The Dividend Edge

Here's a question I think a lot of investors skip: Why invest in stocks when money market accounts currently offer 5% or better, risk-free? An easy answer to that question is that cash and interest-bearing accounts can be ravaged by inflation when the interest paid is too low, while companies with pricing power typically offer investors some protection from inflation in the long run.

One way to balance this dilemma is to invest only in companies selling at prices that offer a margin of safety to that 5% return plus a 4% to 5% equity risk premium. It takes a little time to search such companies out, but in a bear market, capital preservation is, as Ford used to say about quality, Job 1.

How growth fared in the last go-round
With markets that have marched upward the past three years, it is easy to forget what happened to companies that were considered growth stocks in the last bear market. Using the March 2000 high and March 2003 low for the S&P 500, I calculated the performance of three growth stocks over that period and compared them with the S&P. I chose Amazon.com (NASDAQ:AMZN), Cisco Systems (NASDAQ:CSCO), and Broadcom (NASDAQ:BRCM), because all three were viewed as can't-miss growth stocks that could do no wrong. Something to consider today when looking at Google, Baidu.com, or any other company with a great deal of growth priced in.

Today, I think the story for Cisco is likely a bit different, because the valuation is much more realistic than it was six years ago, and the company's share buybacks are putting a meaningful dent in its shares outstanding. However, the performance of these three companies shows that when the bear growls, companies with high growth expectations take the brunt of the bear's attack, and most growth companies pay little in the way of dividends that can help cushion the fall.

Three dividend payers that are attractive now
For contrast, I screened for three dividend payers that are attractively valued now and then checked to see how each performed over the last bear market as well. The metrics I screened for are below, and the table that follows shows the performance of these companies in the last bear market:

• Dividend yield above 3%.
• Return on assets above 9%.
• Return on equity above 15%.
• P/E below 17.

The table makes a strong case for seeking out undervalued dividend payers heading into a market downturn. Genuine Parts is the worst performer of the group, but its 10% annual gain is a welcome sight in the face of the S&P's fall, and shareholders received a healthy amount of dividends along the way that could be reinvested into additional shares.

UST and Polaris Industries, on the other hand, were companies that the market despised at the beginning of the bear market and loved by the end. With its consistent dividend, UST, in particular, is the type of business and situation investors should look for. For additional ideas that follow a similar pattern, investors should consider snooping around in the pharmaceutical industry as well.

Foolish final thoughts
Not all dividend-paying companies will perform as well as the three above. But as someone who holds a mix of dividend payers and smaller companies primed for long-term growth, I can attest to the performance of undervalued dividend payers in a downturn and how much sweeter the gains are when capital is preserved for the next market upswing.

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This article was originally published on June 30, 2006. It has been updated.

At the time of publication, Nathan Parmelee had no position in any of the companies mentioned. Amazon.com is a Motley Fool Stock Advisor selection. The Fool has a disclosure policy.