Together, more than eight years ago now, we watched the beginning of a downturn that cut the S&P 500 in half and dropped the Nasdaq nearly 80% off its highs. It was a maddening time for investors. Telecom and energy executives were caught with their hands in the corporate cookie jar. Technology shares plummeted, with hundreds of companies vanishing from sight. Very few bear markets in U.S. history have hurt so much. JDS Uniphase, a bull-market darling, collapsed from a split-adjusted $1,100 per share. And Alcatel-Lucent (NYSE: ALU ) dropped from $80.
Just how painful was it? Ask Nobel Prize-winning psychologist Daniel Kahneman, who proved that humans are innately loss-averse, particularly when it comes to money. Losses hurt us emotionally far more than gains give us pleasure. Naturally, then, those massive declines crippled tens of thousands of investors, many of whom will -- sadly -- never throw the one-two punch of savings and investment again.
Unfortunately, we're seeing the same trend today. We had corporate malfeasance at some of our country's most respected financial institutions, and now stocks have dropped and investors are swearing off the market. It doesn't have to be that way.
Win with moderate risk
The solution is not to bail out of the market altogether, nor to seek shelter exclusively in bond funds. With the right perspective and useful tools, you can strengthen your stomach and beat the market -- because you'll do so without assuming huge risk. I know that's true because it's being done every year by the world's master investors -- from Buffett to Lynch to Tillinghast to Miller.
Those who take the biggest risks and buy what's hot today usually take the biggest hits in down markets. In the meantime, a host of methodical, smart, and contrarian investors ring up great returns, even through tough markets, by adhering to Warren Buffett's first rule of investing: Preserve capital.
Today, I want to focus on one sweet way to preserve capital and beat the market. The general principle is simple: Buy stocks that have paid uninterrupted dividends for years.
Consistency to victory
Let's investigate this idea by looking first at Procter & Gamble. P&G has paid a stable dividend since 1890. Yep, you read that correctly -- the company has paid dividends steadily for the past 119 years. Some of you may be thinking, "Boring!" But in the past 15 years, the company has returned 11.4% annually, turning a $10,000 investment into $50,000 today. And when stalwarts like this temporarily decline, owners still get the dividend payment, inspiring all of us to be patient and calm (two of the primary traits of the world's greatest investors).
Then there's Hormel Foods (NYSE: HRL ) , which has paid an uninterrupted dividend since 1928. Or McGraw-Hill (NYSE: MHP ) , which has paid a dividend since 1937. Or boring Paccar (Nasdaq: PCAR ) , which has paid a dividend since 1941. Hormel, McGraw-Hill, and Paccar have crushed the S&P 500, returning 11.5%, 11.9%, and 16.7% annually over the past 15 years. This sort of investing success is happening every day in our Motley Fool Income Investor advisory service. Using a combination of outsized yields and capital gains, the service has beaten the market since its 2003 inception.
But II isn't picking just any old high-yielders, because to outperform the market, you have to find financially strong, well-managed, undervalued companies that pay dividends. Why take a chance on Joe's Next-Generation e-Hot Dog Stand -- with its jumpy beta, battered balance sheet, and 50/50 chance of going bankrupt -- when you could invest in a stable ship that returns profits to shareholders and provides capital returns over the long term?
It's a tried-and-true formula, and if you follow it, you'll have the stomach to beat the market.
One monster income investment
Finding great dividend payers isn't as simple as merely screening for yields. If it were, everyone would have bought shares of Southern Copper (NYSE: PCU ) and its 11% yield back at the end of 2008. Alas, Southern Copper's payout is cyclical and sensitive to commodities prices, and today the dividend yield has been cut to less than 1%. As with any investment, it's crucial to scrutinize a dividend payer's financial statements, management team, and business model. Determine how the dividends are being financed, what the payout ratio is and how that might affect future growth, and the potential prospects for dividend increases.
Let's look at one of the II team's favorite monster stocks: Total (NYSE: TOT ) , recommended for subscribers in December 2003. At the time, the international energy giant was trading for $45 (split-adjusted). Using a discounted cash flow model, we pegged its fair value closer to $60. Today, even after the energy correction in the market, the stock trades at $55. Add in the yield that subscribers locked in, and that's a pick that's 47 percentage points ahead of the market.
There are loads of great dividend-paying stocks, but they're not always the market's most popular. In fact, you usually have to go digging to find them. But you can view Income Investor's favorite stocks for new money now by clicking here. There's no obligation to subscribe, and maybe -- just maybe -- we'll come through this crazy market without any massive losses.
This article was originally published as "Do You Have the Stomach to Beat the Market?" on June 10, 2005. It has been updated.
Tim Hanson does not own shares of any company mentioned in this article. Total and P&G are Income Investor selections. McGraw-Hill is an Inside Value pick. Paccar is a Stock Advisor recommendation. The Fool owns shares of P&G. No Fool is too cool for disclosure.