Dividends Save the Day!

We've proven over the past decade that buy-and-hold investing is dead, right? The ignorance of those nutty "long term" investors has been laid bare as the stock market has lost money over the past 10 years. So much for the long term, losers.

I'm kidding.

In fact, I find it laughable to an "LOL" degree that anyone would use the past decade as their "definitive proof" that buy-and-hold investing doesn't work.

Ten years ago, equity valuations were through the roof, and most -- if not all -- of the lackluster performance since then has been downward adjustments in valuations. The idea behind buy-and-hold investing isn't that you indiscriminately buy any old stock and hope that it carries you to retirement just because you don't sell it. Rather, the idea is that you do smart, diligent work up front to find good companies that are attractively valued, and then you hold onto them as long as the company continues to deliver.

In other words, blindly holding onto a stock isn't a silver bullet that will send your portfolio skyward.

But is there a silver bullet elsewhere?
I'm hesitant to refer to anything as a silver bullet when it comes to investing because I don't want to give anyone the idea that they can be lazy and still do well in the stock market. But I'll let the numbers speak for themselves.

Obviously, the performance of the overall stock market for the past decade was pretty horrendous. The S&P 500 lost nearly a quarter of its value between the end of 1999 and the beginning of 2010. A set of all 950 stocks with a market cap above $1 billion at the beginning of 2000 shows a median loss of 3.2%.

But if you had done just one thing back in 2000, you could have grabbed a median gain of 28% over this dismal period. What was that one thing? It was demanding a dividend yield above 3%.

Even though the financial crisis slammed banks such as Huntington Bancshares (Nasdaq: HBAN) and Regions Financial (NYSE: RF) -- both of which paid a healthy dividend a decade ago, but only have a token payout today -- the typical stock among the group would have moved an investor's portfolio in the right direction. And bear in mind that the median 28% gain does not include the impact of dividends.

Why this works
There are three primary reasons that I believe dividends were able to counter the market's terrible performance.

1. Dividends prove real, cash earnings.
2. They impose fiscal discipline.
3. A certain yield level implies a reasonable valuation.

Back in 2000, everyone was busy crowing about eyeballs per share and other ludicrous metrics that were supposed to mean something about the practically immeasurable potential for the Internet. But guess what? You can't pay dividends with eyeballs -- at least not in this day and age -- and the companies that were paying dividends were proving that they had real businesses that put cash, not just promises, in the bank.

But just because a company has a strong, cash-generating business doesn't mean that it's sharing that cash with shareholders. If there's good reason for that, I can get on board. But more often than not, the reason is that some megalomaniac CEO wants to build the company to the size of a small country so that he can collect a kingly paycheck. Usually this is done through acquisitions and usually it wastes shareholders' money.

Finally, if a company is trading at 100 times earnings, it's practically impossible for it to have much of a dividend yield without sucking all the resources out of the company and destabilizing it. In other words, if a stock has a 3%-or-better yield, it's unlikely that the stock is wildly overpriced.

Even easier today
Back in 2000, there were 191 companies with a market cap above $1 billion and a dividend yield of 3% or better. Today, there are 456 such companies.

But while I believe that focusing on dividend payers starts you off on the right foot, I don't think that alone is enough to build a strong portfolio. So when I'm choosing dividend stocks, I'm also looking to diversify across sectors, find quality companies, make sure payout ratios are reasonable, and be sure the company has been growing its payout over the years.

Here are a few stocks that are currently on my radar.

Source: Capital IQ, a Standard & Poor's company.

For dividend investors who forgot about diversification and overloaded their portfolios with bank stocks, the financial crisis was a rude reminder that spreading out over industries is a swell idea.

The group above does just that -- Diageo claims major liquor and beer brands, Illinois Tool Works produces a vast array of industrial products, Bank of Hawaii is exactly what you'd think it is, Conoco is an oil major, and RPM manufactures specialty coatings and other chemicals.

Beyond diversification, though, these are all stable, high-quality businesses, all are reasonably valued, and all have shown a commitment to kicking out cash to their shareholders in the form of dividends.

Over the past decade, we faced the come-down from the Internet-bubble high and the financial and housing crashes. But in the midst of all of that, dividend-paying stocks continued to reward investors.

In the coming decade, we're going to face what looks like a slow, bumbling recovery from those most recent disasters -- not to mention any new fumbles that crop up. It's hard to say for sure whether we're really in for a double-dip recession or how quickly unemployment will ease. But what I do feel safe saying is that stocks like those above will more than likely serve investors well through whatever is ahead.

Think the individual investor is dead? Think again.