A Strategy to Beat Dividend Stocks

For years, investors have looked to dividend stocks as a great all-purpose investment. Not only do dividend stocks provide you with the income many people need to cover living expenses, they also often provide some downside protection when markets start to decline.

But just because dividend stocks have favorable characteristics doesn't mean that they're always your best bet. In particular, when you expect the market to rebound sharply, sticking with dividend stocks -- especially in defensively positioned industries -- can lead to subpar returns.

In 2009, during the depths of the financial crisis, the stock market seemed to be in serious trouble. Many companies were on the verge of failure, as tight credit conditions made it nearly impossible for cash-poor businesses to get the financing they needed. As a result, investors gravitated toward companies in better financial shape, with cash reserves to survive however long the crisis might last. Many of those safer companies were dividend stocks, with business models that not only produced enough cash to finance ongoing operations but also left enough additional money to make dividend distributions to shareholders.

But when the stock market turned around and started to recover, these safer stocks weren't the big winners. Many analysts complained that the companies that rebounded the most strongly were those that arguably deserved it the least: so-called "junk stocks" that had extremely high risks of bankruptcy. Ford (NYS: F) , Freeport-McMoRan (NYS: FCX) , and Las Vegas Sands (NYS: LVS) had all seen major disruptions to their businesses -- with Ford suffering from weak demand that eventually forced its fellow American competitors into Chapter 11, Las Vegas Sands teetering under huge amounts of hard-to-refinance debt, and Freeport dealing with commodity prices that plunged during the market meltdown. Yet they were among the top-returning stocks of 2009, leaving their safer counterparts in the dust.

You can see the same phenomenon in the big run-up that stocks enjoyed between last October and the end of April. The S&P High Yield Dividend Index posted strong gains during that period, but it nevertheless underperformed the overall S&P 500, and it greatly underperformed more aggressive measures like the small-cap Russell 2000.

Specific stocks show this even more clearly. Johnson & Johnson (NYS: JNJ) barely budged during the summer plunge last year that lopped off more than 20% from the S&P 500, but it has also stayed close to flat during the ensuing recovery, and its core businesses have remained relatively stable throughout the period. Procter & Gamble (NYS: PG) was a bit more volatile as it had to deal with rising costs for raw materials, but it too has been steadier -- and less lucrative -- during the bounce.

Of course, it's far too early to start talking about whether the current correction will eventually get anywhere near as bad as the 2008-'09 bear market was. After all, the S&P 500 is still up for the year so far, and while analysts are as always divided about the most likely direction for the market to move in the near future, it's entirely possible that stocks have already seen their worst levels and will rise from here.

But regardless of when stocks bottom out, the thing you should remember is that if you want to maximize your gains in the next big bull market run, the same dividend stocks that protected your portfolio from the worst losses are also quite likely to prevent you from earning the biggest profits.

To make the best investments, you have to know your objective. If you're ambitious and are willing to trade in and out of stocks to capture the best returns possible from any market environment, dividend stocks could hold back your results during major bull markets. But if you want to buy and hold stocks for the long haul rather than trading in and out of stocks, then the risk-reward profile of dividend stocks may be exactly what you're looking for.

If you're in that last group of investors, let me invite you to take a look at The Motley Fool's special report on dividend stocks. Inside, you'll find the names of nine dividend dynamos with big potential. It's free, so click here and get your copy today!

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter@DanCaplinger.

At the time thisarticle was published Fool contributor Dan Caplinger knows that knowledge pays dividends. He doesn't shares of the companies mentioned in this article. The Motley Fool owns shares of Freeport-McMoRan Copper & Gold, Johnson & Johnson, and Ford. Motley Fool newsletter services have recommended buying shares of Johnson & Johnson, Ford, and Procter & Gamble, as well as creating a synthetic long position in Ford and a diagonal call position in Johnson & Johnson. 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 Fool's disclosure policy is always your best bet.

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