Pay Attention to This or Lose 44.7% of Investment Returns

Ken is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

They are not usually exciting and they don’t normally make splashy headlines; but, on average, stocks that pay dividends outperform the market average over time. Since the end of 1929, the S&P 500 index has averaged an annualized return of 9.4%. But, only 5.2% of that total return was from growth. The remaining 4.2%, or 44.7% of the total, was due to dividends paid. 

Don’t Settle for Average

Careful investors don’t have to settle for average returns; a little bit of due diligence can go a long way toward identifying businesses that produce higher yields with lower payout ratios than the overall market and are less expensive as well. A strategic, diversified investment in those special businesses is how long term investors can begin a profitable journey that requires minimal effort to maintain.

Not All Dividends Are Created Equal

When buying stocks for dividend yield, investors who take the extra time to assure they are buying a business with an above average yield at a below average price will be richly rewarded over time. In addition to buying at prices below the market average, it is also important to allocate capital toward businesses that have established a track record of increasing dividends year after year and possess the strength and stability to maintain that record over extended periods of time.

Financial stability should always be a cornerstone consideration. The 5-year average annual dividend increase and current payout ratios are good metrics for this evaluation. Debt to equity ratios are also an important consideration as debt and interest can become problematic in difficult economic environments. While not all businesses meet this criteria, there are some that do. It is also critical that long term investments be diversified across different market segments in order to spread risk.

Evaluating Some Prospects

The table shown provides some interesting possibilities for the beginnings of a diversified, dividend focused portfolio containing Potash (NYSE: POT), Intel (NASDAQ: INTC), Herbalife (NYSE: HLF) and Target (NYSE: TGT); all of which appear to provide metrics that are superior to the overall market in some critical areas.

Business S&P 500 Potash Intel Herbalife

Target

Dividend Yield 2% 2.84% 4.28% 3.08% 2.12%
5-yr. Dividend Growth Rate 5.19% 43.1% 14.09% 31.95% 20.64%
Payout Ratio 34% 29% 39% 28% 30%
Price to Earnings Ratio 15.8 13.32 10.96 8.47 14.67
Price to Cash Flow 15.6 12.9 5.6 7.3 8.5
Debt to Equity 1.57 0.41 0.26 1.16 1.07

As a brief review of this table will reveal, in the metrics covered, each of these stocks appear to be less expensive than the S&P 500 on average, while also providing a higher dividend yield and resting on very solid financial footings.

What Makes These Businesses Special?

Buying a stock just because it has a high current yield is not a Fool's game; it is a fool's game.  Not all companies paying a high dividend will be able to maintain it. These businesses will not only be able to maintain the current dividend payouts, I expect all of them to increase them.

Potash makes fertilizers for the agricultural industry that are phosphate, potash and nitrogen based. It is one of the industry leaders. Without these products, the world would be unable to produce enough food from the acreage available to feed the growing population. As the emerging economies continue to grow, people will want to consume more and better food. The market for the products Potash produces is virtually guaranteed to grow as more food is required. The existing solid financials of this business at the end of a global recession and the necessity of its products provide ample assurance of its ability to easily maintain the dividend, and its 5-year history of generous increases indicate a willingness to raise it when practical.

Intel has increased its dividend at almost three times the rate of the S&P 500 average for the last five years. The company is expanding its dominant presence in computer chips into the chip market for mobile devices and is also beginning to successfully offer its excess manufacturing capacity to the chip designers who do not have their own manufacturing capabilities.  As this expansion will require no real capital expenditure to implement, the extra sales will flow straight through to the bottom line and further enhance the cash stream of this stellar business, which is already gushing profits. With management showing a real willingness to reward shareholders with rapid dividend increases and share repurchases, investors can safely expect more of the same from the new revenue streams coming on board now.

The major criticism of Herbalife is that it is a multi-level marketing business where only those at the top get rich. That is mostly true but is also exactly what profit minded investors want to hear: management that returns value to the owners. The nutritional supplement business overall has grown at an annualized rate of 7.1% over the last five years, but Herbalife has grown their sales at a 13.67% pace.  You can debate the fairness of the compensation structure in multi-level marketing but you can't argue with the effectiveness of the results. The opportunity to acquire the stock at this price was created by accusations made by a prominent short-sellers of the stock that the business was a Ponzi scheme, but those allegations seem to have quietly been pushed aside, having only created an excellent entry point into the stock.

Target is fighting tooth and nail with Wal-Mart in the discount retail arena and doing quite well in the struggle. It is growing sales and earning faster, it is growing its dividend faster and actually produces a better net margin on sales of 4% versus 3.7% for Wal-Mart. With forward 5-year earnings growth projected at 12.2%/year, this could be one of the best retail stocks available today.

Conclusions

Investors interested in establishing a well diversified portfolio of stocks with above average dividend yields and fundamentals superior to the overall market would be well served by considering investments in the businesses discussed here. These companies should all outperform the market for the next five years and all offer the potential to outperform by a wide margin.


Ken McGaha owns shares of Intel. The Motley Fool recommends Intel. The Motley Fool owns shares of Intel and has the following options: Long Jan 2014 $50 Calls on Herbalife Ltd.. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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