Dividend investing may lack the dangers of penny-stock investing or day trading -- but it's not risk-free.
You could always buy into a dividend-paying company that proceeds to reduce its payout ... or eliminate it. But even that scenario isn't dividend investing's biggest risk.
The real danger lies in not parking some of your money -- perhaps a majority of it -- in healthy, growing dividend-paying companies. By ignoring the power of dividends, you're leaving a lot of money on the table.
The numbers don't lie
The folks at Ned Davis Research calculated S&P 500 stock returns from January 1972 to April 2009, based on companies' dividend policies:
|
Category |
Annual Gain, 1972 to 2009 |
$100 Became ... |
|---|---|---|
|
Dividend Cutters or Eliminators |
0.5% |
$120 |
|
Non-Dividend Payers |
0.7% |
$129 |
|
S&P 500 |
6.2% |
$941 |
|
Dividend Payers With No Change in Dividends |
6.2% |
$941 |
|
Dividend Growers and Initiators |
8.7% |
$2,246 |
Monthly data, Jan. 31, 1972, to April 30, 2009. Copyright 2009 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All rights reserved.
That kind of data might surprise most investors. We often consider dividends a conservative investment, but they can clearly produce powerful returns.
Initiator power
The data also reveals that dividend initiators tend to do well. Unfortunately, there's no way to know whether a company will announce a dividend until it does. But you can find promising candidates by seeking established companies with big piles of cash.
When firms are small and young, they need their dollars to fuel their growth. But as they mature, they can end up stockpiling cash. Some will hang on to it, to buy other companies or safeguard the bottom line. But others will ultimately decide that they can't invest it as well as their shareholders might.
These cash-rich companies don't pay dividends -- at least, not yet:
|
Company |
Market Capitalization |
Cash and Cash Equivalents |
Cash as a Percentage of Mkt. Cap. |
|---|---|---|---|
|
Cisco Systems |
$150.2 billion |
$39.6 billion |
26% |
|
Apple |
$216.4 billion |
$39.8 billion |
18% |
|
MEMC Electronic Materials |
$3.6 billion |
$720.6 million |
20% |
|
Amgen |
$58.9 billion |
$13.4 billion |
23% |
Data: Yahoo! Finance.
Seek growers
Since there's no surefire way to find companies launching dividend payments, consider searching for businesses poised to significantly increase their current dividends. Low payout ratios could provide an excellent clue, suggesting that the company sends only a sliver of its net income back to shareholders. That cash cushion could let these businesses hike their dividends without feeling much of a pinch. Look at these familiar examples:
|
Company |
Market Capitalization |
Dividend Yield |
Payout Ratio |
|---|---|---|---|
|
Costco |
$26.8 billion |
1.2% |
28% |
|
Oracle |
$128.9 billion |
0.8% |
18% |
|
JPMorgan Chase |
$181.9 billion |
0.4% |
24% |
|
Goldman Sachs |
$91.4 billion |
0.8% |
7% |
Data: Yahoo! Finance.
As the presence of JPMorgan Chase and Goldman Sachs suggests, there are many reasons why companies may choose to keep their payouts low indefinitely. The uncertainty of financial regulatory reform means that banks are likely to hold onto their cash until they're confident they won't need it.
The proof is in the pudding
For an even richer selection of promising investments, search for companies with an established record of substantially increasing their solid dividend yields. We've rounded up a few examples:
|
Company |
Market Capitalization |
Dividend Yield |
5-Year Avg. Dividend Growth |
|---|---|---|---|
|
PepsiCo |
$104.3 billion |
2.7% |
17.6% |
|
Wal-Mart |
$208.3 billion |
2.2% |
16.5% |
|
IBM |
$167.1 billion |
1.7% |
27.8% |
|
Monsanto |
$38.2 billion |
1.5% |
29.8% |
Data: Yahoo! Finance and DividendInvestor.com.
As always, past performance doesn't guarantee future results. But in the case of dividend growers, it's a reasonable bet.
The Foolish bottom line
All things being equal, the bigger the yield, the better. However, all things are rarely equal. A somewhat modest yield may grow quickly if a company is busy boosting its payout.
Above all, look at a company's big picture. Your search for compelling dividend winners should favor high-quality businesses with sustainable competitive advantages, strong profit margins and growth rates, healthy balance sheets, significant dividends, manageable payout ratios, and solid dividend growth rates.
That's what we look for at our Motley Fool Income Investor service. On average, its picks are beating the market by more than six percentage points, and they boast an average dividend yield of more than 4%. You can see everything we're recommending with a free, 30-day trial. Click here to get started -- there's no obligation to subscribe.
Longtime Fool contributor Selena Maranjian owns shares of Costco, Apple, Amgen, PepsiCo, and Wal-Mart. Costco, Monsanto, and Wal-Mart are Motley Fool Inside Value selections. Apple and Costco are Stock Advisor picks. PepsiCo is an Income Investor pick. Motley Fool Options has recommended a diagonal call position on PepsiCo. The Fool owns shares of Costco and Oracle and has written puts on Oracle. The Motley Fool is Fools writing for Fools.
