The power of dividend investing is pretty well-known these days. Higher-yielding stocks tend to offer higher returns over time than low- or no-yield stocks, according to research from Jeremy Siegel and others. In fact, the 20 best-performing survivor stocks from the original S&P 500 in 1957 are all dividend payers.
What's more, reinvesting dividends acts as a "bear-market protector and return accelerator," according to Siegel. The extra shares purchased and accumulated at higher dividend yields during down periods act as a protector in falling markets, and these extra shares rising in value turn into a "return accelerator" when prices rise.
As the recent economic crisis illustrated all too well, however, you can't buy just any high-yielding stock. Dividends that get cut or suspended entirely can wreak havoc on a stock price -- and thus, your portfolio.
Fortunately, there are steps you can take to lessen your chances of buying one of these train wrecks. James Early, advisor of our Motley Fool Income Investor service, suggests looking at the payout ratio, for starters. That's simply the percentage of a company's net income used to pay its dividend. Obviously, the higher the payout ratio, the tougher it is for a company to meet its dividend obligation. James looks for a payout ratio less than 80% for safer companies, and a sub-60% or even sub-50% payout for companies you consider risky.
To further stack the odds on your side, you can limit your search to companies that have grown their dividend over the past three years or so. That eliminates the less stable or erratic dividend payers.
I constructed a screen to find some promising high-yield, low-risk pharmaceutical stocks for further research. I made sure the stocks met the following criteria:
- Market cap > $1 billion.
- Payout ratio < 60%.
- Three-year dividend growth > 0%.
- Pharmaceuticals, biotechnology, and life sciences sector, as defined by Capital IQ.
Only six companies passed the screen:
Johnson & Johnson
Source: Capital IQ, a division of Standard & Poor's.
Since you're looking for a decent yield, it's probably best to concentrate on the top four companies in the table. I would also be very wary of Medicis Pharmaceutical because both our Motley Fool Big Short and Motley Fool Alpha services have opened short positions on the stock.
However, both Abbott Labs and Johnson & Johnson appeared in the screen I ran last week for my 10 Best Values in Pharma and Biotech article. I recommend you start your research with these two companies.
What this means
Siegel sums it up nicely in his book, The Future for Investors: "Bear markets are not only painful episodes that investors must endure, but also an integral reason why investors who reinvest dividends experience sharply higher returns."
Whether in bear or bull markets, there's a reason why the top-performing stocks over the decades are all dividend payers. If you're lacking that type of exposure in your portfolio, you should take the first steps now toward finding stable dividend payers designed to weather any market cycle.
Fool analyst Rex Moore is brought to you by the letter "R." Of the companies mentioned in this article, he owns shares of Johnson & Johnson. Motley Fool Alpha has opened a short position on Medicis Pharmaceutical, which is a Motley Fool Big Short short-sale selection. Motley Fool Options has recommended a diagonal call position on Johnson & Johnson, which is a Motley Fool Income Investor selection. The Fool owns shares of Johnson & Johnson. Motley Fool Alpha owns shares of Abbott Laboratories and Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.