19.2%

Honeywell (NYSE: HON  )

2.3%

27.2%

10.1%

45.5%

Lockheed Martin (NYSE: LMT  )

1.7%

37.5%

18.5%

34.4%

Valero Energy (NYSE: VLO  )

1.9%

20.2%

33.3%

26.2%

Data from Capital IQ, a division of Standard & Poor's.

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. With more than 70 ready-to-go dividend stock ideas, you'll probably find more than one. The service is beating the market by nearly seven 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 of the stocks mentioned. Staples is a Stock Advisor recommendation. The Motley Fool has a disclosure policy.


Read/Post Comments (7) | Recommend This Article (57)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 05, 2008, at 2:21 AM, WhiteMamba wrote:

    Since July 17, 2008:

    NSC: -27.39 %

    SPLS: -19.73%

    GD: -38.49%

    HON: -48.89%

    LMT: -23.05%

    VLO: -51.72%

    Average: -34.88%

    S&P 500: -32.39%

    Not exactly "statistically advantageous", is it?

    I bet the author is glad he didn't own any of the "screaming buys" that he recommended.

  • Report this Comment On January 06, 2009, at 3:07 PM, YeungFool wrote:

    This is a lesson for all Fool Traders - you must look beyond the company's fundamentals and dividends to make a good pick (ie: overall economic conditions, global, geo political, etc.). Lets not forget that the stock price doesn't always correlate with a company's fundamentals - it's a secondary trading market that can be heavily affected by emotion and human psychology. This was quite evident in the last 3 months of 2008.

    Safe Trading!

  • Report this Comment On March 08, 2009, at 11:10 PM, jwaymoo wrote:

    One year ago, in anticipation of my retirement last summer, I changed my investment strategy to completely focus on income, i.e. return on investments (ROI). This is what I call an income approach to investing. It includes my total portfolio, whether invested in equities paying dividends, master limited partnerships (MLPs) paying unit distributions, closed end funds paying dividends, or cash equivalents (CDs/Savings) paying interest. As YeungFool stated, stock price can be heavily affected by emotion and human psychology, as we have seen in the past six months. Because of these psychological factors affecting stock prices, I view capital gains investing as something similar to betting on the horses. I don’t care about the price as long as the company has sound financials, is shareholder-friendly, and has a good business model – I care about my ROI. I am also careful about diversification and allocation. As of 2/27/2009, my portfolio was:

    Cash/Cash Equivalents: 12.44%

    Stocks & MLPs: 44.48%

    Closed-end Municipal Bond Funds & Bonds 31.37%

    Non-Municipal Mutual Funds / Bond Funds: 11.71%

    Since 3/31/2008, I have made changes in 80% of my portfolio positions to follow my new income approach strategy. The Ned Davis research cited by James Early indicated long-term historical results of dividend investing. You cannot use the price performance over a few months of the small number of stocks cited by James as examples to refute the long term potential result of income investing. The performance of my portfolio in the recent short-term since October 2007, which was down by 21.5% as of 2/27/2009 while the S&P was down by 52.6% in the same period, supports James Early’s thesis as well as the Ned Davis research. However, based upon my stated strategy, I do not care whether the portfolio market value is down or up by 21% - that is not important because my metric is ROI. My income approach strategy has resulted in an actual annualized income increase of 92% in the past 11 months, with a tax equivalent yield of 8.94% on my entire portfolio as of 2/27/2009. This is not fantasy investing – it is my real retirement income. By the way, the mutual funds that were in my 401(k) and managed by professionals tracked with the S&P 500 almost exactly. Last month I rolled over the mutual funds into my self-managed IRA and took over management of them – I am now trying to determine how to get out of the -55% professionally managed hole.

  • Report this Comment On March 24, 2009, at 4:14 AM, FIOutreach wrote:

    Interesting post. I work for Fisher Investments; you should read our CEO (and Forbes Columnist) Ken Fisher's book, The Only Three Questions that Count : http://www.onlythreequestions.com

  • Report this Comment On May 15, 2009, at 6:18 PM, benjns wrote:

    I've been reading some articles on Fisher Investments MarketMinder.com (I work for them as well). Check out this article on the bank stress tests: http://www.marketminder.com/a/fisher-investments-us-economy/...

  • Report this Comment On April 27, 2010, at 9:10 AM, weslindsey wrote:

    Is there a rule that says articles on dividend investing must be at least two years old?

    Or maybe it's just me.

  • Report this Comment On October 16, 2010, at 11:56 AM, witchey wrote:

    Stay away from Fisher!!! Fisher cost us a fortune...I was begging them to take us to cash before the market crash. Fisher was blind to the mortgage mess and the coming crash. I was a property appraiser watching the mortgage fiasco play out. Property Appraisers saw this mess coming!

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