The Market's Most Sinful (and Lucrative) Dividends

Ah, dividends. The allure of a high-yield regular payout has understandable attraction for investors. For ages, my Foolish colleagues have lauded the long-term potential of dividends. And why not? In some cases, dividends can contribute to the majority of a company's returns. Plainly put, dividends are often instrumental in building long-term wealth:

Source: Motley Fool Staff's calculations.

There's the real power that dividends, specifically reinvested ones, can have on a stock's long-term return. And this graphic captures only the dividend yield of the S&P, which is currently 2% and has averaged just north of 4% since 1932. Imagine the compounding impact of a company that pays out a 5%, 6%, or even 8% dividend yield. Huge returns.

But wait ...
But before you dive into the dividend game and buy the highest-yielding companies you can find, you may want to take a minute and ask where these yields come from. Investors may be disappointed to find that oftentimes the companies that pay the highest dividend could be classified as "sin stocks," participating in such lovable industries as alcohol, tobacco, and firearms. Depending on how wide you cast the sin-stock net, you'll also catch some oil companies in the mix.

If investing in these industries makes you uneasy, there are other ways to go. Fellow Fool Alyce Lomax has achieved a strong return while investing in socially responsible companies through her Rising Stars portfolio. If you're indifferent and still want to chase monster dividends, here are some of the market's highest and most sinful dividend stocks.

Source: S&P Capital IQ.
*Transocean's payout ratio is not meaningful because of negative net income.
**Transocean's three-year dividend growth is not applicable, since it began being issued in 2011.

These companies well outpace the S&P's average dividend yield, even more so when you strip them out of the equation since some of them are listed on the S&P and their presence in the index raises the average. The inclusion of oil companies here may skirt the line of what's "sinful," but it may not sit well with every investor that SeaDrill, for example, makes deepwater drilling possible for oil companies -- and then there's the matter of Transocean and BP's roles in the Gulf of Mexico oil spill.

So just how profitable are these companies? Well, over the past 10 years and with dividends reinvested, an equally weighted portfolio of these companies -- excluding Philip Morris and SeaDrill, since they haven't been trading for 10 years -- would have returned an impressive 168.7%. That trounces the S&P's 26.4% dividend invested return over the same period. Because it's typically the mature, profitable companies that can afford to pay dividends, investing based on these payouts can sometimes have the added benefit of getting stable companies in your portfolio.

Guaranteed income isn't guaranteed
Of course, there are risks to consider in any investment. As fellow Fool Robert Eberhard has pointed out, a high dividend yield doesn't always equal a high return. In addition, a company can reduce or even cease to pay a dividend. For Instance, Bank of America reduced its dividend in late 2008, right before practically eliminating it.

An extremely high dividend payout ratio can also leave companies with less cash to reinvest in new products, make acquisitions, or pay interest. That said, Reynolds American and Altria are two extremely mature companies that I don't expect will need large amounts of capital to reinvent their cigarette designs or expand through acquisitions. Both companies operate exclusively in the U.S. market, where cigarette sales have been in a decline, so they are unlikely to need to fund large-scale growth. Since Philip Morris will realistically need free cash to invest in its growing international presence, it's good to see a lower payout from that company.

I am surprised at how high Vector Group and SeaDrill's payout ratios are. Vector Group bullishly raised its dividend in the second half of the year, and it even did so through the recession. But because it relies on one sector that's in decline (cigarettes) and another persistently weak sector (real estate), it may find this pace difficult to upkeep. SeaDrill, meanwhile, has a reputation for paying out most of its earnings, but it's also saddled with a lot of debt. Granted, most of it is long-term debt carrying interest rates of less than 5%, but paying out a lot of cash still leaves that much less on the table to make interest payments. I'm not in love with this setup, and I'll steer clear of this one for now. Finally, Diageo's dividend comes in the form of an interim and final dividend each year, so payouts won't be as regular as with other companies.

The Foolishly sinful pick?
Of the companies here, I like Phillip Morris. It has a strong dividend yield, a reasonable payout ratio for the industry, and huge potential sales ahead in Asia and Latin America. It doesn't offer the highest payout of the companies we've examined, but it's decidedly sinful -- and in my opinion, it has one of the brightest futures.

If you like the idea of dividends but you're queasy about taking payouts from a sin stock, I invite you to check out The Motley Fool's special free report: "Secure Your Future With 11 Rock-Solid Dividend Stocks." In it you'll find 11 undeniably great picks for improving your portfolio's long-term return, with nary a cigarette company in site. Get free access now!