I know you know this, but it's dreadful out there. When the FDIC ups its protection of bank deposits by $150,000 per person per institution, and the federal government takes equity positions in our biggest banks, "bad" takes on a whole new meaning.
And when widow-and-orphan stocks -- so named because they're supposed to be the safest in the market, and thus suitable for those who can't shoulder a loss -- not only tank, but help to create a global fiscal crisis, well, things have definitely gone from bad to worse.
The safest of the safe
Widow-and-orphan stocks typically have three things in common as they go about the business of providing reasonably safe returns:
- Steady but unspectacular rates of return.
- Solid and growing dividends.
- Industries that are neither highly cyclical, faddish, or particularly growth-oriented.
In fact, studies have shown that dividend payers can actually grow faster than non-dividend payers -- belying the reputation of "widow and orphan" stocks as boring and stodgy.
Banks and utilities have historically been the poster companies for a widow-and-orphan portfolio. Banks are the everyday glue that binds together our economic system, and conservative lenders have produced solid returns from holding and lending out funds. Utilities enjoy monopoly-like status, which, although regulated, usually allows for a safe and steady return. Neither is overly cyclical, and both are inflation-resistant, given their ability to pass along cost increases.
The end of the world as we know it
Yet all this supposed safety has flown out the window in a matter of months. Washington Mutual failed, and Wachovia (NYSE: WB ) got bought for a fraction of what it was worth even a few months ago. Bellwethers like Citigroup (NYSE: C ) have cut their dividends and turned to foreign investors for equity capital. And let's not even mention the investment banks that imploded, such as Fannie Mae and Freddie Mac.
Utilities haven't fared much better. Constellation Energy (NYSE: CEG ) almost collapsed from its exposure to the credit market before it was rescued by the white knight from Omaha, Warren Buffett. Other companies -- such as Reliant Energy (NYSE: RRI ) and Mirant (NYSE: MIR ) , down a respective 80% and 60% year to date -- are underperforming even the horrible market we're in now.
And I feel fine
So does the decimation of widow and orphan stocks mean that nothing is safe anymore? Definitely not. Even when the headlines are negative, many solid, stable, dividend-paying companies have been going about the business of creating long-term returns for their shareholders.
But the fall of the "safe" stocks gives us a few things to keep in mind:
- Management matters. The old adage says, "If you can trust your banker, you can trust your bank," and the same goes for any other company. If you don't trust management to make sound decisions, stay far away from that company.
- Understand how the company makes money. As it turns out, even the investment bankers at the center of the storm didn't understand all of the complexities and risks of credit default swaps, mortgage-backed securities, or collateralized debt obligations -- so how could the average investor? If you don't understand how the company generates earnings, it's best to move on to one you do understand -- because unless you do understand it, you won't know how to recognize red flags.
- Even the safest stocks can fail. No stock is "safe" -- bad management, a changing market, or an act of God can undermine even the longest-running business. Given that, a good rule of thumb is to hold any money you need for the next five years somewhere other than the stock market. Near-term money should be in money markets, bonds, or CDs.
The Foolish bottom line
Although some of the biggest names in finance and energy have seen turbulent times lately, there are many solid and stable companies still patiently generating returns for their shareholders.
Giant banks Wells Fargo (NYSE: WFC ) and US Bancorp (NYSE: USB ) , for example, have outperformed the market notably, even as their competitors have imploded. And a whole host of utilities are continuing to do what they always have done: distribute power, and only distribute power -- not take on proprietary energy trading, the way Enron and Constellation did.
And although banking and energy have been the poster children for widow-and-orphan stocks, you can find dividend-paying, stable companies in many industries -- and in many countries.
At the Motley Fool Income Investor, we're committed to finding great dividend-paying companies with good management, strong financial statements, and the ability to weather any kind of market. You can find out what we're recommending today with a free 30-day trial. Just click here to get started -- there's no obligation to subscribe.
Fool analyst Andrew Sullivan does not have a financial interest in any of the stocks mentioned in this article. US Bancorp is a current and Constellation Energy Group is a former Motley Fool Income Investor recommendation. The Motley Fool has a disclosure policy.