Crushing the Market Is Easier Than You Think

Beating the market is incredibly hard, right?

It must be. After all, a heck of a lot of fund managers seem to prove that every year by falling short of the market's returns. And over the past 10 years, not only has beating the market been tough, but showing any positive returns has been a feat because the S&P 500 fell 19% over that time.

But does buying stocks that will give you bragging rights over Mr. Market have to be a brain-bending exercise? Maybe not. In fact, I believe that if you key in on one particular metric, you can improve your investing results and spend less time pulling out your hair over your portfolio (which means more time on the golf course!).

Problem, meet your solution
What is this black magic that I refer to? You've probably heard of it, but if you're like the rest of the investment world, you've left this metric sitting in the corner gathering dust with your bell-bottom pants and black-and-white TV. In this one simple number you get to see whether the company you're looking at is actually making money, if its stock is reasonably priced, and how it views its shareholders.

If you haven't guessed yet, I'm talking about dividends.

Annihilating the market
As I said at the outset, the overall market's performance over the past 10 years -- as measured by the S&P 500 -- has been abysmal. But for investors who had their eyes on dividends back in 2000, the results may have been much different.

From 2000 to 2009, the average dividend-adjusted return on stocks with market caps above $5 billion and a trailing yield of 2.5% or better was a whopping 114%. Compare that with a 19% drop for the S&P 500 and a 2.6% dividend-adjusted decline on the S&P 500-tracking SPDRs, and you'll see why I'm so excited about dividends.

Who were these market-trouncing dividend payers? Don't be too shocked, but many of them are companies that you're probably very familiar with.

Source: Yahoo! Finance; Jan. 6, 2000, to Jan. 6, 2010.

And bear in mind that the returns include some of the bombs in the financial sector, which led to big drops for dividend payers like Regions Financial (NYSE: RF) and Huntington Bancshares (Nasdaq: HBAN). Technically, both of these banks still pay dividends today with 0.5% and 0.6% yields, respectively, but that seems hardly enough of a payout to compensate for the yet-shaky ground that many of the regional banks still operate on. And of course with yields that low, they wouldn't make it into a screen today looking for dividend investments with a yield of 2.5% or better.

This number-crunching also doesn't take into account any analysis past looking at the dividend yield. Value-added analysis such as judging the sustainability of a company's dividend or evaluating the prospects for the company's business could lead you toward the best opportunities among the dividend payers.

A plan for your portfolio
So what's the best way to leverage the power of dividends? Here are three simple steps that can get you started on putting some dividend might into your portfolio.

1. Track down high-quality dividend payers. The obvious first step is to find companies that are paying decent dividends. I generally set my benchmark at 2.5% or better. Once you've got a nice big group of dividend payers, identify the companies with strong, stable businesses that you would feel comfortable owning over the next 10 years.

2. Diversify. Though some sectors may have more dividend payers than other sectors, be careful not to overweight your portfolio too much in one direction. Just ask any bank-happy investor how that has worked out over the past few years.

3. Hang on and reinvest. Few, if any, market-beating stocks put up their stellar returns in a nice, smooth rise. The key to harnessing dividends is to hang onto the stock, reinvest the dividends, and let the magic of compounding and dollar-cost averaging do the work for you. 

Here's a start
The market has charged back considerably from where it was early last year, but there are still a great number of top-flight stocks carrying tasty dividend yields.

Source: Yahoo! Finance.

In the mad rush to bag big returns over the past year, investors have been flocking to some of the riskiest stocks out there. In many cases, they've been rewarded handsomely, but in the process "boring" dividend payers like electric utility giants Duke and Exelon have been left in the dust. That's all the better for us because we can score those huge yields.

Abbott Labs and the Bank of Nova Scotia, meanwhile, are facing some pessimism in their industries -- Abbott because of looming pharmaceutical patent expirations and Bank of Nova Scotia thanks to the global banking crisis. In both cases, though, these companies skirt the issues facing their industries.

While Abbott doesn't somehow magically avoid patent expirations, its diversified business model -- the company gets nearly half of its revenue from outside its pharma division -- gives it a cushion against disappearing patent protection. Bank of Nova Scotia, meanwhile, is among a group of major Canadian banks that operate on a much more conservative model and were able to avoid the huge losses and dividend cuts that many U.S. banks -- like Regions and Huntington -- faced during the global meltdown.

And before you scoff at PepsiCo's comparatively low yield, it's important to note that in the five years ended in 2009, the company's payout more than doubled. With dividend growth like that, you don't need a hefty current payout to end up with big dividend checks rolling in. And of course PepsiCo's business is one of the most stable out there.

You don't have to go down the dividend path by yourself. The investing team at the Motley Fool Income Investor newsletter eats, sleeps, and breathes dividends. If you want to get the lowdown on some of the very best dividend payers, these are the folks to ask. And the best part? You can check out Income Investor in all of its dividend glory with a free 30-day trial. 

This article was originally published Jan. 28, 2010. It has been updated.

Fool contributor Matt Koppenheffer owns shares of Abbott Labs, but does not own shares of any of the other companies mentioned. Exelon is a Motley Fool Inside Value recommendation. The Bank of Nova Scotia, Duke Energy, and PepsiCo are Income Investor selections. Motley Fool Options recommends a buy calls position on PepsiCo. The Fool's disclosure policy always minds the KISS principle.