A Strategy to Beat Dividend Stocks

For years, investors have looked to dividend stocks as a great all-purpose investment. Not only do dividend stocks provide you with the income many people need to cover living expenses, they also often provide some downside protection when markets start to decline.

But just because dividend stocks have favorable characteristics doesn't mean that they're always your best bet. In particular, when you expect the market to rebound sharply, sticking with dividend stocks -- especially in defensively positioned industries -- can lead to subpar returns.

Looking back at the "junk stock" phenomenon
In 2009, during the depths of the financial crisis, the stock market seemed to be in serious trouble. Many companies were on the verge of failure, as tight credit conditions made it nearly impossible for cash-poor businesses to get the financing they needed. As a result, investors gravitated toward companies in better financial shape, with cash reserves to survive however long the crisis might last. Many of those safer companies were dividend stocks, with business models that not only produced enough cash to finance ongoing operations but also left enough additional money to make dividend distributions to shareholders.

But when the stock market turned around and started to recover, these safer stocks weren't the big winners. Many analysts complained that the companies that rebounded the most strongly were those that arguably deserved it the least: so-called "junk stocks" that had extremely high risks of bankruptcy. Ford (NYSE: F  ) , Freeport-McMoRan (NYSE: FCX  ) , and Las Vegas Sands (NYSE: LVS  ) had all seen major disruptions to their businesses -- with Ford suffering from weak demand that eventually forced its fellow American competitors into Chapter 11, Las Vegas Sands teetering under huge amounts of hard-to-refinance debt, and Freeport dealing with commodity prices that plunged during the market meltdown. Yet they were among the top-returning stocks of 2009, leaving their safer counterparts in the dust.

Recent history
You can see the same phenomenon in the big run-up that stocks enjoyed between last October and the end of April. The S&P High Yield Dividend Index posted strong gains during that period, but it nevertheless underperformed the overall S&P 500, and it greatly underperformed more aggressive measures like the small-cap Russell 2000.

Specific stocks show this even more clearly. Johnson & Johnson (NYSE: JNJ  ) barely budged during the summer plunge last year that lopped off more than 20% from the S&P 500, but it has also stayed close to flat during the ensuing recovery, and its core businesses have remained relatively stable throughout the period. Procter & Gamble (NYSE: PG  ) was a bit more volatile as it had to deal with rising costs for raw materials, but it too has been steadier -- and less lucrative -- during the bounce.

Could it happen again?
Of course, it's far too early to start talking about whether the current correction will eventually get anywhere near as bad as the 2008-'09 bear market was. After all, the S&P 500 is still up for the year so far, and while analysts are as always divided about the most likely direction for the market to move in the near future, it's entirely possible that stocks have already seen their worst levels and will rise from here.

But regardless of when stocks bottom out, the thing you should remember is that if you want to maximize your gains in the next big bull market run, the same dividend stocks that protected your portfolio from the worst losses are also quite likely to prevent you from earning the biggest profits.

Consider your objective
To make the best investments, you have to know your objective. If you're ambitious and are willing to trade in and out of stocks to capture the best returns possible from any market environment, dividend stocks could hold back your results during major bull markets. But if you want to buy and hold stocks for the long haul rather than trading in and out of stocks, then the risk-reward profile of dividend stocks may be exactly what you're looking for.

If you're in that last group of investors, let me invite you to take a look at The Motley Fool's special report on dividend stocks. Inside, you'll find the names of nine dividend dynamos with big potential. It's free, so click here and get your copy today!

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.

Fool contributor Dan Caplinger knows that knowledge pays dividends. He doesn't shares of the companies mentioned in this article. The Motley Fool owns shares of Freeport-McMoRan Copper & Gold, Johnson & Johnson, and Ford. Motley Fool newsletter services have recommended buying shares of Johnson & Johnson, Ford, and Procter & Gamble, as well as creating a synthetic long position in Ford and a diagonal call position in Johnson & Johnson. 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 Fool's disclosure policy is always your best bet.


Read/Post Comments (18) | Recommend This Article (22)

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 June 06, 2012, at 10:11 AM, pondee619 wrote:

    "A Strategy to Beat Dividend Stocks". Where is that strategy? Was it written somewhere in the article?

  • Report this Comment On June 06, 2012, at 11:48 AM, TMFGalagan wrote:

    @pondee619 -

    To clarify: consider higher-risk, more volatile stocks that don't necessarily pay dividends. They may perform badly in down markets, but they often outperform in rising ones.

    best,

    dan (TMF Galagan)

  • Report this Comment On June 06, 2012, at 12:28 PM, cp757 wrote:

    Dan to your point. If you invested in the market at the bottom, 40 months ago LVS sold for 1.38 cents a share . That means if you had $13,800 dollars at the bottom of the crash on 03/09/2009 and you bought 10,000 shares you would now have $468,000 dollars on 06/06/2012. With 10,000 shares you would be paid $10,000 dollars on your dividend every year for the rest of you life and that will go up in the future. That's a 72% return of the money you invested 40 months earlier, just on the dividend, and over a 3,000% increase in your stock price. Next year they will increase the dividend because they will have over 6 billion in free cash flow. No other stock did that .

  • Report this Comment On June 06, 2012, at 1:15 PM, whyaduck1128 wrote:

    Hold conservative, dividend-paying stocks when things are going down; buy high-upside stocks when things are going up. We needed an article to tell us this?

  • Report this Comment On June 06, 2012, at 1:44 PM, davaidesign wrote:

    This of course assumes you can tell when the market is going up/down, which is market timing and is impossible. Why not just write another article about how the DOW is doing today? That's just as important.

  • Report this Comment On June 06, 2012, at 2:15 PM, sheldonross wrote:

    Disclaimer: I haven't looked too far into this.

    But, it seems to me earnings and revenues have still increased at most of the blue chips (JNJ,PG) etc. Now if there stock performance since then has been relatively flat, what that tells me, is that they are a better value now then at the start of these rallies.

    Especially since hindsight is 20/20. This article seems to be pointing towards trying to get on the train after it's already left the station.

    So where should I put my money today, the stock that's price increase has mirrored it's earnings growth, or the stock that has stayed flat with earnings growth?

  • Report this Comment On June 06, 2012, at 2:47 PM, pondee619 wrote:

    Dan:

    So the "strategy" is to "consider higher-risk, more volatile stocks that don't necessarily pay dividends." That's "A Strategy to Beat Dividend Stocks"?

    Whyaduck and davaidesign have it right.

    I was looking for a strategy, a plan, that could be executed, and just got Cramer's "are you diversified". Thank lots

  • Report this Comment On June 06, 2012, at 4:58 PM, TMFGalagan wrote:

    @whyaduck1128 -

    Some investors who've turned to dividend stocks as a defensive play may indeed not realize that they don't perform as well as other stocks during bull markets. As the story points out, many people were downright shocked when low-dividend, high-risk stocks outperformed safer dividend-payers in 2009. What seems simple to you may not be so obvious to others.

    best,

    dan (TMF Galagan)

  • Report this Comment On June 06, 2012, at 5:00 PM, TMFGalagan wrote:

    @davaidesign -

    That's why I point out at the end that if you're not into trying to time the market, dividend stocks can be a good buy-and-hold solution. But if you *do* want to try to take a more active role with investments -- and many people do try, whether or not it's advisable -- then you should consider both the pros *and* the cons of dividend stock investing.

    best,

    dan (TMF Galagan)

  • Report this Comment On June 06, 2012, at 7:34 PM, davaidesign wrote:

    C'mon Dan! No need to Febreze that stinker!

    You can call it whatever you want, whether it's "take a more active role with investments" or "trade in and out of stocks to capture the best returns possible from any market environment", the bottom line is it's day trading and/or market timing, or better yet, gambling.

    It's easy to point to a specific time period in the past and call it a bull/bear market, but if you are trying to say that anyone could do it in the present or even future, then you should give me a call about an exclusive investment opportunity in a big red metal bridge out here in the Bay Area. I also have a copy of ZippyTrade 2000 you can borrow to really "capture the best returns possible".

    If I could tell that I'm going to be riding a bull market for the next 6 months, I'd sell everything I have, leverage up 100 times, and buy into the S&P 500. It's crazy, but not too far off from what you're proposing.

    I don't mean to take swings at you Dan, but it just seems to me like the Fool is losing its ways (long term investing in companies based on earnings potential, yada yada yada), otherwise how would you explain stuff like...

    "Dow to Rise, Fueled by Hope"

    "What Investors Should Watch for Today"

    "Why the Dow's Finally Soaring"

    "Finally, the Dow Gets a European Lift"

    "Why the Dow Is Skyrocketing"

    "Here We Go Again: The Dow Is Diving!"

    "The Dow Erupts on Quantitative Easing Rumors"

    "The Dow's Biggest Day of the Year"

    ... and this is all from today! Something tells me content volume is being prioritized over content value, or Fool is becoming the day trader's destination of choice. I sincerely hope your next article caters less to the Yahoo message boards crowd and gives us some of that awesome investment insight we know you can deliver.

  • Report this Comment On June 07, 2012, at 9:17 AM, Darwood11 wrote:

    On reading the article and comments, I have the urge to ruminate. I've seen articles recently that imply that at this time, stocks might be better than bonds.

    This article is not one of them, but bear with me.

    All stocks entail risks, and generally higher risks than bonds. However, today, that might not be true. Or it might be true. Macro events can't be ignored for the short term.

    Everything I have read supports the statement that "stocks do well over the long haul." However, that long haul may be 50 years. In the short term, stocks may be dangerous.

    The old "buy low and sell high" sounds easy. Getting their is not.

    Within the "stock universe" there are stocks that do very well for a short time and then "flame out." Others do well for long periods of time.

    Others do well, only to be overcome by macro events, internal failures, or whatever, and their crippled companies exist for a time or vanish.

    The annals of stock buying are littered with the remains of companies that did very, very well for 5, 10 or even 15 years and then died.

    A real world example; had I purchased 5000 shares of NFLX at $25 in 2008 and sold near the peak at $275, I would have realized a gain of more than $1,000,000. On the other hand, had i purchased in the first half of 2011 I would have realized a loss. Will it recover? Who knows? Macro events that could hurt the stock include new technologies, fees on bandwidth, or better competitors.

    JNJ was mentioned in the article, it is a stock I own. The company has had some serious recall issues. That's hurt the stock price. Looking at its business, I review management, patents and potential patent loss, etc. However, with reinvested dividends I've done all right with the stock.

    My "high flyers" in include other classes of investments, including commodities and Yes, some gold. I've obviously got a portfolio of growth stocks and value stocks and small and mid-caps.

    I also own some NFLX, but I sold most of my investment as it was rising in Q2, 2011 for a nice gain. However, if I look at the current price versus what I paid for it, it represents my largest percentage of loss in a holding in my portfolio. That's not quite true, because I sold such a large amount to ensure a gain. So my investment in Netflix is a What I'm holding today is my "gamble" that the company can perform.

    I've been investing for about 25 years. The first 15 years were pretty wild. I frankly did not have any idea what I was doing. I made money sometimes. The Dot-Com bubble was great and like the housing bubble, just about anything worked. Then it blew up. I realized I was clueless.

    I'm still learning, but I also must say I have learned to listen with a discriminating ear to all of the advice. And I avoid MSNBC and the likes of Cramer. Investing is not entertainment. Some readers come to the Fool for entertainment. Well, I suppose there is entertainment value here, but that's the window dressing.

  • Report this Comment On June 08, 2012, at 5:46 PM, TMFGalagan wrote:

    Aw c'mon, @davaidesign! I'm no day-trader! :)

    Seriously, we all make judgments about which parts of the market offer the best opportunities at any given time. Sometimes, dividend stocks are the best bet. Other times, though, I'd argue they're not -- EVEN from a long-term perspective. To me, it's simple: if you get into the right stocks at the wrong time, and you won't get the best returns. I'm not professing perfect foresight in getting that call right, but it's one I try to make every time I invest.

    As for the Dow articles, you'll almost always find a long-term perspective within them that's sorely lacking from similar articles from other sources. That's one way we try to distinguish ourselves from other writers speaking to that audience, most of whom simply provide the headline of the day with no attempt to put it into broader context.

    In short, I understand what you're saying, but I don't think we've lost our way.

    best,

    dan (TMF Galagan)

  • Report this Comment On June 09, 2012, at 12:13 PM, Regarded49 wrote:

    This is not a strategy, this is a disaster for yield seeking investors. Awful suggestions here.

  • Report this Comment On June 09, 2012, at 1:46 PM, MotleyBuffoon wrote:

    "No need to Febreze that stinker!" - not only the funniest, but also the most accurate sentence on this page.

    You know what they say, Dan - you can't polish a t*rd... But you can roll it in glitter. The author doth protest too much, methinks.

    Having said that, the article did have some value for me - I'm no professional investor, i think it offers some food for thought for the beginners among us.

  • Report this Comment On June 09, 2012, at 2:18 PM, labrun1 wrote:

    Bad bad waste of time.

  • Report this Comment On June 09, 2012, at 2:25 PM, thegebos wrote:

    Hindsight is always 20/20. Who knew to buy Ford and not GM or Chrys? Or to stay away from BA, Leamon Bros, AIG, etc? I bought a bunch of preferreds that were selling 50% below par. Somebody smarter than me though they were worthless.

  • Report this Comment On June 09, 2012, at 6:00 PM, lowmaple wrote:

    The point i get from this article and rebuttals is have a diversified portfolio of dividend stocks and higher risk stocks. As some said no one knows where and when the bottom is.

  • Report this Comment On June 11, 2012, at 10:09 AM, TMFGalagan wrote:

    @lowmaple - Thanks. That's *exactly* the point I was trying to make.

    best,

    dan (TMF Galagan)

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