Our continuing search for the “holy grail” of investing brings us face-to-face with dividend-paying stocks.

I first ran into dividend-paying stocks quite unexpectedly, about a half-year ago, when I was informed by one of my mutual funds of a switch in strategy. Formerly a large-cap growth fund, it was now promising “income plus growth.”

“Income plus growth” sounded good. But I wanted to find out for myself the real story behind the dividend-paying companies my fund would now be investing in. I dove into the research and quickly discovered that my fund is just a very small part of a larger trend. Last year, U.S. companies paid a record $204 billion in dividends, including Microsoft’s $32.6 billion whopper dividend payment in December.

Still, I had my doubts about this spike in popularity. Was it just another example of the market mindlessly following the herd mentality? Or is there really something special about these stocks?

After much research, the truth is . . . dividend-paying stocks are the real deal. They do offer a unique amalgam of benefits on the risk and return side. Today, I’m going to share with you what those benefits are . . . how you can invest in dividend-paying stocks . . . and what you should watch out for.

Here’s What You Need to Know

“Income plus growth.” But exactly how much income are we talking about? How much growth? How safe are these stocks? This is what I’ve learned:

  • Dividend-paying stocks do better than the overall market. An S&P study and a University of Georgia study both found that the total return of these stocks (dividend plus stock appreciation) has outperformed other stocks in both bull and bear markets.
  • Dividend-paying stocks have low volatility. In other words, they don’t fall as fast or far as other stocks. Investors just aren’t in much of a hurry to abandon stocks from which they get a regular paycheck. And when the stock price goes down, the dividend yield automatically goes up. A stock with, say, a dividend yield of 3% can only fall so much before its rising yield starts to attract new investors. At 4%-6%, its price will begin to stabilize as new investors buy it for its higher yield.
  • These stocks have a built-in warning signal for investors. Companies will try to avoid lowering their dividend payout at all costs. So when they do, consider it a red flag: The company is having cash flow problems. At this first sign of trouble, exit the stock promptly.
  • With bond rates remaining stubbornly low, the dividend yields of these stocks are comparable to bonds. There are plenty of companies that offer higher yields than the 10-year treasuries.
  • You get a tax break on the dividend payments. A law was passed in 2003 lowering the tax on dividends to 15%. If you’re in the 27.5% bracket, a 2% dividend is equal to a 3.8% yield taxed at the normal rate.
  • These stocks diversify your portfolio. When interest rates are low, many dividend-paying stocks offer higher returns. When stocks are flat or in decline, these stocks perform much better.
  • Your cash income grows. There are 58 companies that raise their dividends every year. Some do it faster than others. But if a company’s dividends go up just 12% a year, in seven years you will have doubled your payout. Bonds don’t do this, even when you ladder them.

To get started on your search for dividend-paying companies, go to the Standard & Poor’s website (standardpoors.com) and enter a search for “dividend aristocrats.” Here you’ll find those 58 companies that have increased their cash dividend payments for 25 consecutive years. Companies that have the cash to increase dividends for so many years in a row represent fairly safe picks.

However, only one of these companies has a dividend yield of over 5% — Consolidated Edison. If you’re looking for higher yields, they’re out there, but now you’re entering tricky terrain.

Beware the Dogs of the Dow

There are two ways for yields to get higher:

1. If a company raises the percentage of its yield against the stock price. If, for example, Company X raises its yield from 2% to 3% on stock shares worth $100, you get dividends of $3 a share as compared to the previous $2 a share.

2. If a company’s stock price drops. If, for example, Company Y sticks with its $2 a share dividend but its stock price drops to $50, its effective dividend yield becomes 4%.

Just looking at dividend yield, you would choose Company Y with its 4% yield. But Company X is actually the better choice. Its yield is $1 higher and its share price has not fallen.

Selecting good dividend-paying companies is not as simple as going to a finance website and picking the ones with the highest current yield. Those companies are called “Dogs of the Dow.” Technically, they’re the 10 stocks with the highest dividend yield in the 30-stock Dow Jones Industrial Average. (All 30 DJIA companies pay dividends.) A stock typically gets to be a dog because its falling stock price caused its dividend yield to rise. And it usually stays a dog . . . year after year. These dogs take a big bite out of your overall return.

Maximizing Your Return

Aside from staying away from the dogs, there are a few other things you can do to make sure you choose the strongest dividend-paying companies.

First, look at dividend payout ratio. That’s the proportion of company earnings allocated to paying dividends. Determine whether a company is raising the yield of its dividend year after year by increasing earnings or by increasing its payout ratio. You want a roughly constant payout ratio based on year-after-year earnings growth. If the ratio rises every year, it is eating into earnings. At some point, something’s got to give.

The dividend ratio should be less than 55%. Don Taylor, manager of the Franklin Rising Dividends fund, says a higher percentage means the company might have to trim the dividend.

And make sure you apply the same rigorous metrics to these companies as you would to non-dividend-paying companies. Remember, not all dividend-paying companies boast strong fundamentals. If a company expects its stock price to fall because of weakening fundamentals, it can announce a dividend offering to keep its investors happy.

You now have all the information you need to make good investment choices in dividend-paying stocks. And if you do, you’ll have a reasonably safe haven for your money, a regular check, and stable stocks prices.

The only flaw here — and it’s a big one — is that the upside is limited. (Though not as limited as investments in bonds.) Nonetheless, these investments represent a long-term source of reliable steady growth income. But if you really want to squeeze a higher return from dividend-paying stocks, there are three ways to do it:

1. Buy small caps. Most dividend-paying companies are large caps. Their high-growth days are behind them. But some small companies also offer dividends and give you the best of both worlds — low risk, dividend-paying stocks with higher growth potential

2. Look at dividend-paying companies from other countries. On the average, their yields are higher than what is available in the U.S. The best markets are New Zealand (4.1%), Australia (3.7%), Finland (3.5%), Netherlands (3.5%), Belgium (3.3%), and Italy (3.2%).

3. Invest in Real Estate Investment Trusts (REITs). By law, a certain percentage of their earnings must be distributed to shareholders as dividend payments. While their dividends don’t qualify for the 15% tax rate, their yields are higher than those of industrial stock dividends.

Since you’re not going to make outstanding profits from your dividend-paying stocks, this doesn’t quite measure up to the standards we set for the “holy grail” of investments. Yet, I remain convinced that there is an investment approach that combines safety with a much higher upside. I’ve already caught glimpses of it. Investigated it. Tested it out. By all indications, it’s the real thing.

I’ll tell you about this powerful investment vehicle in my next article.

Andrew Gordon

Andrew Gordon is a former editorial contributor for Early To Rise Investor’s Edition. He has 20 years of experience working in infrastructure and environmental projects around the world. When he wasn't traveling, he taught marketing and finance courses at the state university of Maryland. Mr. Gordon has authored several books for McGraw Hill and other publishing companies on energy markets, global countertrade practices and the hot growth sectors of China and Russia. He is also a top-rated speaker at financial conferences.

Shares
Share This