Here's a litmus test for stocks that I picked up from a Warren Buffett quote. Say you knew that the day after you bought shares of a company, the stock market would close for five years, so no matter what happens, you're stuck. Would you still invest?
While I think this test applies to all stocks, I find it especially useful when seeking out dividends. If you're relying on dividend reinvestment to boost your returns then you want to find companies that will keep paying for years to come -- preferably decades -- so compound interest will have time to work its magic.
A moat filled with alligators
I like this test because it largely takes the market's fluctuations out of the equation and forces you to focus on the quality of the company. What you think makes a high-quality company will depend largely on your investment strategy, but I usually begin by seeking out sustainable competitive advantages, or moats for short.
Moats are important because whenever a business starts making money on a new product or service, other companies will notice and say, "Dude, we've got to get in on that." Soon, competition will drive prices down and eat away at profits unless the original company has some kind of advantage that protects it from competition.
For example, consider Procter & Gamble (NYS: PG) . The consumer staples giant sports a dividend yield of 3.2% and ranks in the 20 top-performing surviving stocks of the original S&P 500. You can trace the company's success back to two advantages. First, P&G has built up a portfolio of strong brand names. When you think about it, Tide probably doesn't get your clothes cleaner than the next brand, but we're willing to pay a little more for it anyway.
P&G also benefits from cost advantages. For instance, when you walk down the detergent aisle, you'll find the original Tide formula next to the cold-water version and high-efficiency formula, along with a variety of scents and their corresponding cold-water and high-efficiency formulations. This variation essentially creates a Tide billboard in the middle of the grocery store. Because P&G is so large, adding another variety of detergent is relatively cheap when compared with what a smaller competitor would have to spend to create a similar billboard.
Obviously, no one can predict the future with absolute certainty, but P&G's competitive advantages, 50% payout ratio, and 41-year history of paying out dividends suggest that it would pass the five-year test.
The land of secure economic castles
In addition to P&G, you'll find lots dividends protected by wide moats among consumer product manufacturers. Below I've listed five well-defended companies with yields greater than 3% and low payout ratios from my watchlist.
Source of Moat
Diageo (NYS: DEO)
Massive brand portfolio including Jose Cuervo, Smirnoff, and Guinness. Distribution network spans 180 countries.
Johnson & Johnson (NYS: JNJ)
Well-known brand names like Tylenol and Band-Aid, collection of pharmaceutical and medical device patents, robust research pipeline to keep the patents coming.
Philip Morris International (NYS: PM)
Including Marlboro, the company owns seven of the top-selling international cigarette brands.
PepsiCo (NYS: PEP)
Frito-Lay's collection of brands dominates the snack category. Pepsi's direct-to-store delivery system keeps competitors off the shelves.
Sysco (NYS: SYY)
Food distribution is a capital-intensive business limiting competition. Scale allows the company to negotiate discounts with suppliers.
Source: Yahoo! Finance.
Any one of these massive-moat dividends would make a solid addition to your portfolio. If you would like even more ideas, then you should check out this special report, Secure Your Future With 11 Rock-Solid Dividend Stocks. It's absolutely free, so click here to download it today!
At the time thisarticle was published The Motley Fool owns shares of Diageo, Philip Morris International, Johnson & Johnson, and PepsiCo.Motley Fool newsletter serviceshave recommended buying shares of PepsiCo, Sysco, Philip Morris International, Johnson & Johnson, Procter & Gamble, and Diageo.Motley Fool newsletter serviceshave recommended creating a diagonal call position in PepsiCo.Motley Fool newsletter serviceshave recommended creating a diagonal call position in Johnson & Johnson. 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.Fool contributor Patrick Martin owns shares of Philip Morris International. You can follow him on twitter @TMFpcmart03.
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