A select group of stocks have beaten the market, routinely paid their owners with cash, and have done it all with less zigging and zagging than the S&P 500

Of course, I'm talking about dividend-paying stocks: Companies that reward their shareholders with routine cash payments just for owning their shares.

Numerous studies have shown that investors could have handily beaten the market just by knowing nothing more than whether a stock paid a dividend or not. If you invested only in stocks that paid dividends, and eschewed all others, you'd end up with a better-than-average return, topping most professionally managed mutual funds and the stock market as a whole.

Yes, it really was that simple. Over multidecade periods, dividend stocks have simply crushed stocks that don't pay dividends.

Of course, investors can do even better by digging deeper than just dividend yields. In the article below, we'll explore the world of high-yield stocks for long-term investors, and how to create a stock portfolio that generates passive income that can grow over time. We'll start with the basics and work our way out. 

What are dividends?

Dividends are money that a company pays its shareholders, typically every month, quarter, or year. Because many established companies earn more money than they can reinvest back into their business, they choose to return some of the extra cash to shareholders rather than stuff it under the mattress or plow it into unprofitable research and development.

Dividends typically come in two types:

  1. Regular dividends: A company pays a regular dividend because it expects to continue to pay the same amount, or increase it, over time. Most dividends paid are regular dividends, which are funded with a company's earnings.
  2. Special dividends: These are dividends that are paid sporadically. A company might pay a special dividend in a year when it is especially profitable, after selling a business unit, or to take advantage of changing tax policy (many companies paid large special dividends in 2012 because dividend tax rates were set to increase in 2013). Special dividends are considered one-time events. 

Apple is an excellent example of a highly profitable company that earns far more than it could ever reasonably reinvest back into its business. In 2017, it spent more than $11.5 billion on research and development, trying to improve its existing products and come up with new ones.

But Apple simply earns too much money to find a productive use for all of it. The iPhone maker earned more than $48 billion in 2017 -- even after spending more than $11.5 billion on R&D -- which leaves it with massive amounts of cash for which it needs to find a purpose.

At a certain point, a company simply runs out of good ways to reinvest its earnings power. Could Apple spend $1 billion trying to make the best cookware for a future colony on Mars? Sure. But the returns are likely to be poor, so shareholders would rather receive a dividend than watch their money disappear on silly science projects.

For this reason, most dividend-paying companies tend to be slower-growing businesses that neither have the need nor desire to plow all their profits back into the business. But don't take that to mean that dividend-paying stocks can't produce good returns, as they have categorically beaten the market over virtually any sufficiently long investment horizon.

Why invest in dividend-paying stocks?

There are many reasons to love dividend-paying stocks, but one of the most compelling reasons is because stock dividends have historically been more stable than stock prices.

In 2008, for instance, the S&P 500 lost 37% of its value, as expectations for corporate earnings declined in light of the financial crisis. Despite the plunge in stock prices, dividends paid out by S&P 500 companies actually increased from 2007 to 2008.

It wasn't until 2009 that S&P 500 companies decreased their dividends in light of the deep recession, but dividends only declined by about 20%. By the next year, dividends paid by S&P 500 companies started increasing again, and by 2011, they reached a new record high. Stock prices, however, didn't reach a new high until a year later.

chart of S&P 500 dividends by year

Data source: NYU Stern. Chart by author.

The chart above shows the amazing stability of dividends paid by S&P 500 companies over the last 58 years, a period in which dividends grew at a compounded annual rate of 5.8%. An investor who retired in 1960 and lived on his or her dividends would have had a very prosperous retirement thanks to the gradual increase in his or her dividend checks in excess of the rate of inflation.

Whereas the cost of living increased 741% from 1960 to 2017, according to the Bureau of Labor Statistics, dividends paid by S&P 500 companies increased 2,412%! So not only have dividends increased over time, but they have increased in real terms. A retiree would have been able to enjoy a greater standard of living as they aged, a rare outcome for most retirees. 

More recently, since the year 2000, consumer prices increased by 46% due to inflation. Dividends paid by S&P 500 companies increased nearly 206% over the same period. When it comes to inflation-protected income investments, dividend stocks are truly in the league of their own.

Here are some other reasons why investors prefer companies that pay dividends:

  • Earnings quality: It isn't easy for a company to pay and sustain a regular dividend every single quarter for years on end. Companies that pay dividends typically have more durable business models, as well as higher-quality earnings, as more of their net income comes in the form of cold, hard cash. 
  • Income: Most people buy stocks to make money from capital gains, or the rising value of stock prices over time. But dividend-paying stocks offer the best of both worlds by offering the potential for capital gains, in addition to regular income from dividends. Dividend investors don't have to face the difficult choice of deciding when to sell stocks to fund post-retirement spending, since their portfolio generates income from dividend payments.
  • Disciplined managers: Companies that promise their owners regular cash payments have less potential to make unforced errors by acquiring competitors at high prices, or throwing shareholders' cash at projects with questionable returns. 
  • Less volatility: Dividend-paying stocks tend to be less volatile than stocks that don't pay dividends, meaning the difference between their highs and lows is smaller than the highs and lows of companies that don't pay dividends. In a study titled "What Difference Do Dividends Make?," researchers noted that dividend-paying stocks produced higher returns, but they also zigged and zagged to a much smaller degree than non-dividend paying stocks.
  • Favorable tax treatment: Dividend income is generally given preferential treatment by the U.S. tax code. Income earned from dividends is typically taxed at the long-term capital gains tax rate, which tops out at 23.8% for the very highest of income earners. In contrast, income earned from interest-paying investments is taxed as high as 37% at the federal level. For most taxpayers, it's better to earn $1 from dividends than $1 from interest or labor.

Analyzing dividend stocks

Though dividend-paying companies have historically outperformed companies that don't pay dividends, that doesn't mean that you should buy all stocks that pay dividends, or buy a stock simply because it pays a higher dividend than another stock. Investors should analyze any dividend-paying company with the same rigor they would apply to any company that doesn't shower its investors with regular dividend checks.

That said, there are a few metrics and attributes that are unique to dividend investing. Here are three high-level things investors think about when looking at a dividend stock.

1. Dividend yield
This is the most simplistic metric for understanding a dividend-paying stock. To calculate a dividend yield, you divide the company's annual dividend payments per share by the stock price. Thus, if a stock pays $1 in annual dividends, and trades for $10 per share, it has a dividend yield of 10%.

Investors often use dividend yields as a way of comparing the income potential of stocks to other income-producing investments like bonds. With a dividend yield in hand, it's easy to understand how much dividend income you could earn by investing $10,000 into a particular stock or stock fund, and compare it to alternatives.

2. Dividend payout ratios
Payout ratios are important for understanding a business's capacity to afford its current dividend. The classic dividend payout ratio is calculated by dividing a business's annual dividends per share by its earnings per share. Thus, if during one year a company earns $5 per share and pays out $2 in dividends, then its payout ratio would be 40%.

U.S. currency stuffed in a glass jar.

Image source: Getty Images.

Some investors take this calculation a step further by calculating a payout ratio based on free cash flow, rather than net income. Doing this is as easy as dividing a company's dividends per share by its free cash flow per share to arrive at a more conservative estimate of its dividend-paying ability.

In industries that are capital-intensive (businesses that require a lot of investment to grow), calculating a dividend payout ratio based on free cash flow can make more sense. For example, cruise ship operator Royal Caribbean Cruises spends heavily to build new ships to repair, replace, and expand its fleet. Since one cruise ship can cost as much as $1 billion or more, cruise lines have to reinvest a greater share of their earnings to maintain and grow their fleets.

Over the past 10 years, Royal Caribbean Cruises has earned $6.7 billion in net income. However, because it spends heavily to expand, repair, and replace its fleet, it generated just $0.3 billion of cumulative free cash flow over the same period. The company could carry about 40% more passengers in 2017 than it could in 2008, but that expansion cost it billions of dollars to buy the ships to do it.

A company's income statement smooths out these major investments over multiple years. If a cruise line were to buy a $1 billion ship today, it would reduce its free cash flow by $1 billion in the current year. However, on the income statement, the purchase would be expensed over 30 years, resulting in an expense of roughly $28 million every year for the next three decades, until the ship is sold for scrap.

For this reason, it's not uncommon for capital-intensive companies to earn significantly more in net income than free cash flow, particularly if they are growing. Accountants often say that "you can't pay your bills with net income," which is why investors who care about dividends often replace net income with free cash flow in calculating a company's payout ratio.

3. Dividend policy
Many companies have a stated or implied dividend policy that can be gleaned from a combination of earnings reports, conference calls, or historic behavior. A company may specifically target a certain payout ratio, declaring to the market that they intend to return a certain percentage of their income to investors in the form of a dividend over time.

Cigarette producer Altria sells an addictive product for which demand is relatively easy to forecast. As a result, it can comfortably target a payout ratio equal to 80% of its income from year to year. Its dividend policy and predictable business has made it one of the best stocks of all time

Car insurer Progressive Corp takes its dividend policy to an extreme, deciding its annual dividend based on a simple equation that multiples a measure of income by a target payout percentage and what it calls the "gainshare factor," which it also uses in deciding employee bonuses. Because insurance industry profits can rise and fall substantially in any given year, Progressive's dividend payments to shareholders are highly volatile. 

Using a dividend reinvestment program (DRIP) to buy dividend stocks

One of the interesting things about dividend stocks is that they often offer a unique method for purchasing their shares. Many of the largest dividend-paying companies offer what's known as a dividend reinvestment program (DRIP), which allows individual investors to buy shares directly from the company and have the dividends automatically reinvested into new shares of stock every time a dividend is paid.

DRIPs offer a few big advantages over buying stock through a brokerage firm:

  • No commissions: Because some companies want to encourage long-term investors to buy their shares, many pay for the trading commissions and other fees on behalf of DRIP participants. Thus, it's possible to buy shares of stock, have the dividends automatically reinvested, and pay nothing in commissions to do it. Since most discount brokers charge $5 per trade or more, DRIPs can potentially save investors a lot of money in commissions over time. (Note: Not all DRIPs are commission-free, as some charge a small fee per trade, typically $0.05 to $0.20 per share.)
  • Fractional shares: Some DRIPs allow investors to buy partial shares of stock, which is advantageous for companies with a high share price. If a stock costs $300 per share, but your dividends for the quarter only add up to $30, a DRIP that offers fractional share ownership will allow you to buy 0.1 share with the dividends rather than letting the cash build up.
  • Convenience: Managing a dividend portfolio can be time-consuming, since payment dates aren't standardized. One company may pay dividends in the third week of every month, while another might pay a dividend on the second day of January, April, July, and October. DRIPs eliminate the need to log in to a brokerage account to reinvest some or all of your dividends. 

While I tend to think highly of DRIPs for individual investors, they certainly aren't for everyone. One downside to DRIPs is that they are almost always taxable events, meaning that you'll have to pay taxes on any dividends you earn, even if they are immediately reinvested into more shares of stock. Investors often refer to this as a "dividend reinvestment tax."

In contrast, buying stocks through a brokerage account can help you take advantage of tax-advantaged retirement accounts like traditional or Roth IRAs. Dividends earned on stocks held in a traditional IRA are tax-deferred, meaning you won't pay taxes on any dividends or gains until you withdraw from it in retirement. In a Roth IRA, dividends and gains are tax-free, since withdrawals are not taxed because Roth IRAs are funded with post-tax dollars.

Building a DIY dividend portfolio

One common mistake new dividend investors make is to focus on the income potential alone and ignore other important investment tenets, like the importance of diversification. Since some types of companies pay higher yields than others, constructing a portfolio based on yields will create a portfolio that is heavily invested in just a small portion of the stock market.

Instead, it makes sense to shop for dividend stocks that are in different stock market sectors. Below, I put together an illustrative portfolio using the No. 1 or No. 2 largest companies in each of the 10 sectors that make up the stock market as a whole.

Note that it includes companies with varied business lines, from one that make money from content (Disney) all the way to banks (JPMorgan Chase), aircraft manufacturers (Boeing), and a technology stock (Apple).

Dividend Stock

Sector

Yield

Disney

Consumer discretionary

1.6%

Procter & Gamble

Consumer staples

3.7%

ExxonMobil

Energy

4%

JPMorgan Chase

Financials

2.1%

Johnson & Johnson

Healthcare

2.9%

Boeing

Industrials

2%

DowDuPont

Materials

2.3%

Simon Property Group

Real estate

4.6%

Apple

Technology

1.6%

Duke Energy

Utilities

4.5%
 

Average

3%

Data source: Google Finance.

Importantly, I view all of these as safe, blue chip stocks with varied business lines and dependable sources of income. Duke Energy, for example, makes its money selling power in regulated markets where it has a monopoly on the production and sale of electricity. Businesses do not get much more safe or dependable than that. 

Procter & Gamble is the epitome of a consumer staples investment. It has more than 20 brands, which individually produce more than $1 billion in annual sales. From Charmin bathroom tissue to Crest toothpaste and Head & Shoulders shampoo, the company makes money from virtually every trip to the grocery store, and that trickles down to investors.

The durability of these dividend-paying businesses is also reflected in their stock prices. Over the last 10 years, a period which includes the financial crisis, this portfolio produced a substantially higher return than the S&P 500. In the worst year, 2008, it only lost 31% of its value, compared to a 37% loss for the S&P 500. Admittedly, past performance is no guarantee of future results, but there is a treasure trove of data supporting the fact that dividend-paying stocks as a whole (not just this portfolio of 10 stocks) tend to be much less volatile than non-dividend-paying companies. 

Diversification is everything in the stock market. It's normal for sectors or industries to go through cycles of extreme outperformance and extreme underperformance. Energy stocks were crushed in 2015, when oil and gas prices plummeted. One year later, the sector was the standout star, generating the best return of all 10 sectors. This isn't out of the ordinary.

Having investments in different sectors can help smooth out your portfolio's return over time. When financial stocks were the laggard in 2011, utility stocks were the top performers. The next year, financial stocks were back on top, and utilities were the worst performers.

An investor who owned just financials or just utilities would have gone on a rocky ride. The investor who owned stocks in both sectors would have sailed through the ups and downs without much excitement, which is a good thing!

Building a dividend portfolio with funds

Investors who want to get a taste of dividend-paying stocks without picking their own stocks may prefer to invest in mutual funds and exchange-traded funds (ETFs) that specialize in stocks that pay dividends. Investing in a dividend fund is a really good way to benefit from dividends without selecting individual stocks and managing them by yourself.

Funds that invest in dividend-paying stocks offer several key advantages:

  • Diversification: Buying shares of a fund gives you immediate diversification at a very low cost. For example, Vanguard Dividend Appreciation Index Fund, one of the most popular dividend-focused index funds, owns more than 180 different dividend-paying stocks in various industries. Best of all, you can get started with about $100, or the current price to buy one share of the ETF.
  • Convenience: There is a lot to be said for having a fund take care of your investing for you. Higher-cost actively managed funds allow you to turn over your investment decisions to professional managers and pay a small fee for the service. Similarly, unmanaged index funds offer a lower-cost way to track a large portfolio of dividend-paying stocks by buying shares of just one mutual fund or exchange-traded fund.
  • "Free" rebalancing: Most funds automatically rebalance their holdings each year so as to avoid letting a few holdings dominate the investment portfolio. Rebalancing your own portfolio of individual stocks can get expensive, since you'll pay a commission every time you buy or sell a stock. Of course, mutual funds and ETFs also incur these trading expenses, but they get a much better deal on trading costs than individual investors do.

Funds are a great choice for investors who are just getting started, since you can add to a fund regularly and do so without paying a commission. It's my view that investors who are working with less than $10,000 would almost always be better off with funds, if only because commissions you pay to buy individual stocks will quickly eat into your would-be profits.

The ground rules for dividend investing

Dividend investing can be rewarding. But there are a few things you should always keep in mind if you choose to create your own portfolio of individual stocks. Here are my simple -- but important -- ground rules for investing in dividend stocks:

  • Don't buy a stock just because of its dividend. A good dividend is never a reason to invest in a bad business. In the long run, the performance of the business is what ultimately drives a stock's return and the company's ability to pay a dividend.
  • Don't put too much emphasis on yield. While a stock that yields 3% may be optically more attractive than a stock that yields 2%, payout ratios may be responsible for the difference. A stock with a lower yield that has a low payout ratio may offer more in the way of dividend growth, and ultimately a higher return over time.
  • Don't ignore fund fees. One of the greatest predictors of a fund's future returns is the fee it charges for investing in it. Fees are quantified as an expense ratio, which reports the annual costs as a percentage of the amount invested. Expenses are particularly important for dividend funds, since fees are subtracted from the dividends that the fund passes on to its investors. If a fund owns stocks that yield 2%, but the fund charges fees of 1.5% per year, investors will only receive a yield of 0.5%. Costs always matter, but they really matter for an income portfolio!

Finally, and most importantly, remember that investing is a long-term game. Just because you can buy a stock and sell it a minute later for a 0.1% gain doesn't mean you should. Treat stocks as you would ownership of any other business: Something to hold for the long haul, rather than flip for a quick buck.

Jordan Wathen has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends AAPL and DIS. The Motley Fool owns shares of JNJ and has the following options: long January 2020 $150 calls on AAPL and short January 2020 $155 calls on AAPL. The Motley Fool has a disclosure policy.