Wednesday, October 26, 2011

Survive with Dividend Paying Stock Strategies

If the "lost decade" has taught us anything, it's that we need to change the way we invest in stocks. Today's generation of investors--myself included--came of age in a world where capital gains were easy and the homework was light. Although generating returns today isn't nearly as easy as it used to be, Wall Street continues to perpetuate the myth that capital gains are the be-all and end-all in investing.

It's been almost seven years since I charted a new course. I'd had quite enough of the buy-low, sell-high circus and found that there were other ways of making money in stocks--strategies that didn't rely on analyst upgrades, quarterly earnings estimates, celebrity CEOs, or patterns on charts.

I went back to first principles: investing in stocks that paid me back in cash through large, reliable, and growing dividends. If I could get the dividend right, everything else would take care of itself.

These principles became the cornerstone of Morningstar Dividend Investor, the newsletter I founded in 2005. Its goal is to provide you with practical, actionable, and timely investment advice from someone who is not trying to double your money every 90 days with high-risk picks, but rather to preserve capital, earn attractive income, and encourage long-run wealth accumulation.

Given the turmoil and tragedy in the years since Dividend Investor's inception, I'm pleased to report that we've made money while others have lost it. Our real-money Harvest and Builder portfolios have collected steady dividends--over $33,000 on a $100,000 initial investment based on one measure--while stocks have gone up, crashed, rebounded, and fallen again. Even without trying to "beat the market," Dividend Investor's recommendations have beaten Wall Street at its own game, with more total return and less risk.

I believe passionately in the principles and procedures that have produced our results thus far. In fact, our recommendations aren't just on paper. We've actually bought everything we've called a "buy" with Morningstar's own money. The same goes for our sells and holds. Sure, we've made some mistakes--who hasn't? But we always provide complete transparency for our subscribers. You get to learn from our steps and missteps. I will say, however, that our overall record speaks volumes about the true nature of stocks and the best way to profit.

How many of Wall Street's myths are you holding dear?

For me, this is more than a business. It's a mission. Wall Street is not telling the truth about how stocks really work, and almost no one seems to have a vested interest in making money for clients first and themselves second.

Though I am a professional investor by trade, I'm a historian at heart. Let's reach past the media-driven, debt-fueled bubbles of the past 20 years to examine how to really make money in stocks, starting by exploding a few myths that seem nearly universally held by investors.

Myth: Stocks are all about capital gains.

Fact: More than 90% of stock market returns are explained by dividends.

Depending on who and what you read, you've probably heard that the stock market returns 9%, 10%, or 11% a year. Do you know how many times the stock market has actually returned between 9% and 11% since 1945? Just once! (That was in 1993, in case you want to impress your friends.) In all other years, the returns on stocks were either higher or lower--sometimes a lot lower.

Yet amid all these fluctuations, dividends are the steadying factor. Not only does dividend income account for 36% of the total returns of the stock market* over the past 65 years, but dividend growth--the increasing income you can't get from bonds or other fixed-income investments--accounts for another 53%. The pure speculative piece (and what occupies 90% of Wall Street's attention) accounts for only 11%.

The Dividend Investor strategy seeks companies that pay solid yields--generally at least 3% and sometimes as much as 7%, but not so high that they're at risk of being slashed. But we don't stop there. We also want dividend growth that is at least equal to inflation, and the lower the yield on the stock the more growth we insist upon. This simple goal has paid off with over 230 separate dividend increases for our portfolio recommendations since 2005--and only 16 cuts.

Myth: A stock is worth whatever someone will pay for it.

Fact: The value of a stock comes from its future dividend payments.

I could wander off into the tall weeds of financial theory, but it's really not all that complicated. Think of it this way: You wouldn't put your hard-earned savings into a bond that paid no interest and never gave your original investment back, would you? Or invest directly in a small business that would never share its earnings? Why should the publicly traded stock of a large corporation be any different? Unlike bonds, stocks don't pay interest and they don't mature. An awful lot don't pay dividends either. But the ones that do are providing real, tangible, spendable value to their shareholders every year. Why make investing any more complicated than it needs to be?

One of my favorite companies, one that pays dividends every month and raises its dividend four and sometimes five times a year, puts this phenomenon in sharp relief. Since the end of 1994, when its stock traded at $8.56, it has paid dividends totaling almost $20 a share. The dividends keep right on coming, and right on growing, even as that stock now trades for $35.

Myth: You don't need income from your investments--you can always sell shares.

Fact: Only dividends can help you avoid selling shares at the worst possible prices.

We all remember that 2008 was a terrible year for the stock market. The Dow Jones Industrial Average dropped 4,488 points and the Standard & Poor's 500 Index fell 38.5%. The value of my portfolio holdings dropped too--it isn't as though dividends are guaranteed to prevent short-term paper losses. Excluding income, my two model portfolios lost 29.1% of their starting value of about $223,000. Even so, they threw off more than $11,000 worth of income--cash that could be used to pay the bills without having to sell stocks at 30% or 40% below their peaks. And since I didn't have to sell out, I could enjoy the recovery in full.

If you remember nothing else from this letter, remember this: dividends, and only dividends, provide returns that are always positive and paid in cash. That much should make dividend-paying stocks and strategies worth getting to know!

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Best regards,

Josh Peters, CFA, Equities Strategist, Editor, Morningstar Dividend Investor