The Best Returns Possible

Dividend investing isn't just for your grandma. It's a savvy approach to investing that can lead to superior returns. Sure, dividends benefit investors close to, or in, retirement -- most U.S. stocks pay you cold hard cash four times a year, and a rising dividend payment can help fight inflation. But long-term shareholders who reinvest that cash year after year are setting themselves up to become quite wealthy.  

For example, the dividend-paying monster that is Johnson & Johnson has turned an initial investment of $25,000 into $1.7 million over 30 years -- through dividend reinvestment. That's a return of more than 7,000%. By reinvesting the dividend payment each quarter, shareholders continuously increase their stake in a company -- without having to dig into their own pockets.

Buy the best like the best
Furthermore, there's a reason why Warren Buffett has found himself owning so many dividend payers, even if that's not his explicit strategy. Stocks such as UPS (NYSE: UPS) pay shareholders because they're strong businesses with wide moats that generate loads of cash year after year after year.

Dividend or no, these are precisely the types of companies you want to own for the next few decades. Alas, if you're not a master investor like Mr. Buffett, how can you find the very best ones at the very best prices?

The magic formula
A recent study by Credit Suisse revealed that you could have beaten the market by eight percentage points annually (19.2% vs. 11.6%) by investing in the S&P 1500 stocks with the highest yields and lowest payout ratios.

In other words, these companies pay shareholders a healthy amount while keeping enough money on hand to reinvest in the business. Perhaps more importantly, a low payout ratio also means that the company's dividend will be safe in times of hardship, and that it has plenty of room to raise its dividend payment in the future.

Andy Cross, co-advisor of our Motley Fool Income Investor dividend investing service, particularly likes companies with a low payout ratio. According to Andy, "they have the freedom and flexibility to put their earnings to good use -- through dividend increases, stock buybacks, or reinvestments into their businesses."

Here's your homework
Now is a particularly good time to look for stocks with a low payout ratio -- the payout ratio of the S&P 500 has dropped to 30%. That's the lowest it's been in 50 years! Start by screening for companies with a payout ratio of 50% or less, and a yield that's well above the S&P average of 1.8%.

For example:

Foolish final thought
By buying reliable dividend payers, you can watch your nest egg compound and grow during your working years, and rest assured that your dividend payments will boost your spending power during retirement. Learn more strategies for finding strong companies that pay their shareholders and make for great long-term investments in the Fool's dividend newsletter, Income Investor.

Co-advisors Andy Cross and James Early search the dividend universe for above-average companies with below-average prices. Click here for a no-obligation 30-day free trial. You'll have access to all stock recommendations and back issues, as well as the team's thoughts and insights via the subscriber-only discussion boards.

This article was first published Dec. 14, 2007. It has been updated.

Claire Stephanic does not own any of the stocks mentioned. UPS is an Income Investor recommendation. The Fool has a disclosure policy.