Dividend stocks are as popular as ever. These income producing securities offer the safety, and stability, that both newer and cautious investors crave. But dividend stocks can be much more than a safe alternative. By taking two, simple, extra steps in your stock selection, you can also find dividend stocks that beat the market handily.

Yes, you can beat the market
Buying and holding dividend stocks, over long periods of time, beats the market. Research proves it. First, dividend stocks as a group, outperform in bull and bear markets and beat the S&P 500, by 1.6% on average according to Ned Davis Research. But you can do even better (than a 1.6% beat) by focusing your stock selection only on dividend stocks that also have a low payout ratio. In a study by Credit Suisse, tracking investment returns from 1990-2008, the universe of high yielding, low payout dividend stocks, nearly doubled the returns of the S&P 500. 

There's two reasons why screening for high dividend yield, and a low payout ratio, leads to quality stocks so regularly.

  1. First, high yielding dividend stocks give you a head start on total returns. If your dividend stock yields 3%, and gains 5% per year, it would have a better total return (8%) than a non-dividend payer that gained 7% per year.
  2. However, a dividend can't tell how a business is doing. That's why the payout ratio, which is the percentage of earnings paid out in dividends, is crucial to watch. Short-sighted management teams will sometimes raise a dividend, even as earnings slide, to placate investors. For instance, RadioShack juiced its dividend above 11%, even as it was suffering big losses. Stocks with high payout ratios are always at risk of a dividend cut; it's just not sustainable.

The low payout ratio, means a business can pay shareholders dividends, and still have money left over to invest in labor, advertising, R&D, or other vital areas. Generally speaking, it means the business is generating stable cash flows. 

The approach of buying low payout ratio, and high yielding, dividend stocks beats the market, but only over time. To match these results, you need to take advantage of patience and avoid moving in and out of stocks. If you can do that, there are some stocks that meet the "Credit Suisse" criteria today, that you should consider. 

3 low payout, high yielding stock picks
Today, the average dividend yield of S&P 500 stocks is 2.07%, and the average payout ratio is 51%. Not many stocks are better than average in both categories, which is why Wal-Mart (NYSE:WMT), J.M. Smucker (NYSE:SJM), and Kellogg (NYSE:K), look interesting. The three have have high dividend yields of 2.5%, 2.6%, and 3.3% respectively, and they have a track record of keeping their payout below 51% as well.  

K Payout Ratio (TTM) Chart

K Payout Ratio (TTM) data by YCharts

If you purchase one of the three aforementioned  individual stocks, you should consider the potential down falls of each. While J.M. Smucker is performing relatively well, earnings grew 11% in Q1, it trades at a relatively high valuation. Its P/E is around 18, which is pretty high for a slow growth business.

Wal-Mart trades at a reasonable P/E multiple of 14, and Kellogg's P/E is only 11,  but both businesses are facing consumer headwinds. Kellogg is being challenged by consumers fading interest in cold cereals. To combat this, Kellogg is investing in its snack business. It purchased Pringles in 2012, and is currently bidding for British cookie and snack maker, United Biscuits.

Wal-Mart is confronting consumers changing preferences by scaling back on big-box growth, introducing new smaller format stores, and investing heavily in e-commerce. 

These are all serious challenges, but not new ones. All three stocks have been able to slowly grow earnings, over the past five years as these challenges have developed (below).  Kellogg has averaged 10% growth annually, J.M. Smucker 11%, and Wal-Mart about 8%, even amid some flat quarters. 

K Retained Earnings (Quarterly YoY Growth) Chart

K Retained Earnings (Quarterly YoY Growth) data by YCharts

At the same time, all three stocks have maintained operating margins that are both consistent, and in line with their peers. This metric is the percentage of profit each company records from sales, after expenses. If it is stable, and earnings continue growing, cash flow should generally be stable. This is necessary for dividend payment increases. 

K Operating Margin (Quarterly) Chart

Operating Margin comparision (Kellogg/J.M. Smucker vs. Campbell Soup and General Mills) (Wal-Mart vs. Target)  (Quarterly) data by YCharts

Keep it simple
Most investors will feel uncomfortable with a strategy that is this simple. It's human nature to believe that beating the market has to be harder than following a two step process. But taking in too much information, which often causes too much emotion driven trading, is precisely why so many investors fail. Showing restraint, by only focusing on what matters, is a skill. 

Wal-Mart, J.M. Smucker, and Kellogg, are not sexy stock picks. But they, along with other high yielding, low payout, dividend stocks, may be your simplest path to market beating returns. 

Adem Tahiri has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.