Beating the Market With Dividends

In the summer of 2001, we presented a special feature on dividend investing in The Motley Fool Select ("Stocks That Pay -- High Dividend Investing," Select, Vol. 1, No. 3, p. 2), in which we argued for dividends as a safer way to invest in stocks in bear markets.

But a diversified, high-yielding portfolio may not only be less volatile than growth stocks, it may actually outperform the market.

A research report issued by Ira Malis and Richard Cripps of Legg Mason suggests that companies paying dividends actually outperform those that don't. In contrast to their reputation as low-growth, unexciting investments, stocks paying a dividend appreciated an average of 6.65% per year since 1973, while those that didn't returned an average of 1.96%, according to the report. (It should be noted that the returns cited were based on an equally weighted geometric average, rather than the market-cap weighted average used in calculating S&P 500 index returns. The study included all companies added to or removed from the index in that time.)

In his 1996 book What Works on Wall Street, James O'Shaughnessy notes that the returns of dividend-yielding stocks depended mainly on the companies' market caps. A portfolio of the top 50 dividend-yielding stocks (excluding utilities) taken from the entire stock universe would've turned in an average total return of 13.75% from 1950 to 1994, versus 14.61% for the stock universe as a whole. However, when invested in the top 50 dividend-yielding large stocks (those with a market cap in 1996 dollars of at least $1 billion), the results were very impressive, beating the overall large-cap investing universe by almost 2%, annually, with a return of 14.51% to the large-stock universe average annual return of 12.62%.

In short, a diversified portfolio of carefully selected high-dividend stocks remains an excellent evergreen strategy for investors who want the long-term benefits of equity returns with a bonus of current income comparable to that of bonds. The combination of the two should offer a very satisfactory "total return" over time, with the added benefit of moderate overall risk and superior capital preservation during market downturns, as compared to more conventional stock portfolios. And even aggressive investors would be well advised to consider adding a few high-dividend-paying stocks to their portfolios to reduce risk.

In our previous special, we looked for stocks that paid a minimum dividend of 4.5% and excluded real estate investment trusts (REITs), utilities, and bank stocks. The result was a portfolio of nine stocks with an average yield of 5.8%.

How did we do?
In the 18 months since our dividend special appeared, investors have experienced a tough bear market -- one that put our thesis of dividend stocks to the test. In this month's Select, we see how these stocks fared as a group versus the broader market, and present an updated sampling of dividend stocks, keeping those from the original portfolio that continue to offer compelling value and adding some new stocks that appear to offer an attractive combination of dividends and business quality at a reasonable valuation.

The portfolio featured only one big winner, WD-40(NYSE: WDFC), two reasonably strong performers, and one that basically broke even. Five of our companies turned in negative stock performances, with Ford Motor(NYSE: F) leading the way with a loss of almost 60%.

But here's the kicker. Price appreciation is only part of the total return of high-yield stocks -- we also get the return of capital in the form of dividends. Too often the major media focus intently on stock prices -- which means that those who seek total appreciation, including dividends, are less likely to have to deal with the momentum-style speculators. Dividend stocks are just less likely to come onto their radar screens. That's a good thing.

In our basket of companies, including the "assist" from big dividend checks, investors would've fared just fine with our sample dividend portfolio. The table below shows that $1,000 invested in each of the nine stocks on June 13, 2001 (for a total investment of $9,000) would've been worth $8,907.94 on Dec. 4, 2002, for a loss of about 0.1%. The stocks lost about 8.5% in value over the period, but the hefty dividends added back 7.4%, for a total loss of less than 1%.

In comparison, the S&P 500 index lost about 26% of its value (not including dividends), or about 23% of its value (assuming a 2% composite dividend yield for the 18-month period). The Nasdaq lost 33% of its value over the same time period. For this short period, this list of companies would have destroyed the returns of the major indexes.

Dividend stocks for the next 18 months
In this month's issue of The Motley Fool Select, we're back on the trail, looking for high-quality companies reporting a dividend yield of 4.5% or higher. In so doing, we've decided to dump four of our last picks, hold five, and add four new names to the list. Sign up forSelect to get the full scoop. For a limited time, you'll also receive a free copy of Stocks 2003 (a $55 value), a volume of our top analysts' favorite stock selections.

Remember that in addition to the dividend yield, a portfolio of dividend-yielding stocks should also grow in value over time, adding the component of equity growth to current income. The result should be a more superior total return over a long-term horizon than a portfolio of bonds. 

Zeke Ashton has been a long-time contributor to The Motley Fool and is also the managing partner of Centaur Capital Partners, LP, a money-management firm in Dallas, Texas. His analysis appears every month in The Motley Fool Select . He also picks two asset management firms as great investments for the years ahead in our Stocks 2003.