Save Yourself From Massive Losses

Together, six years ago, we watched the beginning of a downturn that cut the S&P 500 in half and dropped the Nasdaq nearly 80% off its highs. It was a maddening time for investors. Telecom and energy executives were caught with their hands in the corporate cookie jar. Technology shares plummeted, with hundreds of companies vanishing from sight. Very few bear markets in U.S. history have hurt so much. Sun Microsystems (NASDAQ:SUNW), a bull-market darling, fell from a split-adjusted $63 per share to $4. And Cisco Systems (NASDAQ:CSCO) dropped from $80 to $20.

Just how painful was it? Ask Nobel Prize-winning psychologist Daniel Kahneman, who proved that humans are innately loss-averse, particularly when it comes to money. Losses hurt us emotionally far more than gains give us pleasure. Naturally, then, those massive declines crippled tens of thousands of investors, many of whom will -- sadly -- never throw the one-two punch of savings and investment again.

It doesn't have to be that way.

Win with moderate risk
The solution is not to bail out of the market altogether, nor to seek shelter exclusively in bond funds. With the right perspective and useful tools, you can strengthen your stomach and beat the market -- because you'll do so without assuming huge risk. I know that's true because it's being done every year by the world's master investors -- from Buffett to Lynch to Tillinghast to Miller.

Those who take the biggest risks and buy what's hot today usually take the biggest hits in down markets. In the meantime, a host of methodical, smart, and contrarian investors ring up great returns, even through tough markets, by adhering to Warren Buffett's first rule of investing: Preserve capital.

Today, I want to focus on one sweet way to preserve capital and beat the market. The general principle is simple: Buy stocks that have paid uninterrupted dividends for years.

Consistency to victory
Let's investigate this idea by looking first at Procter & Gamble (NYSE:PG). P&G has paid a stable dividend since 1890. Yep, you read that correctly -- the company has paid dividends steadily for the past 116 years. Some of you may be thinking, "Boring!" But over the past 15 years, P&G has returned 14% annually, turning a $10,000 investment into more than $70,000 today. And when stocks like this temporarily decline (as they are doing right now), owners still get the dividend payment, inspiring all of us to be patient and calm (two of the primary traits of the world's greatest investors.)

Then there's Colgate-Palmolive (NYSE:CL), which has paid a dividend since 1895 and has increased its dividend in each of the past 43 years. Or Pfizer (NYSE:PFE), which has paid a dividend since 1938 and has increased its dividend in each of the past 39 years. Since 1990, both Colgate and Pfizer have crushed the S&P 500 by 8 and 5 percentage points, respectively.

This sort of investing success is happening every day in our Motley Fool Income Investor advisory service. Using a combination of outsized yields and capital gains, analyst Mathew Emmert has beaten the market by nearly 3 percentage points since his newsletter's 2003 inception.

But Mathew isn't picking just any old high-yielder. He believes that to outperform the market, you have to find financially strong, well-managed, undervalued companies that pay dividends. Why take a chance on Joe's Next-Generation e-Hot Dog Stand -- with its jumpy beta, battered balance sheet, and 50/50 chance of going bankrupt -- when you could invest in a stable ship that returns profits to shareholders and provides capital returns over the long term?

It's a tried-and-true formula, and if you follow it, you'll have the stomach to beat the market.

Two monster income investments
Finding great dividend payers isn't as simple as merely screening for yields. If it were, everyone would own shares of Nordic American Tanker Shipping (NYSE:NAT) and its 20% yield (which is highly cyclical). As with any investment, it's crucial to scrutinize a dividend-payer's financial statements, management team, and business model. Determine how the dividends are being financed, what the payout ratio is and how that might affect future growth, and what the prospects for dividend increases may be. This is exactly what Mathew does each month for his members.

Let's look at one of his favorite monster stocks:

Mathew recommended Diageo (NYSE:DEO) in May 2004. At the time, the liquor leader was trading for $53. Using his discounted-cash-flow model, Mathew pegged its fair value closer to $61 -- later revising that valuation upward. Today the stock trades at $68, a 28% return for investors before dividends. Add the 3% yield subscribers have locked in, and that's good for an investment that's 19 points ahead of the market.

There are loads of great dividend-paying stocks, but they're not the market's most popular. In fact, you usually have to go digging to find them. But to view Mathew's two newest picks and favorite stocks for new money now, click here. There's no obligation to subscribe, and maybe -- just maybe -- we'll come through this crazy market without any massive losses.

This article was originally published as "Do You Have the Stomach to Beat the Market?" on June 10, 2005. It has been updated.

Tim Hanson does not own shares of any company mentioned in this article. Pfizer and Colgate-Palmolive are Inside Value recommendations. No Fool is too cool fordisclosure.