How to Turn a Water Heater into a Ferrari

Did you know that $1,000 invested in Altria in 1980 would be worth $205,000 today, with dividends reinvested? In other words, if you'd forgone an expensive VCR back then for a boring stock investment, you could have a Ferrari now.

Of course, Altria is an exceptional stock, but if you want a shot at turning $1,000 today -- about the price of a basement water heater (not that we're suggesting you forgo hot showers) -- into a few hundred grand as quickly as possible, where should you be investing to maximize your odds? I'll have some advice -- and seven stocks to check out -- for you later, but let me take you through the process of making this kind of money in the stock market first.

Step 1: Ignore the hype that you secretly want to believe
Sure, we hear cocktail-party stories about the guy who turned a quick fortune in some biotech or Sino wonder-stock (N.B.: If you've got any tips, send 'em my way). But this is not reality for most. For every winner, there could be dozens of losers, and odds are you own one of them. But as you'll see below, dividend stocks help stack your odds -- significantly.

Step 2: Befriend the dorkiest guys you know
These are the people who are doing studies of what's actually proven effective in the market. You should listen, because you've worked hard for your money -- too hard to squander it.

You don't need a study to show that Altria is an aberration. Most dividend stocks don't perform that well; Altria's a best-case scenario, but it's still noteworthy that studies soundly confirm dividend investing to outperform non-dividend investing by a hefty margin.

For instance, according to a Morgan Stanley report, stocks paying dividends delivered nearly six additional percentage points of return annually from 1970 to 2005.

Given the rough economy, it's nice to know that dividend stocks are shown to outperform in declining markets. A paper by Fuller and Goldstein found that in down markets from 1970 to 2000, dividend stocks beat non-payers by 1.5% per month -- and did so with less risk!

There are many more studies, but I'll move on for now.

Step 3: Decide whether you're a man or a mouse
Or a woman or a mouse, to extend the phrase. And being a mouse isn't bad. In fact, given that investors often aren't rewarded for taking on additional risk, being a mouse can be downright smart. Dividend stocks are great places for security-seeking investors. If that's you, dividends can be your equivalent of a cheese buffet.

Ignore the misconception that dividend-paying companies are slow and stodgy. It's incorrect. In fact, if you're a maverick, you're in luck: Dividend stocks come as risky as you want 'em -- from a stable utility to a power-packed yielder like Frontline.

Of course, only an idiot seeks risk just to seek risk. (OK, I do that sometimes.) In investing, risk tends to mean higher return potential, and as noted above, Fuller and Goldstein found higher returns with lower risk with dividend stocks -- in short, more bang for your risk-adjusted buck.

Let's look at some stocks
I used institutional software package Capital IQ to screen for dividend payers with betas greater than 1 -- indicating that they've been more volatile than the market. Risk, being a future concept, can't be measured. But past volatility (measured relative to the market) is a decent approximation.

For stability, I chose companies with yields greater than 2% and market caps of $1 billion or more. I required a payout ratio -- using free cash flow instead of earnings for accuracy -- of less than 90%. While not formal recommendations unless otherwise indicated, these stock ideas can provide starting points for further research.

Company

Beta

Yield

Market Cap (billions)

TexasInstruments (NYSE: TXN  )

1.69

2.5%

$23

Siemens (NYSE: SI  )

1.19

4.4%

$32

Applied Materials (Nasdaq: AMAT  )

1.06

2.1%

$15

Arcelor Mittal (NYSE: MT  )

1.73

7.6%

$22

For balance, how about a stab at the other side of the coin -- dividend stocks a bit safer than average? I kept the same criteria as above, but I selected stocks with betas of less than 1. (Beta is a measure of a stock's volatility relative to that of the S&P 500, which by definition has a beta of 1.) Here are the results:

Company

Beta

Yield

Market Cap (billions)

IBM (NYSE: IBM  )

0.90

2.5%

$107

Lockheed-Martin (NYSE: LMT  )

0.62

3.1%

$29

Chevron (NYSE: CVX  )

0.91

4.2%

$127

Dividend stocks: Cheese for the thinking mouse or maverick
Turning $1,000 into a Ferrari is an obvious long shot, but there are people investing right now -- this very day -- who will do just that. Some will do better. The key lies in finding the right stocks. I haven't found the all-powerful secret to that yet, but I try every day in our Motley Fool Income Investor dividend stock investing service.

If you'd like more than a starting point with dividend-stock investing (such as full recommendations, updates, and tracking), take a free guest pass to the Income Investor service. It's beating the S&P 500 by three percentage points to date.

This article was first published on May 16, 2007. It has been updated.

James Early owns no stocks mentioned in this article. The Motley Fool has a disclosure policy.


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