Off the top of my head, there are perhaps two certainties that the stock market offers.
First, the aggregate value of the broad-based S&P 500 (SNPINDEX:^GSPC) will increase over time. Though it may be impossible to predict when stock market corrections will occur, how long they'll last, or how steep the decline will ultimately be, one constant is that these downdrafts are eventually always erased by a bull market rally. Since 1950, each and every stock market correction in the S&P 500 of at least 10% (not including rounding) has been completely erased.
That second certainty offered by the market is the idea that dividend-paying stocks will outperform non-dividend-paying companies over the long term.
Dividend stocks are likely to play a key role in helping you reach your financial goals
This probably comes as little surprise, since the most successful retirement portfolios are often littered with dividend stocks. In general, dividend stocks offer three core advantages over their non-dividend-paying counterparts.
First, paying a regular quarterly, semi-annual, or annual dividend acts as a beacon to investors that a company has a time-tested business model with presumably good long-term visibility. Think about it this way: A company is unlikely to continue to share a percentage of its profits with its shareholders if it didn't expect to remain profitable and continue growing for some time to come. Since there are plenty of companies not making money right now, you can be assured as an investor that most dividend-paying stocks are profitable and on relatively sound financial footing.
Second, the simple act of receiving a payout from a dividend stock can help to calm the psyche of jittery or short-term-minded investors. Although a dividend payout alone is unlikely to completely offset a short-term stock market correction, dividends act as a hedge to the inevitable downside in the market. Think of dividend payouts as small reminders that your patience in buying great businesses will eventually pay off.
Third, but most important, dividend payouts can be reinvested back into more shares of dividend-paying stock. A dividend reinvestment plan, or Drip, can be set up with your brokerage to do so automatically with each dividend payment, and may allow you to purchase fractional shares of stock. No matter how you set up your Drip, the key is that doing so leads to more shares owned of dividend-paying stock, a bigger payout, and even more shares owned, in a repeating pattern. Drips are what many of the most successful money managers use to create wealth for their clients.
The safest dividend stocks in the world
Of course, picking out the right dividend stocks isn't necessarily easy, because every business comes with risks (some more than others). However, there are two brand-name dividend stocks that stand taller than every other publicly listed company. That's because they're the only two public companies to bear Standard & Poor's AAA credit rating: Johnson & Johnson (NYSE:JNJ) and Microsoft (NASDAQ:MSFT).
Standard & Poor's examines more than a dozen factors when assigning its credit ratings, and these are the only two companies it has the highest confidence in their ability to repay their existing debt. For added context, the United States government currently has a AA credit rating. Let's take a closer look at what it is about Johnson & Johnson and Microsoft that makes them the safest dividend stocks on the planet.
Johnson & Johnson
Despite toting around $30.3 billion in debt, healthcare conglomerate Johnson & Johnson, also known as J&J, is about as safe as they come on the dividend-paying front. For instance, last year Johnson & Johnson reported adjusted diluted earnings growth 12.1% to $8.18 per share, marking the 35th consecutive year J&J has delivered adjusted operational earnings growth. Think about that for a moment. We have to go back to the early days of the Reagan presidency to the last time that J&J's bottom line didn't grow on an adjusted annual basis. That's the definition of consistency.
Johnson & Johnson's secret sauce is that each of its three operating segments brings something to the table that its other segments lack. Consumer health products is J&J's slowest-growing and smallest segment by sales, but it also generates the most predictable cash flow of the group. Next up is medical devices, which have struggled in recent quarters due to device commoditization, but have arguably the longest growth runway as the global population ages and gains better access to medical care. Lastly, there's J&J's pharmaceutical segment, which accounts for half of its revenue and the bulk of its operating margins.
To boot, Johnson & Johnson also generates a relatively even distribution of sales from the U.S. and international markets. This helps to protect J&J from significant downturns in any one developed market, which admittedly isn't a huge deal for healthcare companies since people don't get to decide when they get sick or what ailment they develop.
Considering that J&J has averaged more than $16 billion in free cash flow over the past five years, it's easy to see why its $30 billion in debt isn't a big deal.
Furthermore, Johnson & Johnson is among the elite of the elite when it comes to dividend stocks. Part of the Dividend Aristocrat family, J&J increased its quarterly payout in April for the 57th consecutive year. Suffice it to say, this 2.7% yield is rock-solid.
The other big kahuna on the dividend safety front is Ole Softy. Microsoft's $86 billion in total debt might sound alarmingly high, but it's really nowhere near as concerning once you factor in that the largest company in the world by market cap has $131.5 billion in cash and cash equivalents (i.e., more than $45 billion in net cash), and has been generating an average of over $28 billion in annual free cash flow over the past five years.
Like J&J above, Microsoft has multiple operating segments, and they each serve a purpose. But unlike J&J, there's virtually no weakness, even among its legacy businesses. When Microsoft reported its third-quarter fiscal results in April, of its 15 most prominent product and service segments, all but three grew by a double-digit percentage on a year-over-year basis (Windows OEM, gaming, and enterprise services). The company's cloud products continue to demonstrate insane levels of growth, with Azure recognizing 75% year-over-year sales growth, on a constant currency basis.
Microsoft's revenue distribution is well balanced, with $10.2 billion coming from Productivity and Business Processes, $10.7 billion from its Personal Computing segment, and $9.7 billion from Intelligent Cloud, in the fiscal third quarter. Keep in mind that although personal computing is growing at the slowest pace (9% on a constant currency basis, year-over-year), it also bears some of the highest and most predictable margins thanks to its still-dominant Windows operating system. Meanwhile, cloud service products offer juicy margins, and it should soon become the leading sales producer among Microsoft's three business segments.
In other words, we're talking about a company that has a real shot of seeing gross margin perhaps push toward 70% as cloud services becomes an increasingly larger component of total sales.
Although Microsoft's current payout of 1.4% might seem rather ho-hum, the tech giant has increased its quarterly payout in nine straight years, and it's doubled its payout over the past six years. With a payout ratio of 40% and abundant cash flow, future hikes appear to be nearly certain.