Growth investors and value guys have opposing worldviews. Some folks are loath to take too big a gamble with their investments, while others espouse the concept that you've got to risk big to win big. But from newbies to grizzled veterans, the daring to the cautious, there's one category of investments that should be in every portfolio.
Dividend payers.
Dividends are time-tested, reliable, punctual, and put money in your pocket. Reinvest them and watch them increase your stake in a value play. Use dividend payers to hedge against the volatility of the more aggressive stocks you believe in. If you're young, let the magic of compounding build your nest egg. If you're nearing retirement, use dividend income to pay your bills.
The power of dividends is proven. Consider the case of Sears. Over the course of a 20-year period (namely, 1978 to 1998), Sears delivered a 9% return without dividends. With dividends, that return rose to 20%, for a difference of 11 percentage points. Let's say you graduated from college in the late '70s and wanted to throw some of those first hard-earned paychecks into the market. Without dividends, a $2,000 investment in Sears in 1978 would've turned into $11,208.82 in 20 years. Respectable, to be sure. But with dividends, that same $2,000 in 1978 turned into $76,675.20 two decades hence.
And I'm not simply cherry-picking the shiniest investment vehicle in recent history. Putting the power of dividends in your portfolio is a proven market-beating strategy. If you'd invested $50,000 in the S&P 500 -- i.e., just in the overall market -- 10 years ago, you'd be sitting on more than $140,000 now. With dividends, that figure increases to nearly $180,000. What would you do with an extra $40,000?
Here's what we know
While pumping up your returns, dividends also transmit information about management's expectations regarding company prospects. Increases and initiations are a positive sign; reductions are a bad sign. Think about that classic American company, Johnson & Johnson (NYSE:JNJ). J&J has had 43 consecutive annual dividend increases -- a statistic that underlines its market-beating returns over the past 25 years.
Dividends are also "the best predictor" of so many other features and traits of a business. For one, dividends indicate a profitable business. But the dividend isn't simply a "sign." There's that little matter of the dividend being cash -- cash that you can either (1) take as a quarterly income to spend on necessities or luxuries, or (2) reinvest to enlarge your stake in the company through a dividend reinvestment plan (Drip).
This decision, of course, depends on your investment time frame and strategy.
Not-so-risky business
Managing risk is crucial in any portfolio, and dividends help investors achieve that goal. As Fool dividend guru Mathew Emmert says, "The beauty of the dividend is market outperformance with lower risk."
Skeptical? Well, let's put that statement under the lights. Do reliable dividend-paying companies "outperform"? Yes. In 2004, dividend payers in the S&P 500 outperformed non-payers 18.35% to 3.65%. Do reliable dividend payers carry less risk? Yes. For instance, because the dividends Mathew looks for are paid from free cash flow, his Income Investor recommendations are also less likely to cause you a total loss of capital.
Curiously, dividend-paying companies are slowly disappearing. The number of companies paying a dividend today is about one-fourth that of the mid-1950s. Also, dividend payers are becoming more industry-specific. Approximately 75% of companies in the oil and gas sector pay a dividend today (BP (NYSE:BP), for instance, pays an excellent dividend yielding 3.3%), while 0% of firms in the airline sector pay them. Which makes sense when you consider that ...
Cash is king
Here's a staggering stat for you: Of the nearly 10,000 publicly traded companies on the U.S. markets, about one-third currently report negative earnings. And these aren't all fly-by-night operations and airlines -- some are solid, proven businesses. The unprofitable ranks include giants like $14 billion Sun Microsystems (NASDAQ:SUNW), $11 billion Qwest (NYSE:Q), $7 billion Eastman Kodak (NYSE:EK), and $7 billion Cablevision (NYSE:CVC).
Read that again. Now take a deep breath.
Companies with free cash flow create shareholder value by paying dividends, buying back shares, and reinvesting in the business. In other words, cash creates shareholder value, and dividends indicate cash. But let's be clear: Not all dividend-paying companies are surefire bets. Some companies even try to manipulate investors by taking on debt to pay or increase a dividend (which is why it's imperative to look for dividends that are paid from money the business actually generated).
Making money is never boring
The case of California Water (NYSE:CWT) illustrates exactly what the Income Investor strategy is all about. The company had no Street coverage, a relatively small market cap (about $450 million), and a 4.7% yield. As a largely regulated water utility, its business model was stable. And California Water was undervalued by the market despite its dividend-paying fundamentals. The company is up 68% since Mathew's October 2003 recommendation and has been paying investors along for the ride.
Investing is about earning money that will support you and your family, generate income, subsidize utility bills, and pay for those umbrella drinks at the beach. You're a step closer to those goals in day one of dividend investing. If you can build a portfolio today, down the road you can turn off that "reinvest" feature and let the spigot open.
Dividend-paying stocks make money. Period. For that simple reason, they are what every portfolio needs.
If he could, Mathew Emmert would eat and sleep dividends. Since he can't, he just dreams about them. Click here to be Mathew's guest at Income Investor free for 30 days. You'll score two monthly recommendations, as well as a lively community of discussion boards; special members-only feature articles; and advice, FAQs, and tax tips for dividend investors.
This article was originally published on May 11, 2005. It has been updated.
Brian Richards wishes he'd reinvested the $4.18 dividend check he received on a quarterly basis as a kid. Instead, he bought gum. Brian does not own shares of any company mentioned in this article. The Fool has a strict disclosure policy.
