Dividends Save the Day!

We've proven over the past decade that buy-and-hold investing is dead, right? The ignorance of those nutty "long term" investors has been laid bare as the stock market has lost money over the past 10 years. So much for the long term, losers.

I'm kidding.

In fact, I find it laughable to an "LOL" degree that anyone would use the past decade as their "definitive proof" that buy-and-hold investing doesn't work.

Ten years ago, equity valuations were through the roof, and most -- if not all -- of the lackluster performance since then has been downward adjustments in valuations. The idea behind buy-and-hold investing isn't that you indiscriminately buy any old stock and hope that it carries you to retirement just because you don't sell it. Rather, the idea is that you do smart, diligent work up front to find good companies that are attractively valued, and then you hold onto them as long as the company continues to deliver.

In other words, blindly holding onto a stock isn't a silver bullet that will send your portfolio skyward.

But is there a silver bullet elsewhere?
I'm hesitant to refer to anything as a silver bullet when it comes to investing because I don't want to give anyone the idea that they can be lazy and still do well in the stock market. But I'll let the numbers speak for themselves.

Obviously, the performance of the overall stock market for the past decade was pretty horrendous. The S&P 500 lost nearly a quarter of its value between the end of 1999 and the beginning of 2010. A set of all 950 stocks with a market cap above $1 billion at the beginning of 2000 shows a median loss of 3.2%.

But if you had done just one thing back in 2000, you could have grabbed a median gain of 28% over this dismal period. What was that one thing? It was demanding a dividend yield above 3%.

Even though the financial crisis slammed banks such as Huntington Bancshares (Nasdaq: HBAN  ) and Regions Financial (NYSE: RF  ) -- both of which paid a healthy dividend a decade ago, but only have a token payout today -- the typical stock among the group would have moved an investor's portfolio in the right direction. And bear in mind that the median 28% gain does not include the impact of dividends.

Why this works
There are three primary reasons that I believe dividends were able to counter the market's terrible performance.

  1. Dividends prove real, cash earnings.
  2. They impose fiscal discipline.
  3. A certain yield level implies a reasonable valuation.

Back in 2000, everyone was busy crowing about eyeballs per share and other ludicrous metrics that were supposed to mean something about the practically immeasurable potential for the Internet. But guess what? You can't pay dividends with eyeballs -- at least not in this day and age -- and the companies that were paying dividends were proving that they had real businesses that put cash, not just promises, in the bank.

But just because a company has a strong, cash-generating business doesn't mean that it's sharing that cash with shareholders. If there's good reason for that, I can get on board. But more often than not, the reason is that some megalomaniac CEO wants to build the company to the size of a small country so that he can collect a kingly paycheck. Usually this is done through acquisitions and usually it wastes shareholders' money.

Finally, if a company is trading at 100 times earnings, it's practically impossible for it to have much of a dividend yield without sucking all the resources out of the company and destabilizing it. In other words, if a stock has a 3%-or-better yield, it's unlikely that the stock is wildly overpriced.

Even easier today
Back in 2000, there were 191 companies with a market cap above $1 billion and a dividend yield of 3% or better. Today, there are 456 such companies.

But while I believe that focusing on dividend payers starts you off on the right foot, I don't think that alone is enough to build a strong portfolio. So when I'm choosing dividend stocks, I'm also looking to diversify across sectors, find quality companies, make sure payout ratios are reasonable, and be sure the company has been growing its payout over the years.

Here are a few stocks that are currently on my radar.

Company

Dividend Yield

Payout Ratio

10-Year Annualized Dividend Growth

Diageo (NYSE: DEO  )

3.6%

59%

6%

Illinois Tool Works (NYSE: ITW  )

3.3%

41%

13%

Bank of Hawaii (NYSE: BOH  )

4.1%

49%

10%

ConocoPhillips (NYSE: COP  )

4.2%

32%

12%

RPM International (NYSE: RPM  )

4.8%

59%

5%

Source: Capital IQ, a Standard & Poor's company.

For dividend investors who forgot about diversification and overloaded their portfolios with bank stocks, the financial crisis was a rude reminder that spreading out over industries is a swell idea.

The group above does just that -- Diageo claims major liquor and beer brands, Illinois Tool Works produces a vast array of industrial products, Bank of Hawaii is exactly what you'd think it is, Conoco is an oil major, and RPM manufactures specialty coatings and other chemicals.

Beyond diversification, though, these are all stable, high-quality businesses, all are reasonably valued, and all have shown a commitment to kicking out cash to their shareholders in the form of dividends.

Over the past decade, we faced the come-down from the Internet-bubble high and the financial and housing crashes. But in the midst of all of that, dividend-paying stocks continued to reward investors.

In the coming decade, we're going to face what looks like a slow, bumbling recovery from those most recent disasters -- not to mention any new fumbles that crop up. It's hard to say for sure whether we're really in for a double-dip recession or how quickly unemployment will ease. But what I do feel safe saying is that stocks like those above will more than likely serve investors well through whatever is ahead.

Think the individual investor is dead? Think again.

Diageo is a Motley Fool Income Investor pick. The Fool owns shares of Diageo. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy assures you no Wookies were harmed in the making of this article.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.


Read/Post Comments (10) | Recommend This Article (30)

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 01, 2010, at 4:01 PM, thomfahr wrote:

    Dividend Aristocrats are companies in the S&P 500 that have increased dividend payouts to shareholders every year for the last 25 years:

    http://www.dividend.co.nr

  • Report this Comment On September 01, 2010, at 5:22 PM, scanlin wrote:

    COP is a good covered call candidate. You can buy it for 54.05 and sell the Oct 52.50 fro 2.88. Net debit (break even) of 51.17. If called annualized return of 21.1%, with 5.3% downside protection. No earnings release risk before Oct expiration.

    MikeS

    http://www.borntosell.com

  • Report this Comment On September 01, 2010, at 11:56 PM, catoismymotor wrote:

    + 1 for Truth's truths!

  • Report this Comment On September 01, 2010, at 11:57 PM, catoismymotor wrote:

    Matt, thanks for the article.

  • Report this Comment On September 02, 2010, at 12:23 AM, goalie37 wrote:

    Great article and fantastic commentary by truthisntstupid. I have some relatives thinking about getting in the market. I'm forwarding this to them now.

  • Report this Comment On September 02, 2010, at 1:26 AM, goalie37 wrote:

    Wanted to add one additional observations on dividends. Last week, Johnson and Johnson (JNJ) issued bonds. They were able to lock in long term rates at 2.95%. What is interesting to me is that the common stock pays a dividend of 3.79%. That's 84 basis points more than the bond holders get, just for buying the stock. That means that all the retained earnings (59% of net income), all the future retained earnings, and all future dividend increases can be had for free.

  • Report this Comment On September 02, 2010, at 4:28 PM, TMFKopp wrote:

    Thanks all for the comments! And truthisntstupid, I know I can always count on you to get excited about dividends :) ... And, hey, I'm on the same page.

    What really surprises me is that it would seem that high-quality dividend-paying stocks would be on every investor's radar as they flock on a flight to quality. As far as I can see, that hasn't been the case -- partially because they've been so scared that many have been running to bonds (which are TRULY scary).

    Anyway, I'll keep beating the dividend drum. Good to know I'm not playing to a completely empty house!

    Matt

  • Report this Comment On September 03, 2010, at 2:05 AM, TMFKopp wrote:

    @truth

    "Kind of a neat way to look at it, but I was just playing around. Tracking it that way could get real impractical real fast."

    Yeah, maybe not the easiest way to track, but gives you an idea of the magic of compounding that you can leverage when you are able to buy quality stocks at a discount.

    Matt

  • Report this Comment On September 03, 2010, at 4:07 AM, TMFKopp wrote:

    @goalie37

    So yeah, I'm scratching my head about that as well.

    Now of course we do have to place some extra value with the bonds due to the better position that bondholders get in the case of a bankruptcy (even though that seems about as likely as me getting drafted to play center field for the Yankees).

    But right now, I figure one of two things are true:

    1) I've had too much stock market Kool-Ade and am overlooking the terrible firestorm that's going to hit stocks.

    2) Investors are so scared out of their wits after the last downturn that they don't know up from down. This is leading them to do things like give companies rock-bottom debt financing, but refusing to buy equities.

    I think #2 is more likely, but I'm a little biased.

    Matt

  • Report this Comment On September 17, 2010, at 2:59 AM, philkek wrote:

    Thanks MF and fellow fools. Great article and educational comments. Better Business Bureau tells all fools to investigate BEFORE you invest. This article helps start the investigation of finding gains.

    Now more homework begins. Thanks again. Fool on for profits.

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