Editor's note: This article was updated on September 9 to correct the S&P 500 dividend yield to 1.5%.
Conversations like the one I had with a neighbor this past weekend demonstrate just how challenging this job is sometimes. After I spent the better part of 15 minutes trying to explain how some stock dividends are dangerous and contending that some others just aren't worth the price, he shot back: "Well, isn't it good anytime a company gives you cash?"
Hmmm. Although this is a good point, not all payouts are created equal. In fact, the majority of dividend-paying stocks won't help you earn market-beating returns, even if they look like it at first blush.
Wait a minute. Don't companies pay dividends when their stocks have run out of gas; when investors can count only on minimal growth? Of course. And some of you undoubtedly turn to the large-cap dividend-paying rocks -- notably General Electric (NYSE:GE) and Coca-Cola (NYSE:KO) -- to Foolishly diversify an income-generating portfolio. Yet income is but one reason to buy dividend-paying stocks. It may even be the least important reason.
Indeed, for those of us not nearing retirement, dividends can be much like a sturdy stick is to a pole vaulter: They give your portfolio a lift by providing a guaranteed return. That return lowers the bar over which your remaining stocks and funds have to leap in order to beat the market. Statistics bear this out. A study by Standard & Poor's found that in the 17 years from 1986 to 2003 a basket of U.S. stocks with the best history of boosting dividends and profits had an annual compounded return of 12.3% vs. 10.8% for the S&P 500 over the same period. Clearly, dividends deliver when aiming to beat the market.
But that still doesn't answer our question: If not all payouts are equal, then what kind of dividend should we be looking for? Well, how about one that beats the market?
A market-beating dividend
Yep, that's right. There is such a thing. As of this writing, the Standard & Poor's index of 500 stocks offers a dividend yield of roughly 1.5 %. Any stock paying more than that is technically offering you a market-beating dividend.
A check of my broker's stock screener shows 212 of the S&P's stocks yield at least 1.5%. Broaden the search to the entire market, and more than 1,600 qualify. That's a wide range of potentially market-beating stocks.
But beware: Some of these stocks are bound to be toxic for your portfolio. Take Middleton Doll (OTC BB: DOLL), for example. This frankencompany operates both a real estate investment trust (REIT) and sells collectible dolls. That alone might keep you away from the stock till you realize its dividend yields a positively mouth-watering 52%. A check of its key statistics at Yahoo! Finance finds free cash flow would cover the proposed payout, but with earnings down more than 89% over the trailing 12 months, even an eye-popping yield might not be enough to juice overall returns. (Indeed, the stock has lost more than 60% of its value over the past three months.)
Don't get greedy
It's so easy to go for the big yield when searching for dividends. But yields can be deceiving. As with Middleton Doll, you might be collecting a check while the value of your core holdings sinks faster than a boulder in the ocean.
Remember, there's an inverse relationship between a company's yield and its share price. When the yield goes up, it's very often because the share price has gone down. AT&T (NYSE:T) is a great example of this phenomenon at work. It's decidedly un-Foolish to chase a big percentage payout offered through a lousy stock.
And then there's that pesky payout ratio. When a dividend costs more to pay than the company has in cash flow, it's a sign of trouble ahead. As a rule, a company that pays, say, 30% of its cash flow is better than one that pays 100%. (Unless we're talking about REITs, which are required to pay out 90% of all taxable profits to investors.)
Still, there's no way to screen for payout ratios. So how can you tell whether a yield is safe? Unfortunately, you can't, at least not without doing some firsthand research. Since a stratospheric dividend is usually a bad indicator, let's just agree to not get greedy. My rule of thumb is to screen for stocks that offer at least a point more than the market's average payout, but no more than triple its yield. For this exercise, that leaves a yield range of 3.07% to 6.21%.
What's your strategy?
Even after running the traps to eliminate the most dangerous uber-yielders, we're still left with 550 stocks. That's too many choices for anyone to weed through. So, how do you make choices from 550 stocks? Sometimes, you simply can't. Or you might see a stock that you particularly like that falls just outside the range. Heinz (NYSE:HNZ) fits this description for me, yielding a market-beating 2.97% and trading for 17 times free cash flow.
But going by gut feel generally isn't smart since investing demands discipline. That's why pros such as Hewitt Heiserman, author of the wonderfully enlightening It's Earnings That Count, suggest you literally write down an investing philosophy that states the attributes of the kinds of stocks you look for. Tom Gardner follows this rule for Motley Fool Hidden Gems, and doing so has provided him with market-trouncing returns.
So, when searching for market-beating yields, you've got to first ask: What kind of stocks am I looking for? For me, it's well-managed, growing companies trading at a low enough price per share that there's a reasonable chance of doubling my investment in five to 10 years. That leads me to screen for growing earnings, cash flow, and high return on equity in addition to an attractive yield. And to create a margin of safety, I limit the field to established firms valued at $500 million or more that have a history of annually hiking their payouts. (For a short lesson in stock screening, try this excellent overview from Fool Selena Maranjian.)
What did I find? Eleven stocks, mostly banks, REITs, and foreign-born American depository receipts (ADRs). Two really sparked my interest: Bank of America (NYSE:BAC) and Redwood Trust (NYSE:RWT). Each firm boasts a dividend yield at least double that of the market with cash flow, earnings, and return on equity all growing at healthy clips. Both also have ample cash to fund their payouts. But that's where the similarities end.
Fellow Fool David Meier glowed at the prospects for Redwood Trust recently, praising the firm for its obviously shareholder-friendly management. Bank of America, on the other hand, was one of the first firms implicated in the mutual fund scandal. Yet the taint of the scandal, and the accompanying $375 million settlement, hasn't hurt returns.
I'm no expert in the trends impacting the banking and real estate industries. All I know is that management at both these firms has found a way to consistently boost dividends. That matters. Because as your dividend payout grows, so grows the amount you, the investor, yield. If beating the market is like clearing a high bar, then earning a market-trouncing dividend that keeps growing is like putting springs in your shoes. The bar just seems to get lower with each successive year.
Call it dividend achievement. In investing, it's as good as it gets.
Fool contributor Tim Beyers considers the high jump and pole vault two of the scariest events in track and field. They might also resemble investing, except that stock picking needn't be frightening. You can get help from any of our investing newsletters . Tim owns no shares in any of the companies mentioned, and you can view his Fool profile here . The Motley Fool has a disclosure policy .