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 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's 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 Applied Materials (NASDAQ:AMAT), JDSU (NASDAQ:JDSU), and Sirius Satellite Radio (NASDAQ:SIRI) because all three were viewed as can't-miss growth stocks that could do no wrong. That's something to consider today when you're looking at Google, Baidu.com, or any other company with a great deal of growth priced in.

Today, I think the story for Applied Materials is likely a bit different, because the valuation is much more realistic than it was six years ago, and the company has begun paying a dividend. However, the performance of these three companies shows that when the bear growls, companies with high growth expectations take the brunt of its attack. 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, 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 when the market is heading into a downturn. The worst performer of the pair is PetroChina, but that is before dividends. After dividends, PetroChina turned in a slightly positive return, and it's been a tremendous performer the last couple of years.

VF, on the other hand, was despised by the market at the beginning of the bear market and loved by the end. With its consistent dividend, VF is the type of business and situation investors should look for.

Foolish final thoughts
Not all dividend-paying companies will perform as well as the two mentioned 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.

To learn more about currently undervalued dividend payers, take a 30-day free trial to our Motley Fool Income Investor service. Our picks are beating the market to date and offer an average current yield of more than 4%. Click here to learn more.

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. VF is a Motley Fool Income Investor selection. The Fool has adisclosure policy.