Why Smart Investors Buy Dividend Stocks

Let's get a few things straight.

Dividend stocks are not cool. They are not exciting. And they do not make for good conversation topics at parties. They're like the trombone player from high school who never had a date to prom.

In fact, come to think of it, the only thing dividend stocks are good for is making money. And potentially lots of it. So if you're not interested in making money, then proceed no further. There's nothing glamorous to see here. But if you clicked on this article because you're greedy and want to get rich from investing, like most of us here at The Motley Fool, then read on.

The unsung virtue of dividends
If you take only two things away from this article, make it these principles.

First, stocks that pay higher dividends have historically outperformed stocks that pay lower dividends. As Fool analyst Morgan Housel has noted, $1,000 invested in the S&P 500 in 1957 was worth $176,000 by 2006. The same $1,000 invested in the top 10 S&P companies with the highest dividend yields (more on this below) was worth $1.3 million.

Second, companies that pay more in dividends typically tend to experience higher earnings growth in the future. A study by researchers Rob Arnott and Cliff Asness divided stocks into 10 groups by dividend yield and found that the highest-yielding 10% had the highest earnings growth over the next decade. In this interview, Wharton professor Jeremy Siegel implied this was because high dividends encourage company executives to focus on profitability as opposed to imprudent acquisitions and share buybacks.

But here's the really interesting thing: While corporate cash flows are at or near record levels, the companies making up the S&P 500 are paying out less in dividends than ever before. For most of the 20th century, companies paid out the majority of their earnings as dividends. But this began to change in the 1960s, as the dividend payout ratio -- the percentage of net income paid out as dividends -- slid from more than 60% to around 50%. As of the end of last year, it was down to 29%, leaving most shareholders as unwitting victims of the lower-payout trend.

Knowing and using the dividend yield
While the knowledge that dividend-paying stocks generally outperform their non-dividend-paying brethren is important, it's nevertheless only half the battle. You still have to know which dividend stocks are worthy of your capital. And this is where the dividend yield enters the equation -- literally and figuratively.

The dividend yield is a ratio that shows how much a company pays out in dividends relative to its share price. It's calculated by dividing the annual dividends paid per share by the price per share. Let's take pharmaceutical giant Johnson & Johnson's (NYSE: JNJ  ) stock as an example. Its share price is $65.22, and over the past year, it paid out $2.28 in dividends per share. Therefore, its dividend yield is 3.5% ($2.28 divided by $65.22).

Or how about consumer products giant Procter & Gamble (NYSE: PG  ) ? With the stock at $64.98 and $2.10 paid in dividends, its dividend yield is 3.2% ($2.10 divided by $64.98). I used these companies because both are textbook examples of core dividend stocks; their businesses are globally diversified and have earnings streams that are ample and consistent.

In addition to communicating expected return, moreover, the great thing about a dividend yield is that it also communicates risk. While dividend stocks in general are typically less risky than non-dividend-paying stocks, among dividend stocks, it's fair to start with the idea that one with an ultra-high dividend yield is riskier than one with a more reasonable yield.

A textbook example of this is provided by the mortgage real estate investment trusts Annaly Capital Management (NYSE: NLY  ) and Chimera Investment (NYSE: CIM  ) . While the companies are related -- Chimera is managed by an Annaly subsidiary -- the former invests largely in riskless assets that are guaranteed by the federal government, whereas the latter invests in non-guaranteed securities. By that standard, that makes Chimera patently riskier than Annaly even though Chimera uses less leverage. And as a result, it shouldn't be any surprise that Chimera's dividend yield of 15% is higher than Annaly's 13.9%.

You could even take this one step further, in turn, and argue that both Annaly and Chimera are significantly riskier than Johnson & Johnson and Procter & Gamble. But sometimes, comparing yields across industries can be misleading, so be careful.

I like to think of dividend yields much like how Goldilocks thought of porridge. On the one hand, a yield that's too high exposes you to too much risk. And on the other hand, one that's too low doesn't expose you to enough, thereby handicapping your return. Consequently, what you want is one that's just right -- say a point or two above the broader market average. What I like to use in this regard is the SPDR S&P Dividend ETF (NYSE: SDY  ) , an exchange-traded fund that tracks the performance of the S&P 500 Dividend Aristocrats Index, a group of stocks that have increased their dividend payments for at least the last 25 years. At present, it yields 3.2%.

Looking for a dividend stock that beats this?
Of course, finding a stock with a dividend yield that both beats this benchmark and allows you to sleep soundly at night is easier said than done. It's for this reason, in turn, that our analysts drafted a free report about 11 rock-solid dividend stocks that the smartest investors are using to pad their pockets on a quarterly basis. It includes a number of reliable stalwarts, as well as one high-yielding telecom that is much more secure than its monster yield would otherwise lead one to believe. To learn the identity of this company, as well as the other 10, click here now -- it's free.

Fool contributor John Maxfield does not have a financial position in any of the securities mentioned above. Motley Fool newsletter services have recommended buying shares of Johnson & Johnson and Procter & Gamble. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (35) | Recommend This Article (118)

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 January 27, 2012, at 12:06 PM, reddingrunner wrote:

    If dividends are really this important (they are), then doesn't that mean that MF Caps is badly flawed?

  • Report this Comment On January 27, 2012, at 3:01 PM, Hawmps wrote:

    1) ^ Dividends are accounted for in CAPS.

    2) what do you got against a dude and his trombone?

  • Report this Comment On January 27, 2012, at 3:20 PM, JohnMaxfield37 wrote:

    Hawmps -

    I didn't mean anything bad about a dude and his trombone. Prior to edit, it was followed with a clause about how that dude now works for Google. The implication being . . . while dividends may appear boring, they turn out to be pretty lucrative.

    - John

  • Report this Comment On January 28, 2012, at 2:05 PM, twobeerjohn wrote:

    I am 52 years old, and have been investing in dividend stocks since I was 12. 40 years of investing, and now my dividends are in excess of $93,000 this year. And, they are taxed at the 15% tax rate. Also, while the market has been bad since about 1999, I have made substantial gains by reinvesting the dividends at the lower prices. This is how true wealth is created, I think?

  • Report this Comment On January 28, 2012, at 2:15 PM, twobeerjohn wrote:

    ps, I play the saxophone.

  • Report this Comment On January 28, 2012, at 2:36 PM, MoreIsNotEnough wrote:

    "I am 52 years old, and have been investing in dividend stocks since I was 12. 40 years of investing, and now my dividends are in excess of $93,000 this year. And, they are taxed at the 15% tax rate."

    Never mind that you worked hard, invested your money, and took risks, instead of spending every penny you made. That makes you a greedy, scourge of the earth, one percent-er, upper class, capitalist, and enemy of the state, the new world order, and all mankind, who is guilty of sucking up all the money, and paying a lower tax rate than a fireman. ;-)

  • Report this Comment On January 28, 2012, at 3:01 PM, HarryCarysGhost wrote:

    I think the full value of dividends is when you reinvest said dividends

    (I did'nt see that mentioned in the article, if I missed it AIA)

    Building wealth through coumpound interest is so booooring, and totally awesome!

    Disclaimer- I play the drums.

  • Report this Comment On January 28, 2012, at 3:08 PM, JohnMaxfield37 wrote:

    HarryCarysGhost -

    You are correct about reinvestment -- it was an implicit assumption. Probably should have made it explicit.

    We now have a saxophone player and a drummer. Getting close to a full band.

    - John

  • Report this Comment On January 28, 2012, at 3:20 PM, MoreIsNotEnough wrote:

    I play guitar.

    I've stopped DRIPs for the most part.

    I was becoming too top heavy in certain holdings, and in other cases, I found that I could do better by choosing the time to reinvest. But it all eventually gets invested somewhere.

  • Report this Comment On January 28, 2012, at 3:36 PM, twobeerjohn wrote:

    I didn't think to mention that I have been working since 11 years old. Didn't think it was important, but I have earned every penny I've got. No handouts here. Also, worked very hard to develop an investment system that works for me. I also buy more shares on dips when they happen, but if you listen closely, since 1999 has been a dip, so it's all been good. lol I want to be in the 1 %. I'm not jealous of them. I also learned a long time ago, NOBODY gets the chicks like the sax palyer, NOBODY!!!!

  • Report this Comment On January 28, 2012, at 3:42 PM, JohnMaxfield37 wrote:

    truthisntstupid -

    Thanks for the link. If any of you all were wondering how CAPS accounts for dividends, check it out.

    - John

  • Report this Comment On January 28, 2012, at 3:47 PM, JohnMaxfield37 wrote:

    MoreisNotEnough -

    I typically don't use DRIPs either - choosing likewise to reinvest myself.

    We now have guitar, and sax.

    - John

  • Report this Comment On January 28, 2012, at 3:48 PM, JohnMaxfield37 wrote:

    and drums...

  • Report this Comment On January 28, 2012, at 4:24 PM, rd80 wrote:

    "increased their dividend payments"

    A key point. Most know about the power of compounding. But, reinvesting dividends in a company that also grows the dividend serves up a double helping of compounding. Once from reinvesting and second shot from the growing dividend.

    I don't play any instruments, but I'll be happy to listen to the band. :)

    Fool on!

    Russ

  • Report this Comment On January 28, 2012, at 8:41 PM, saximan1 wrote:

    I've been a professional musician for 22 years. I play saxophones, clarinet, flute, and electric bass professionally. I make enough dividend income to work only part time and spend the rest of my time managing my portfolio. I reinvest over 1/2 my dividend income, then use the rest to supplement my income. I am a musician, you know!

  • Report this Comment On January 30, 2012, at 6:29 AM, jcblighthouse wrote:

    Hi Guys,

    I Have just finished reading Aftershock and it appears we are all doomed unless we sell all our stocks and buy gold

    I would appreciate your comments

  • Report this Comment On February 02, 2012, at 8:44 PM, accordionist wrote:

    I'm 59 and been investing since I was 25. I will NOT have a pension when I retire so what I have at that point in my retirement accounts is it. I never thought for 1 second that trying to build wealth so that I don't have to depend on anyone else including the government is considered greed. Please don't use use that "progressive" class warfare crap in your newsletters.

  • Report this Comment On February 03, 2012, at 11:08 AM, Canuck2010 wrote:

    Just a note for the Canadian Fools out there (which seem to be about 10% of the Fools readership): US Dividend stocks are not quite the deal that they are for our southern neighbours. If you hold these in your RRSP or TFSA, the dividends are still subject to a 15% US withholding tax. If you hold them in a cash account, US dividends are taxed at the full marginal tax rate in Canada (~43% but varying depending on your income level and province) although you will get a credit for any US taxes withheld. You are much better to go for capital gains which are taxed at half your marginal rate or for Canadian dividend bearing stocks which get preferential tax treatment. (No I'm not a tax professional--I just got bit on this one quite badly a couple of years ago).

  • Report this Comment On February 03, 2012, at 12:28 PM, bruguera wrote:

    Pardon my ignorance, but let's say I invested $50,000 in JNJ in February 2005. Taking into account the dividend earnings, how much would I have earned up to the present?

  • Report this Comment On February 03, 2012, at 12:40 PM, obga18 wrote:

    I love how everyone gets sensitive at stereo types, they are stereo types for a reason. They are typically right, Hold on a lady just cut me off while I was driving..

    This article is about making money, and lots of it. Keep fooling on friends

  • Report this Comment On February 03, 2012, at 12:47 PM, CromulentBrad wrote:

    I love DRIP, the prettiest acronym I know. If a stock is worth owning, it's worth owning more of.

    DRIP also saves me from paying broker fees.

  • Report this Comment On February 03, 2012, at 1:42 PM, gregnfc wrote:

    No mention of MLPs in this article - a nice balance to dividend stocks, of you can deal with the K1 accounting.

    And I play keyboards and Bass AND have a pro studio! Lets put on a show!!!

  • Report this Comment On February 03, 2012, at 1:56 PM, JohnBallow wrote:

    All dividends are not created equal...It's about the Dividend Quality!

    Cash flow coverage of the dividend paid is more relevant than dividend payout. Traditional dividend analysis focuses on dividend payout from net income, but the focus really should be on the cash flow coverage of dividends in order to determine their quality and sustainability. The question should be – are dividends being paid from operating, investing and issuance cash flows?, or is the beginning cash balance needed to make this payment? See our full assessment at http://www.analytixinsight.com/index.php/all-dividends-are-n...

  • Report this Comment On February 03, 2012, at 4:29 PM, WineHouse wrote:

    So long as you don't need the income, it's true that dividend reinvestment is smart.

    However, imagine that you're now retired and you are relying on your assets to supplement your Social Security and pensions. You're worried that, over time, inflation will eat away your purchasing power (and worse, rampant inflation will suppress the market value of your shares), and if you keep selling your stock shares to raise $$ you will have fewer shares, so ... what's a person to do?

    Ta-Da! Invest in companies that not only pay dividends but also increase those dividends each year. You can draw out that lovely dividend income and see two things happen: one, each year the dividends increase, so you're keeping up with inflation without having to sell any of your shares; and two, your stocks (on average) won't go down as much during rampant inflation as the typical non-dividend-producing stocks.

    How's that for a good outcome?

    Of course, during retirement you'll need to stick primarily with companies that not only increase their dividends through thick and thin, but that are involved in businesses that do okay during rampant inflation; i.e., companies that sell goods and services that are more like "necessities" and less like "luxuries." Such companies can increase their prices in pace with inflation, thus maintaining their profits and -- importantly -- maintaining their ability to pay and grow dividends. That means you should also make sure that your companies have substantial market shares (the big guys survive better under these circumstances). Examples that come to mind include (but are not limited to): Kimberly-Clark, Kraft, General Mills, Kellogg, Coca-Cola, Pepsi Cola, Verizon, AT&T, Proctore&Gamble, Colgate-Palmolive, and non-US mega-internationals like Unilever, Reckitt-Benkiser, Diageo, Vodaphone, etc.

    You can get a list of US Dividend Aristocrats at the S&P website. Finding the internationals might require a bit more sleuthing but definitely worth the trouble.

  • Report this Comment On February 03, 2012, at 4:38 PM, Hawmps wrote:

    On January 28, 2012, at 3:01 PM, HarryCarysGhost wrote:

    I think the full value of dividends is when you reinvest said dividends { <- excellent point, agreed}

    (I did'nt see that mentioned in the article, if I missed it AIA)

    Building wealth through coumpound interest is so booooring, and totally awesome! { <- I disagree on the booooring part, I get pretty excited when the divys get dropped into my account}

    Disclaimer- I play the drums. { <- awesome, me too, I may have to blog on that}

  • Report this Comment On February 03, 2012, at 4:48 PM, Hawmps wrote:

    So we got two drummers, guitar, bass, sax, keys, and a studio... sweet.

    DRIPs are great, but I only do that for JNJ and GE. Everything else (like CIM, WM, PSEC, and other dividned holdings) accumulates pennies from heaven until I start feeling really Foolish.

  • Report this Comment On February 03, 2012, at 6:40 PM, plankton97 wrote:

    @bruguera - according to Yahoo finance, you would now have $60,834, assuming you reinvest your divvys. JNJ closed at $65.60 on 2/1/2005 (I see what you did there), essentially flat from today's price, which actually serves to illustrate the power of divvys.

    A better illustration -- had you invested $39K ($50K in 2005 dollars) in JNJ on 4/3/95 at (surprise!) $65.00 per share, you would now have 3,388 shares worth $222,411 and you would be collecting $7,724 per year in divvys.

    Take it back another decade -- if you invested $28K (again, equivalent to $50K in 2005 dollars) at (surprise again!) $65.87 on 4/1/86, you would now have 11,618 shares worth $762,622 paying you $26,489 per year in divvys. That’s only 25 years of investing, and all that was required was to leave it alone...

    A fun exercise – take a look at 5/2/77, JNJ was trading at, you guessed it, $65 per share. How much would you have today if you had invested $15,500?

    (Of course, if your account wasn't tax-sheltered, you end up with a lot less…)

  • Report this Comment On February 03, 2012, at 7:07 PM, golferboy101 wrote:

    Best comment I heard - "Leave it alone" How true. Guitar players rock, especially when they can sing. When's the next (first)gig?

  • Report this Comment On February 03, 2012, at 9:15 PM, Darwood11 wrote:

    @Canuck2010

    I can state that getting dividends in Canadian companies isn't all that good for those of us in the US.

    The Canadians take their 15% tax off the top, then I get to give the US it's 15% share with what's left.

    Basically, a 27.75% contribution to two governments, on my part.

  • Report this Comment On February 04, 2012, at 11:31 PM, Dizzy28 wrote:

    If you want more "excitement," combine dividend investing with a GARP strategy. Clay King has written extensively on this, you pick up some crazy good companies on the cheap, let the div accumulate to cash, and then buy growth at a cheap price. There were tons of industrials, especially in Europe that were available at firesale prices back in August. Siemens, Disney, and Dover were fantastic pickups back then. These companies all had enourmous moats and swimming in cash but were crazy cheap and have risen since. Even if they had not risen, you could just sit there and collect the dividend. IGARP is the best of both worlds.

  • Report this Comment On February 05, 2012, at 2:29 PM, visian2002 wrote:

    I am a guitar picker. And the stock that I picked was BAC. Price in Oct 5.60 and again Nov at 5.10

    averaging 5.35 . Gain to date - - 46%. Probably hold til it hits 15.35. I maybe the Biggest Fool of All.

  • Report this Comment On February 05, 2012, at 11:29 PM, sutah wrote:

    FYI, Sure Canada take out 15% tax on dividends, non IRA accounts, but you get to take the CA taxes you pay as a tax credit on your US taxes so the real tax you pay is the 15% only to CA not USA. I've collected thousands in CA oil royalty dividends over the years, retired at 58 with the appreciation and income. Wish more would learn about dividend investing at a young age.

  • Report this Comment On February 06, 2012, at 3:43 PM, ziq wrote:

    @MoreIsNotEnough: Nothing wrong with taking risks and getting rich--or not (else they wouldn't be risks, would they?) But if you think your riches entitle you to buy access to government others don't have, then you have a quarrel with me. Stop pretending it's all about class envy.

  • Report this Comment On February 06, 2012, at 3:55 PM, Hawmps wrote:

    John-

    I was just kidding about the trombone bit... I'm a drummer.

  • Report this Comment On February 06, 2012, at 8:27 PM, SteveMD123 wrote:

    Visian2002, You should be glad you didn't buy BAC in 2006-2007 when BAC was over $50 per share. Or even 2004-2006 when it was in the $40s. I lost close to 70% by the time I got out at $13.25 in 2010. Taxpayer subsidized firms are on my list of companies to never invest in. I had Fannie Mae years ago also, and got our well before that crash and only lost ~20-25%. Firms in Communist China are on that list also. Just like FNM, one can never trust the numbers coming from Chinese firms. Income manipulation, to this day remains my biggest fear in investing in stocks. I can't tell you how many companies I've invested hard earned money into, just to find out in a month or two that the earnings need to be "recalculated". That's another word for hearing that "I lost and it's way too late to get my money back"

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