The Agony of Dividend Defeat

To me, cheap, dividend-paying stocks are as inviting as hot cocoa on a cold winter's day. There's simply no better juice for muscling up your portfolio than buying and holding shares in sturdy businesses that pay out heaps of excess cash.

Let's go to the judges
Just ask Jeremy Siegel. Author of The Future for Investors and a Wharton business school legend, Siegel revealed that cigarette purveyor Altria (NYSE:MO) has been as dominant in the market as two-time gold medalist Benjamin Raich was on the slopes of Torino. Indeed, since 1957, the former Philip Morris has racked up annualized gains in excess of 19%, with dividends reinvested, of course.

I find that remarkably encouraging. But I'd have to relinquish my belled cap if I didn't also pass along this warning: Dividends won't always save you.

Like that ski-jump crash from "Wide World of Sports"
Some businesses just don't measure up. Either their stocks are too expensive, or competition is too fierce, or cash flow can't cut it, or ... whatever. For these firms, dividends don't matter. The underlying fundamentals are too much like a troublesome mogul: They'll send your portfolio into a painful tailspin.

Don't believe me? A search for firms with stocks that have dropped at least 30% over the past year finds 58 with dividend yields of 3% or higher. Mix in a minimum price-to-earnings-to-growth (PEG) ratio of 1.7, and the list dwindles to four really bad stocks, three of which income investors ought to be especially wary of:

The signs of a loser
Why did these stocks tumble down the hill? At some level, we don't really know because we're only talking about one year. Investors are prone to irrational behavior over short periods.

That said, there's no denying that these businesses have problems. Take Ford, for example. It isn't exactly in a wonderful place right now. Sure, the company could miraculously recover a la Bode Miller. But, also like Miller, the fundamentals suggest that it isn't on track for a medal of any sort any time soon. In fact, expenses are rising faster than sales, and 30,000 jobs are due to be cut. Ouch.

The signs of a winner
Of course, most dividend payers don't look this bad. But not all can be high performers, either. Mathew Emmert, Fool dividend guru and chief analyst for Motley Fool Income Investor, has identified four characteristics of the most promising dividend payers:

1. Enough size and financial strength to create growth and pay a substantial dividend. Alternatively, a company offering a deep value.
2. A market capitalization of $1 billion or more and debt less than 60% of capital.
3. Return on equity in excess of 10% and return on assets approaching 2% for financials, 5% for property real estate investment trusts (REITs), and 7% for others.
4. A dividend yield approaching 3% that's fully funded through free cash flow.

Using that approach has led Mathew to some major winners, including Equity Inns (NYSE:ENN) and Snap-on (NYSE:SNA), which are beating the market by 38 percentage points and 23 percentage points, respectively. And, of course, both still sport market-leading dividend yields. (If you're seeking more stocks like these for your own portfolio, ask us for a guest pass to Income Investor. You'll be able to browse the service free for 30 days.)

The Foolish bottom line
Blindly juicing up on big yields can be dangerous for your portfolio. Don't do it. Instead, be like the Olympic athlete who follows a relentless training regimen: Buy stock only in dividend payers that pass Mathew's tests, and then routinely reinvest the proceeds. Doing so is the surest path to earning gold and a place atop the stock market's podium.

Fool contributor Tim Beyers loves getting paid to invest. Won't you join him? Tim didn't own shares in any of the companies mentioned in this story at the time of publication. You can find out what is in his portfolio by checking Tim's Fool profile. The Motley Fool has an ironclad disclosure policy.