Why Smart Investors Buy Dividend Stocks

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Let's get a few things straight.

Dividend stocks are not cool. They are not exciting. And they do not make for good conversation topics at parties. They're like the trombone player from high school who never had a date to prom.

In fact, come to think of it, the only thing dividend stocks are good for is making money. And potentially lots of it. So if you're not interested in making money, then proceed no further. There's nothing glamorous to see here. But if you clicked on this article because you're greedy and want to get rich from investing, like most of us here at The Motley Fool, then read on.

The unsung virtue of dividends
If you take only two things away from this article, make it these principles.

First, stocks that pay higher dividends have historically outperformed stocks that pay lower dividends. As Fool analyst Morgan Housel has noted, $1,000 invested in the S&P 500 in 1957 was worth $176,000 by 2006. The same $1,000 invested in the top 10 S&P companies with the highest dividend yields (more on this below) was worth $1.3 million.

Second, companies that pay more in dividends typically tend to experience higher earnings growth in the future. A study by researchers Rob Arnott and Cliff Asness divided stocks into 10 groups by dividend yield and found that the highest-yielding 10% had the highest earnings growth over the next decade. In this interview, Wharton professor Jeremy Siegel implied this was because high dividends encourage company executives to focus on profitability as opposed to imprudent acquisitions and share buybacks.

But here's the really interesting thing: While corporate cash flows are at or near record levels, the companies making up the S&P 500 are paying out less in dividends than ever before. For most of the 20th century, companies paid out the majority of their earnings as dividends. But this began to change in the 1960s, as the dividend payout ratio -- the percentage of net income paid out as dividends -- slid from more than 60% to around 50%. As of the end of last year, it was down to 29%, leaving most shareholders as unwitting victims of the lower-payout trend.

Knowing and using the dividend yield
While the knowledge that dividend-paying stocks generally outperform their non-dividend-paying brethren is important, it's nevertheless only half the battle. You still have to know which dividend stocks are worthy of your capital. And this is where the dividend yield enters the equation -- literally and figuratively.

The dividend yield is a ratio that shows how much a company pays out in dividends relative to its share price. It's calculated by dividing the annual dividends paid per share by the price per share. Let's take pharmaceutical giant Johnson & Johnson's (NYS: JNJ) stock as an example. Its share price is $65.22, and over the past year, it paid out $2.28 in dividends per share. Therefore, its dividend yield is 3.5% ($2.28 divided by $65.22).

Or how about consumer products giant Procter & Gamble (NYS: PG) ? With the stock at $64.98 and $2.10 paid in dividends, its dividend yield is 3.2% ($2.10 divided by $64.98). I used these companies because both are textbook examples of core dividend stocks; their businesses are globally diversified and have earnings streams that are ample and consistent.

In addition to communicating expected return, moreover, the great thing about a dividend yield is that it also communicates risk. While dividend stocks in general are typically less risky than non-dividend-paying stocks, among dividend stocks, it's fair to start with the idea that one with an ultra-high dividend yield is riskier than one with a more reasonable yield.

A textbook example of this is provided by the mortgage real estate investment trustsAnnaly Capital Management (NYS: NLY) and Chimera Investment (NYS: CIM) . While the companies are related -- Chimera is managed by an Annaly subsidiary -- the former invests largely in riskless assets that are guaranteed by the federal government, whereas the latter invests in non-guaranteed securities. By that standard, that makes Chimera patently riskier than Annaly even though Chimera uses less leverage. And as a result, it shouldn't be any surprise that Chimera's dividend yield of 15% is higher than Annaly's 13.9%.

You could even take this one step further, in turn, and argue that both Annaly and Chimera are significantly riskier than Johnson & Johnson and Procter & Gamble. But sometimes, comparing yields across industries can be misleading, so be careful.

I like to think of dividend yields much like how Goldilocks thought of porridge. On the one hand, a yield that's too high exposes you to too much risk. And on the other hand, one that's too low doesn't expose you to enough, thereby handicapping your return. Consequently, what you want is one that's just right -- say a point or two above the broader market average. What I like to use in this regard is the SPDR S&P Dividend ETF (NYS: SDY) , an exchange-traded fund that tracks the performance of the S&P 500 Dividend Aristocrats Index, a group of stocks that have increased their dividend payments for at least the last 25 years. At present, it yields 3.2%.

Looking for a dividend stock that beats this?
Of course, finding a stock with a dividend yield that both beats this benchmark and allows you to sleep soundly at night is easier said than done. It's for this reason, in turn, that our analysts drafted a free report about 11 rock-solid dividend stocks that the smartest investors are using to pad their pockets on a quarterly basis. It includes a number of reliable stalwarts, as well as one high-yielding telecom that is much more secure than its monster yield would otherwise lead one to believe. To learn the identity of this company, as well as the other 10, click here now -- it's free.

At the time this article was published Fool contributor John Maxfield does not have a financial position in any of the securities mentioned above.Motley Fool newsletter serviceshave recommended buying shares of Johnson & Johnson and Procter & Gamble. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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