This Is the Secret of the Market's Best Stocks

Whether a stock pays a dividend should make absolutely no difference in whether it outperforms its peers. In reality, though, it makes a huge difference -- and you ignore it at your peril.

At first glance, you'd think that how a company earns a profit is a lot more important than what that company decides to do with its spare cash. After all, as long as a company consistently brings in strong cash flow, it has a number of attractive options to put that cash to work, whether it's to reinvest in its business, make a strategic play like a merger or acquisition, or return money to its shareholders.

But the ability to pay dividends over time requires a predictable stream of profits. That's one reason why investors have used dividends for decades as a signal that a stock has other favorable traits.

One way to think about dividends
For a company to pay a sustainable dividend, it has to earn enough money to support its dividend payments. Although a company can keep paying dividends during temporary downturns by dipping into cash reserves or getting outside financing, eventually, its earnings must recover or else it's likely it will have to cut its dividend. That's one reason why most companies pay out only a fraction of their earnings in the form of a dividend; doing so gives the company a cushion to make it through short-term earnings shortfalls.

Many companies, though, have managed their dividend payouts extremely well over long periods of time, by maintaining and increasing dividends year after year. Therefore, many investors see a long track record of rising dividends as the first and best sign of success and growth for a stock.

Yet dividends aren't quite as important as they used to be. From the viewpoint of an investor, selling shares is much less costly thanks to low-cost brokers, and thus many shareholders aren't as reliant on dividends as the only efficient way to get cash from their portfolios as they were in the past. Moreover, companies have increasingly used other methods such as repurchasing shares to return excess cash to shareholders. As a result, even successful companies like Apple (Nasdaq: AAPL  ) and Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) don't pay dividends to their shareholders.

Why dividends matter
In theory, shareholders should end up with the same amount of wealth regardless of what decision a company makes about paying a dividend -- especially those who don't need the income for current expenses. If a company pays out its earnings through dividends, then many shareholders choose simply to reinvest those dividends in additional shares. In contrast, the value of a company that simply retains its earnings should increase by the cash it doesn't spend on a dividend. Shareholders should end up in exactly the same position no matter what.

Indeed, until just a few years ago, investors had to pay a penalty for their dividend-paying stocks. Although investors traditionally have had to pay income tax on dividends as though it were regular income, capital gains have received preferential rates. Therefore, if a shareholder has a choice between receiving $1 in dividends and seeing the stock price rise by $1, tax-averse investors should prefer the stock appreciation.

But there are many reasons why shareholders prefer dividends. Dividends mean real money in investors' pockets, providing certainty that's valuable, especially during times of market turmoil. They also mark a big difference in investor perception; companies like General Electric (NYSE: GE  ) and Wells Fargo (NYSE: WFC  ) that cut dividends earlier this year are seen as far riskier than they were in past years, while those like PepsiCo (NYSE: PEP  ) and Chevron (NYSE: CVX  ) , which have raised dividends, inspire confidence. In addition, tax-deferred accounts like IRAs make the tax implications of dividends unimportant for many investors.

How dividend stocks do
The most important aspect of dividend stocks is that they tend to outperform the overall stock market with somewhat less risk. Unlike sexier growth stocks, many dividend payers are mature companies in low-growth industries. While their days of fastest growth may be behind them, the cash they produce promises good returns over the long haul.

That outperformance shows that even aggressive investors, who might ordinarily ignore dividend-paying stocks as being too boring, should look to dividends to help them make smarter investment decisions. Although there's more than one way to make money in the market, stocks that pay dividends are the best way for those who prefer a bird in hand to count their investment gains quarter after quarter.

Not all dividend plays make smart investments. Todd Wenning has a warning you need to read now about one investment you should avoid.

When it comes to helping people with their money, Fool contributor Dan Caplinger has never been able to keep a secret. He owns shares of Berkshire Hathaway and General Electric. Apple and Berkshire Hathaway are Motley Fool Stock Advisor picks. PepsiCo is an Income Investor pick. The Fool owns shares of Berkshire Hathaway, which is an Inside Value recommendation. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy reveals all secrets.


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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 September 16, 2009, at 10:13 AM, DaveMoody2 wrote:

    The Dow Jones Industrial highest dividend stocks top 30, shows you exactly what the currect top 3 highest dividend yielding Dow stocks are:

    AT&T, Verizon and Dupont.

    http://www.TopYields.nl/Top_dividend_yields_of_DOW30.php

  • Report this Comment On September 16, 2009, at 11:33 AM, Dbraem wrote:

    The problem with dividend policies are they are completely backwards. You mentioned Berkshire Hathaway hasn't paid a dividend - it is important to note their philosophy. Basically, they will pay a dividend if they cannot invest the cash at a higher rate than shareholders. Since Buffett is a world class investor, that explains why they haven't paid a dividend.

    Beyond that, company's tend to pay a fixed or increasing dividend. The thought process is backwards. Companies should be paying all excess cash that doesn't:

    1) put the balance sheet below a strong position

    2) cash that can't be reinvested.

    I cover this in my book - "Building the Next Berkshire Hathaway". Unfortunately, many common business practices today defy common sense and logic.

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