The Wrong-Headed Approach to Dividend Investing

We're asking ourselves the wrong question about dividend stocks.

That thought occurred to me while I was reading a USA Today column that highlighted the fact that dividend stocks currently give you a much better current return than other vehicles:

Dividends are especially important in these days of low interest rates. The average money fund yields 0.03%, according to iMoneyNet, which tracks the funds. And you'd be lucky to get more than 1% on a one-year CD.

That snippet, along with much of the rest of the article, is a good answer to the question: "Why should I buy dividend stocks?" But that's really an odd question for investors to be asking.

If we think about a business like the famous golden-egg-laying goose, asking why dividends should be on our radar is like asking why we should concern ourselves with the magical bird's shiny eggs.

But what's good for the goose...
The more appropriate question than "Why should I buy dividend stocks?" is "Why did we suddenly stop focusing on dividend stocks?" As the USA Today column rightly points out, in decades past the dividend was a primary, if not the primary, driver for equity investments.

So what changed? Part of it was the increased focus on the academic view of efficient markets. From many an ivory tower in academia, the markets were viewed as a supercomputing mechanism that properly priced stocks to reflect all known information, which included capital-allocation decisions like a dividend payout. In essence, this said that the value of your investment ended up the same regardless of whether or not profits were paid out.

So why worry about dividends at all?

Indeed, as long as investors were willing to swallow that concept -- which, like many other academic concepts, works better in theory -- then the skies were suddenly brighter for many CEOs and the suit-wearing folks on Wall Street.

There are many reasons why no dividend payout is better for the folks that aren't you, including:

• The thrill is gone. With so many corporate managers getting paid with stock options, the thrill of a dividend payment is lost on them. In fact, since a dividend shrinks a company's balance sheet and generally the stock price as well, a dividend is actually a value-detractor for a manager with options-heavy compensation.
• Empire building. If you crack open a company's proxy statement, you'll find that many a CEO's compensation is justified based on the size of the company. With this as a compensation benchmark, there is a strong incentive for managers to make acquisitions to make the company bigger. For a company that's giving out cash through a dividend, there's less left behind for bloating the company -- and the CEO's paycheck -- through acquisitions.
• Speaking of acquisitions. A big part of Wall Street's traditional business is advising companies on mergers and acquisitions. Typically, bankers get paid a percentage of the deal size, so larger deals can mean tens of millions of dollars in fees for companies like Goldman Sachs and Bank of America's Merrill Lynch. What does Wall Street get out of a good, solid, growing dividend? Diddly squat.

With all of that in mind, it should be little surprise to see that the clear trend has been toward less cash ending up in shareholders' pockets through dividends.

Sources: Robert Shiller and IrrationalExuberance.com. Author's calculations.

Still on your side
Dividends are making a comeback, and investors looking for huge payouts can certainly find them. However, sky-high dividends aren't always all they're cracked up to be, while dividend Johnny-come-latelies may or may not have a real, long-term dedication to sharing their profits with investors.

On the other hand, a quick screen brought up 59 companies whose stocks are trading at less than 15 times trailing earnings -- which gives us a rough read that the valuation is reasonable -- and, more importantly, have been both paying and raising their dividend consistently over the past decade.

Here are five of the stocks that showed up in that screen.

Source: S&P Capital IQ.

It's important to note that the screening data, while significant, does not excuse you from further research. For starters, understanding the businesses behind these stocks is key. Walgreen and Teva, which are both giants in the health-care space, will generally fare better through recessions, as consumers will generally continue to purchase medications even in a down economy. On the other hand, investors in Caterpillar need to understand the cycles that the industrial machinery market goes through and what that means for the company.

Meanwhile, there are other important numbers to explore, as well. After adjusting for one-time items, Pitney Bowes pays out the vast majority of its income through dividends. While that may sound great -- and is, to some extent -- it also gives the company comparatively less room to raise its dividend and makes the continuity of the dividend at its current level riskier. On the other end of the spectrum, Aflac paid out just 28% of its earnings through dividends in 2011, which puts it in a very different position from Pitney Bowes.

Now go ask the right question!
Dividends aren't a gimmick. They're a very real, very important piece of the stock-investing puzzle. It's been far too long that investors have been ignoring this piece of the puzzle, and it's high time they started looking at more companies and asking, "Why aren't you paying me a dividend?"

For nine companies that are unlikely to ever make you ask that question, check out The Motley Fool's special report, "Secure Your Future With 9 Rock-Solid Dividend Stocks." You can get a free copy of that report by clicking here.