The Best Dividend Stocks You Can Buy

Investors want dividends these days. Maybe it's a fad, maybe it isn't. Either way, I think it's a good thing as long as it lasts. Dividends have historically treated investors very well because they:

1. Are a key component of total equity returns.
2. Are an indicator of a company's financial health.
3. Provide downside protection in the form of "yield support."

I could continue, but I'm going to assume you're already convinced of the importance of dividends. And in that case, what you're after is which dividend stocks you should be herding into your portfolio.

In a paper from Tweedy, Browne titled "The High Dividend Yield Return Advantage," the revered value manager brings together a collection of academic and Wall Street research that not only highlights the need for dividends, but extolls the virtues of higher-yielding equities.

One of these reports in particular -- a 2006 paper from Credit Suisse titled "High Yield, Low Payout" -- caught my eye. By studying stock returns during the period between 1990 and 2006, the researchers came to the conclusion that investors should focus on higher yields, but not simply the highest yields. They found that the best performance was captured by investing in the highest-yielding stocks that also had the lowest dividend payout ratio.

Sounds good, but ...
When it comes to numbers like these, I always like to kick the tires a bit. So what I did was pull up the total returns over the past decade for all companies that had a market cap of $500 million or more 10 years ago. I then split the group in a way similar to what the folks at Credit Suisse did -- that is, into nine separate groups based on yield and payout ratio (high, medium, and low for each).

Unfortunately, the results I came up with didn't confirm what Credit Suisse found. Though the numbers over the past decade don't tell a particularly cogent tale overall, they do show one thing pretty clearly: Dividend payers with a low payout ratio largely underperformed the rest of the dividend payers.

How could this be? I think a lot of it comes down to the banking and financial sector. Most banks and many non-bank financials have a history of healthy payouts, but also (REITs aside) tend to keep their payout ratios at low levels. During the 1990 to 2006 period that Credit Suisse studied, the financial industry was flourishing, and therefore dividend payers with low payout ratios appeared to have an advantage over the rest of the group. The story has been very different post-financial-meltdown and so the results of the past decade aren't so kind to low-payout companies as a group.

So which group should you buy?
I could point out that the best performing group over the past decade was the stocks with the highest yield and the highest payout ratio. I might add that stocks with both middle-of-the-pack yields and payout ratios took a close second. But then I'd be continuing to lead you astray.

Frankly, you'd probably be happy with the results if you followed Credit Suisse and invested in only high yielders with low payouts. I also wouldn't be surprised if you got satisfactory results investing in high yielders with high payout ratios. But then again, as I've pointed out in the past, you would probably do well simply investing in any group of moderate-or-better dividend payers, period.

But if you want to go further than just cluster bombing the dividend universe, you need to be willing to look behind the numbers. Though it's easy to forget as we watch the tickertape flash by on CNBC, there are businesses behind the stocks we're buying and it's the success or failure of those businesses that is going to determine whether those stocks perform. The numbers can be signposts of quality and value, but they don't tell the whole story.

For example, Chimera Investment (NYSE: CIM) and American Capital Agency (Nasdaq: AGNC) have become investor favorites thanks to massive dividend yields. If the numbers were all that mattered, I'd be very hard-pressed to turn my nose up at either of these companies. But both are very young businesses and both are currently operating in a pretty ideal environment for their business model. At the moment it seems like these two -- and the other mortgage-paper REITs -- are printing money risk free. But I feel like we've heard that story before and I have a feeling neither will be among the next decade's top performers.

Five to consider
The following five companies may not have quite the massive dividends that Chimera and American Capital Agency do, but the payouts are still nothing to sneeze at and I think the businesses will provide much more reliable returns over time.

Source: Yahoo! Finance.

To be sure, these aren't spectacularly exciting businesses. However, they're businesses that create value by serving a definite market need: Knightsbridge's ships help oil cross oceans, Suburban Propane provides propane to residents and business, and AT&T connects millions with communications services. I believe they're also businesses that will support healthy long-term cash flow that will find its way to shareholders.

Loading up your portfolio with attractive dividend yields is a great way to bolster your returns. But the best dividend investments come from companies that combine a sustainable business with that tasty dividend payout.

Looking for more high-yield opportunities? My fellow Fools have put together a special report "13 High-Yielding Stocks to Buy Today." Check out a free copy of that report.