Do you allocate your stock portfolio dollars consistent with your level of comfort? It's best to divide your money among companies that provide growth at a reasonable price and present risks with which you are comfortable.

Here's what I follow as a rough guide:

  • 40%-50% in dividend-paying stocks; large, dominant companies; low-expense S&P 500 index fund; and cash waiting to be invested;
  • 30% value investing, mostly in small capitalization stocks; and
  • 20%-30% informed speculations, meaning Rule Breakers, unprofitable development-stage companies, shorts, options. High risk.

I don't sell to maintain this percentage allocation. Rather, even if a winner takes up a larger percentage of the port, business performance and valuation still determine whether to buy, sell, or hold. To a point, of course. If a holding simply becomes so large, it likely invokes the "don't put all your eggs in one basket" rule. That's a problem it will be great to have.

Today, I want to focus on finding dividend-paying stocks for the first category. This is the second of four columns taking a mid year look at the ol' portfolio in light of portfolio allocation goals. Last week, I began by asking, "How Much Risk Do You Want?"

The first group
If a doctor's Hippocratic oath is "First, do no harm," that applies for me to the 40%-50% group. This category is the "sleep at night" bedrock, a combination of:

  • Dividend-paying stocks of businesses with at least some potential for growth
  • Low expense S&P 500 index fund
  • Stocks of large, dominant well-managed companies priced reasonably
  • Cash (usually between 5%-10% waiting to be invested)

My goal here and overall is to outperform the S&P 500, which may not offer much in the coming decade. Berkshire Hathaway (NYSE:BRK.A) chief Warren Buffett has made the case for low to mid single digit returns, and money manager and writer John Mauldin regularly presents persuasive evidence for flat returns. But both speak of the broad, overall market, and Mauldin notes that value investors may do well.

Just as in the Great Depression, some businesses will outperform. It's a stock picker's market, and it may be for a long time.

Why dividend paying stocks?
Like many of you, the largest amount of my investable dollars reside in tax-advantaged accounts. For me, that's a Motley Fool 401(k), a Roth IRA, and a traditional IRA rolled over from a former employer. They are ideal for dividend-paying stocks -- even the 401(k), because our plan allows the option of investing part in stocks through a brokerage account (we are, after all, a financial education company!).

But the new tax law reduces (with some exceptions) the dividend tax to 15%, creating a curious anomaly. While there is no tax when dividends are distributed to shares held in a tax-advantaged account, those dividends are taxed fully as regular income when eventually withdrawn from a traditional IRA (but of course not from a Roth IRA). So dividend-paying stocks may be more attractive in a taxable account versus a traditional IRA. Don't take this as the last word. There's still more to find out about the law's fine print.

Even more important than tax status is research showing that dividends comprise almost half of the long-term return from the S&P 500. For that reason alone, all investors should give dividend-paying stocks serious consideration.

Finding ideas
For high yield ideas, a great place to start is with our newest Foolish analyst Mathew Emmert (TMF Gambit) and his debut three-part series on dividend-paying stocks: A Six-Pack of Stocks, Where to Put Your Money Now, and Stocks That Pay. Mathew does not just take any old high yield and buy. In the true spirit of Foolish investing, he wants high-quality businesses that pay you while they perform. He applies the following criteria:

  • Safe, proven companies, shown by stable, dependable earnings growth through good times and bad
  • Market capitalization over $1 billion
  • Dividend yield over 3%
  • Payout ratio under half of free cash flow (with one exception, to follow)
  • Low valuation

You can read the columns for Mathew's incisive analysis -- we don't call him the Fool's Jimmy Neutron, Boy Investing Genius, for nothing -- but I'll summarize and editorialize here.

You want stable businesses so that the dividend is stable. A dividend may well decline in a given year for legitimate business reasons, but sustainable businesses can return the dividend to its former level and beyond. The 50% payout ratio limit is to ensure that the company still has cash to invest in its business for future growth. A ratio over 50% can mean that the company is starving itself to pay a dividend, endangering the future not only of the business but of course of that dividend itself. (For fun, read this glib treatment of the subject I wrote in Oct. 2000 and have a laugh. It's proof that people do learn.)

Applying his own criteria, Mathew's six pack included RPM International (NYSE:RPM), Altria Group (NYSE:MO), ConAgra Foods (NYSE:CAG), BellSouth (NYSE:BLS), Stanley Works (NYSE:SWK), and Newell Rubbermaid (NYSE:NWL).

Three dividend-paying stocks
Like Mathew, I own Altria Group, owner of Philip Morris, 84% owner of Kraft Foods (NYSE:KFT), and 36% owner of SAB Miller. Both of these consumer brand non-tobacco businesses balance the litigation risks to Altria's Philip Morris tobacco business, though those uncertainties keep its shares at a market capitalization to free cash flow ratio under 10. It was far lower than that before the shares climbed 50% from April 1 to May 23 after a favorable Florida appeals court decision. If you're going to own Altria, you must expect that tobacco litigation may move the share price dramatically in the short term.

On my own
My other two dividend paying stocks depart from Mathew's list. The first is smokeless tobacco, wine, and cigar maker UST Inc. (NYSE:UST), which I first took seriously upon reading UST: Double Dippin' by TMF Money Advisor manager Buck Hartzell (TMF Buck). (Buck also turned me on to the TiVo TV service, for which I am almost as grateful. It doesn't pay a 5.9% dividend but is certainly addicting.) Buck's piece details UST's many business strengths.

One change involved a stock that crosses the first two categories. I recently wrote about diagnostics and recombinant protein manufacturer Meridian Bioscience (NASDAQ:VIVO), a small cap value investment that I bought when it had over a 4% yield. Its dividend is especially tasty given its rapid free cash flow growth the last three quarters, but the company is of course not the stable giant UST is.

How have these three performed? I can't believe I did this, but I actually constructed a spreadsheet that produces the Internal Rate of Return (IRR) for each company, accounting for the fact of multiple purchases and dividends, and compares it to the S&P 500, using SPDRs (AMEX:SPY). If you would like this spreadsheet, e-mail me at tcjmail@cs.com with "spreadsheet" in the subject and I'll shoot it to you when I return to town on June 16.

  
                               S&P 500   
Company IRR (inc. divs.) Altria Group 44.27% 41.72%UST 83.76% 31.77%Meridian Bioscience 196.87% 87.09%

Over an admittedly short period -- I purchased the first of these, shares of Altria, last September -- and all three are outpacing the S&P 500.

Others?
I'm pretty happy with my portfolio right now and will be adding cash to my current dividend-payers (and other stocks) rather than new ones. But because I'm always looking for great investments at attractive prices, the on-deck circle contains Mathew's list as well as several others.

At some point, big drug makers Bristol-Myers Squibb (NYSE:BMY) and Schering-Plough (NYSE:SGP) may qualify. They yield 4.6% and 3.7%, but given their recent years of business disasters it's hard to say how secure the dividends are and when the growth will return.

Bristol-Myers Squibb must probably boot CEO Peter Dolan before any turnaround can really happen. And while Schering-Plough has changed management, I'm not yet comfortable enough with its product pipeline to evaluate whether over the next five years it can regain growth lost from product patent expiration and generic competition.

Large caps and the S&P 500
As for the rest of this category of my portfolio, I don't currently own any large-cap, dominant companies that pay small or no dividends -- companies such as Johnson & Johnson (NYSE:JNJ) or Pfizer (NYSE:PFE), for example -- but am always open at the right price. Passing by these or another stalwart like Wrigley (NYSE:WWY) presents a risk of failing to pay up for quality and thus missing excellent returns. I remember looking at Wrigley in junior high -- over 30 years ago -- and skipping it. Big mistake!

But from today's valuation? Neither these nor any number of other excellent companies yet persuades me to buy at today's price, but that may change. Many may start paying or increase their dividends, for one thing, given the new tax law changes, making them more attractive.

Finally, I plan over the coming year to reduce the 20% of my portfolio currently invested in an S&P 500 index fund, taking advantage of the Motley Fool 401(k) plan's benefit of a brokerage account option provided you maintain a minimum percentage of the account balance outside of individual stocks.

That's category one of the portfolio allocation. Next week, value investments, mostly small cap.

Share your dividend-paying stock and portfolio allocation ideas on our Fool on the Hill discussion board. Or, it's not too late to join our Perfect Your Portfolio: Asset Allocation for Long-Term Wealth online seminar.

Writer and Senior Analyst Tom Jacobs (TMF Tom9) exemplifies living below your means in the clothing budget department. He owns shares of Altria, UST and Meridian Bioscience, as well as other companies listed in his profile . Motley Fool writers are investors writing for investors .