Only an Idiot Would Buy This Stock

Don't worry -- I'm not calling you an idiot. I'm just being emphatic in case you know someone who is.

Heard of the serial position effect? It's what causes us to have a better memory for the first and last items in a list, and makes the initial and end-round job interviewees to be more likely to score the position.

It also leads us, as fellow investors, to assume that risky bets that have worked out well will continue to do so. Speculation is one thing, but do you really want to invest your retirement cash into risky names like Citigroup (NYSE: C  ) , Bank of America (NYSE: BAC  ) , and Wells Fargo (NYSE: WFC  ) ?

Pocket an instant 11% advantage!
As a former hedge fund analyst and current advisor to the dividend-focused Motley Fool Income Investor newsletter, I have different take on the markets than most. Most investors focus on growth, glamour, and glitz -- and whatever's done well. In doing this, they pass up a big advantage -- but I'll tell you about it right now.

Let's turn to a famous study by an academic trio: Lakonishok, Schleifer, and Vishny -- we'll call them "LSV" for short. Their 1994 study divided stocks into deciles according to earnings yield (upside-down P/E ratios) and historical sales growth. In analyzing the period from 1968-1994, LSV found three statistical tendencies that you can exploit in your own investing.

The 4% Edge: LSV found that "value" stocks with low P/E ratios beat "glamour" stocks with high P/E ratios by four percentage points per year.

The 7.3% Edge: LSV also found that stocks with low sales growth outperformed high-growth stocks by 7.3 percentage points annually!

The 11% Edge: Most importantly, LSV found that if you combined low P/E with low sales growth -- terrible as that sounds -- you'd beat high-P/E high-growth stocks by 11 percentage points annually!

And regarding the stocks above, LSV would probably point out the obvious point: The best to time buy them was before they rallied -- back when they were unloved -- and not after. Duh.

The LSV "formula" is a great starting point -- one that's more useful to most investors than buying what's in the news (another unfortunate, and academically studied, bias). In the field of dividends, specifically -- my specialty, and a style of investing poised to do well in the coming year, according to The Wall Street Journal -- a few more pointers help point your portfolio from pain to no-brain gains.

Now, I'd like to share what you need to get started finding dividend-paying winners -- lessons drawn from what I've learned from working in investing over the years.

5 pathways to idiot-proof returns

  1. A dividend: Studies show that dividend stocks beat those that don't pay dividends, but you don't need a study to point out that dividends require cash -- a surefire indicator of financial health.
  2. Long-term management: We'd all like to make a quick buck, corporate managers included. But identifying management teams with ample experience (especially at their current company) and ownership stakes in their company puts a layer of protection between you and the fly-by-nights.
  3. No. 1 or No. 2 market share: Sure, you can make good money by betting on the inferior underdog, but that's hardly idiot-proof. A better way for most investors is to look for market leaders -- and sleep at night.
  4. A competitive advantage: Remember the kid who tried to cheat over your shoulder in grade school? Well, he grew up and entered the business world. Companies with defensible niches are less vulnerable to being cheated off of.
  5. An attractive valuation: One of the best safety measures is simply buying stocks at attractive prices, as LSV demonstrated well. But while a simple P/E metric is fine for studies based on thousands of stocks, it's loose enough to burn you on any given company. To compensate, I create a discounted cash flow model for a company that warrants my inspection.

These are all things I look for when choosing recommendations for my Motley Fool Income Investor service -- which is beating the S&P 500 by over 7 percentage points. Some of the service's investments using the five criteria above include Coca-Cola (NYSE: KO  ) , PepsiCo (NYSE: PEP  ) , and Procter & Gamble (NYSE: PG  ) .

If you'd like to get started with some stocks that meet at least a few of these criteria (valuation aside), see the table below:

Company

Reason for Inclusion

eBay (NYSE: EBAY  )

Competitive advantage in online auctions

McDonald's (NYSE: MCD  )

No. 1 market share

Your next step
If you'd like to take the next step -- valuations included -- it's on me. I'll give you a free 30-day guest pass to my service, because I'd like you to have access to my investment recommendations. Click here to access your guest pass.

James Early owns shares of PepsiCo. As mentioned, Coca-Cola, Pepsi, and Procter & Gamble are Income Investor recommendations. The Motley Fool has a disclosure policy. No idiots were harmed in the creation of this article.


Read/Post Comments (6) | Recommend This Article (20)

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 17, 2009, at 4:05 PM, withOpenMind wrote:

    This sounds very much like a self-promotor!

  • Report this Comment On December 17, 2009, at 4:06 PM, megabuc wrote:

    CITIBANK IS THE JOKE ON THE STREET. THEY THINK THE FED WILL LET THEM OFF THE TARP HOOK SO THEY CAN BIG PAY the clowns that they have. SORRY!!!!! Citibank has THREE BAIL OUTS they trick paid one TWO ARE LEFT. THE FED SHOULD FURTHER REDUCE CITIBANKERS PAY NOT UP IT. CITIBANK WILL CLOSE.....

  • Report this Comment On December 17, 2009, at 4:20 PM, danteps wrote:

    I thought this brief missive was interesting; not sure about the 2 equities in the table. I am glad they meet some of the criteria. Perhaps the most important is valuation, since the LSV study results highlighted were based on P/E ratios (earnings yield).

    The caveat "valuation aside" is misleading. I am usually not a very critical person, but I would be embarrassed if I penned this brief article.

  • Report this Comment On December 17, 2009, at 6:09 PM, sandiner0 wrote:

    NYSE highest dividend yielding stocks top 100 (including P/E values):

    http://www.TopYields.nl/Top-dividend-yields-of-NYSE.php

  • Report this Comment On December 17, 2009, at 8:04 PM, Fool wrote:

    Major correction back to 6000 Dow

  • Report this Comment On December 20, 2009, at 4:46 PM, tbossert wrote:

    When it comes to price Wal-Mart can not be out price on most products

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