Together, nine years ago, we watched the beginning of a downturn that cut the S&P 500 in half and dropped the Nasdaq nearly 80% from its highs. It was a maddening time for investors. Executives were caught with their hands in the corporate cookie jar. Technology shares plummeted, with hundreds of companies going bust. Very few bear markets in U.S. history have hurt so much. Even strong names such as Cisco Systems
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. Emotionally, losses hurt us 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.
Unfortunately, we're seeing the same trend today. We had corporate malfeasance at some of our country's most respected financial institutions, and now stocks are dropping and investors are swearing off the market.
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 and that will continue to do so even as many companies cut their dividends in this economic downturn.
Consistency to victory
Let's investigate this idea by looking first at Procter & Gamble. P&G has paid a stable dividend since 1890. Yep, you read that correctly -- the company has paid dividends steadily for the past 119 years. Some of you may be thinking, "Bor-ing!" But over the past 15 years, P&G has returned 10.6% annually, enough to turn a $10,000 investment into $45,000 today. And when stocks like this temporarily decline, as is happening during the current market swoon, owners still get a dividend payment that inspires us to be patient and calm -- two of the primary traits of the world's greatest investors.
Then there are PepsiCo
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 James Early has beaten the market by 4 percentage points since the service's inception in 2003.
But James 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 save yourself from the market's volatility.
A monster income investment
Finding great dividend payers isn't as simple as merely screening for yields. If it were, everyone might have bought shares of IndyMac Bancorp before it suspended its formerly significant dividend and, well, went under. And Pfizer
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, how that might affect future growth, and what the prospects for dividend increases may be. This is exactly what James does each month for members.
Let's look at one of his favorite monster stocks. Income Investor recommended California Water in September 2003. At the time, the sleepy utility was trading for $26. Using a discounted cash flow model, our team pegged its fair value closer to $37. Today, the stock trades for more than $40. Investors got a nice 50% capital gain to go along with the greater than 3% yield they locked in.
There are loads of great dividend-paying stocks, but they're not the market's most popular stocks. In fact, you usually have to go digging to find them. But to view James' favorite stocks for new money now, you can 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. California Water and Pepsi are Motley Fool Income Investor recommendations. Coca-Cola is an Inside Value pick. Pfizer is a former Income Investor selection. The Motley Fool owns shares of P&G. No Fool is too cool for disclosure.