Cash is king, and the regular return of cash to shareholders ultimately helps to dampen the volatility of stocks. Dividend-paying stocks provide the cash flow certainty of a tax-advantaged fixed income investment, along with the potential upside of the equity markets. There have been numerous reputable studies done proving that, throughout the history of the stock market, dividend-paying companies outperform non-dividend-paying companies over time. The outlook here is long term, so growth companies will naturally have particular years when they trounce both the broad market, and stocks with dividends. But dividends have a way of keeping companies honest, and the current tax treatment of dividends is also very favorable.
Now, don't go out and start buying the highest-yielding dividend stocks you can find. I'm sure you could quickly assemble a portfolio with a yield in excess of 8%. But just as in the bond market, high-dividend yields on stocks often reflect the higher risk of the company's shares, which makes the dividend coverage ratio all the more important. If you want to start buying stocks with income, familiarize yourself with this ratio.
By buying shares of a company sporting an attractive 13% dividend yield, you may quickly expose yourself to significant capital depreciation if things start to head south. Or worse yet, the company may reduce or even cancel its dividend if things are really bad. Not exactly a winning proposition. Any dividend yield in excess of 4.5% warrants extra investigation, particularly those special one-time dividend payments.
The real key to investing in dividend stocks is consistency -- a history of paying regularly scheduled dividends, coupled with a consistent annual increase in dividend. Suddenly, the universe of dividend stocks gets much, much smaller. Fortunately for us income hounds, Standard & Poors has compiled two indices that track those companies that have increased their dividend payments for 25 consecutive years. That's right, 25 consecutive years. These companies are typically more blue chip in nature, consisting of many energy and financial companies. The indices are the S&P Dividend Aristocrats and the S&P High Yield Dividend Aristocrats.
Most companies in the high-yield index have current dividend yields in excess of 3.5%. There's even an ETF for this index, the SPDR Dividend ETF (AMEX:SDY). Top holdings include Altria Group (NYSE:MO), Bank of America (NYSE:BAC), Con Edison (NYSE:ED), and First Horizon National (NYSE:FHN). The iShares series also has an ETF based on the Dow Jones Select Dividend Index (NYSE:DVY), which has outperformed both the SPDR ETF and the S&P 500. If you're a stock picker at heart, though, these indices are a great place to find potential gems. With Treasury bond yields near all-time lows, dividend stocks can provide a great alternative for steady cash flow at lower tax rates.
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Fool contributor Michael Mancini owns shares of Bank of America, an Income Investor recommendation. The Fool has a disclosure policy.
