Dow Dogs With Meaty Dividends on Their Bones

Lately, economists and soothsayers alike are beginning to talk of another recession likely to occur next year. This means we need to think defensively, as markets may head further south in anticipation of economic weakness. Stocks in the Dow Jones Industrials (INDEX: ^DJI) are perhaps one of the safer ways to ride out the storm and minimize losses. Why? Because these stocks have weathered many past storms and will be docked safely at port when the sky clears.

A time-tested practice for investing in Dow stocks is called "Dogs of the Dow." You simply purchase the 10 highest-yielding Dow stocks, and update the portfolio yearly. For this commentary, I'll only focus on the five highest-yielding stocks: AT&T (NYSE: T), Verizon Communications (NYSE: VZ), Merck (NYSE: MRK), Pfizer (NYSE: PFE), and Procter & Gamble .

Source: Motley Fool.

Before I continue, a word about earnings quality. None of these five stocks have impressive earnings quality, as evidenced by their TMF Earnings Quality Score. If they did, however, then they might not be listed in this group. Why? Because better earnings quality could push up their stock prices, thereby lowering their yields. In order to make my point, let's look at these stocks since the start of 2011, because I want to demonstrate the power of reinvesting dividends to achieve compounding returns. Keep in mind, however, that P&G wasn't a "dog" at the start of 2011.

Source: Author's calculations. *Total return equals price advance or decline combined with compounded dividends.

Each stock paid six dividends between the start of 2011 and the present, and all five companies increased their dividends at some point during this period. In order to make it easier to calculate the total return, I used the average stock price for dividend compounding, and I also started with 100 shares of eash company's stock. Dividends paid were used to purchase additional shares via a dividend reinvestment program available through many brokerages, and so there were no commissions deducted.

The chart first shows the change in each stock's price since Jan. 3, 2011. Although space considerations kept me from showing my work in more detail, I then used average stock price to compound the dividends and used actual dividends paid for the last six quarters to calculate how many additional shares you would have purchased for each quarter. That then formed the basis for my total return calculation, which appears in the last column.

Compounding dividends in all cases provides a slightly higher yield (the effective yield) than if the dividends were received and not used to purchase additional shares. Unfortunately, the total return is not always higher if the stock price declines, as in the case of Procter & Gamble.

To see the benefit of allowing dividends to compound, take AT&T as an example. AT&T appreciated 18.23% during the period, and dividends yielded 7.5%. Add these together for a total return (without compounding) of 25.73%. Compounded dividends added 7.97 shares and the total return for the period was 27.66%, a difference of 1.93%. This yield is higher than the yield of a 10-year Treasury bond, and quite possibly a less risky investment. In P&G's case, however, the loss is slightly exagerated: A loss of -2.47% (-8.17% + 5.70%) ends lower at -3.89% because more shares ended at a lower price.

Foolish Takeaway
The long-term benefit of compounding dividends into additional shares of stock should be clear. Dow stocks can be viewed as relatively safe investments during periods of economic turmoil or downturns. Combining Dow "Dogs" with compounded dividends can provide higher returns over time than merely owning the stocks and allowing dividends to be deposited into a cash account. Can you lose money if the economy tanks and takes the market down with it? Yes! Can Dow stocks perform poorly and experience price drops? Absolutely! Might you be safer in cash? Perhaps. If the stock price drops, then the yield by definition rises. And if you're in cash you won't be positioned to take advantage of stock price increases when the market turns around. As always, Foolish readers should always make their investment decisions based on earnings quality.

One of the great things about companies like AT&T or Verizon is the great dividends they pay, but there are even better ones out there. You can read about them in our special free report: "Secure Your Future With 9 Rock-Solid Dividend Stocks." To see which dividends made the grade, click here now.