Cash Cows
Great Companies with 10%+ Dividend Yields

John D. Rockefeller once quipped that the only thing that gave him pleasure was to see his dividend coming in. The famous oil tycoon made that statement in the early 20th century, and for some investors during the tech boom of the late 1990s, it may well have seemed a hopelessly anachronistic sentiment. After all, with the new millennium fast approaching in 1999, the average dividend yield on the S&P 500 had sunk to a multi-decade low below 1.2%. Meanwhile, the yield offered by the industry titans of the Dow Jones Industrial Average had sunk to just 1.6%, less than half the 3.4% rate dished out ten years earlier. At that point in time, no one seemed to care about a 1% or 2% yield when the market was rallying +15-20% annually and offering capital gains galore.

However, the frothy bull market of the 1990s was a statistical anomaly, as dividends have historically formed a key component of stock market returns over the long haul.  In fact, between 1926 and 2005 the S&P 500 delivered total returns of +10.5% per year. Capital appreciation alone accounted for just +6.1% annually, or 58% of the total gains. The remaining 42% of the market's total return came in the form of dividend payments. This is a much larger percentage than most investors realize!   

In part, the decline of dividends can be attributed to their high taxation, as payments were usually taxed heavily at both the corporate and personal level. However, favorable tax legislation was enacted in 2003. This effectively reduced the personal tax on dividends from as high as 38.6% (the top marginal tax bracket in 2003) to just 15%. Dividends suddenly became a much more efficient way to increase shareholder value. As a result, many companies decided to either increase their payouts or to initiate dividends for the first time, suddenly reversing a 20-year slide in the number of S&P dividend-paying firms. 

In fact, according to the Cato Institute, total aggregate dividend payments shelled out by S&P 500 members jumped +18% to $172 billion in the twelve months following the new law. That staggering total has swelled in years since, coming in at $247 billion in 2007. And turning our attention to the broader markets, 1,745 companies announced dividend increases in 2004, the first full year after the change in tax legislation. Clearly, dividends are back in favor with both corporate executives and investors.  

(1.)  The Importance of Compounding

The dividend payments generated by a modest investment might seem to be inconsequential initially, but through the magic of compounding, it won't take long before they can begin to make a dramatic impact on your portfolio.   

After all, these dividends can be used to purchase more shares, leading to even larger dividend checks. These larger checks can then be used to buy even more shares and so on. In time, even a small stake in such stocks can grow into a tidy sum. 

For example, suppose an investor buys 1,000 shares of stock in XYZ Corp. at a purchase price of $10 per share (for an initial investment of $10,000). Next, let's assume that XYZ pays a steady annual dividend of 10%, and the shares rise at an +8% annual rate going forward. 

In the beginning, the first quarterly dividend check would be worth just $250: (($10,000 * .1)/4). 
While that amount will certainly not go very far on its own, it is enough to purchase around 25 more shares at the initial $10 per share price. Of course, those 25 shares would then generate dividend payments of their own. As the chart below shows, this steady compounding process can yield amazing results over the long haul.

After 30 years, the initial 1,000 share stake in XYZ would have grown to 17,449 shares! At the same time, assuming a conservative +8% compounded annual growth rate, those shares would have soared from $10 to more than $100. As a result, the beginning $10,000 investment would have swelled to more than $1.7 million dollars,  without ever adding another penny! 

But what would have happened if the investor just pocketed those dividend payments year after year? Well, the stock would still be worth about $100 after 30 years, but without any reinvestment he or she would only be left with the same 1,000 shares, for a total of approximately $100,000. Even when the cumulative dividends paid of $122,346 are included, the entire investment would still only have grown to around $223,000, which is more than $1.5 million less than with dividends reinvested. 

It's also worth pointing out that at the end of the 30-year period, the first portfolio would be generating annual dividend payments in excess of $170,000 ($1.7 M * .1). In other words, the investor's annual dividend income alone would amount to more than 17 times his or her initial $10,000 outlay!

(2.)  More Than Just Solid Dividends

You might ask why should an investor bother buying high-income stocks just to earn a few extra percentage points of return when the bond market offers a safer yield? Well, the answer is deceptively simple. Stock returns are really the product of two elements: dividends and capital gains.

Both bonds and income-oriented stocks can offer attractive yields. However, unlike their fixed-income counterparts, most dividend paying securities also offer decent capital appreciation prospects over time. That means investors are able to not only earn stellar dividend yields, but they can also realize additional gains from rising share prices. Bonds simply cannot match that upside potential. Furthermore, bonds are much more susceptible to interest rate fluctuations, as rising rates can quickly erode the value of their fixed interest payments. 

Income Investing is Now Back in Vogue

After more than a decade of playing second fiddle to capital gains, dividends are back in style. History shows that periods of abnormally large stock market gains are typically followed by extended periods of below-average returns. For example, the huge bull run in the Dow Industrials from the late 1940s to the mid-1960s gave way to a flat market from 1965 to 1980. Over this period, the Dow actually returned less than +1% annually (excluding dividends). This same pattern held true after the 1920s bull run and was also seen in the Japanese Nikkei after its huge advance during the 1980s. After the big run-up we've seen in the past few years, we could be in for a period of uninspiring trading action. 

One effective way to make money in a flat (or even declining) market is to collect dividends. In the slow growth decade of the 1970s, dividends accounted for nearly 80% of the market's total returns (as opposed to 10% during the 1990s). This strategy holds true because companies that pay dividends tend to have more reliable, stable businesses that hold up better during challenging economic conditions. After all, to pay dividends over a prolonged period of time, a company must be able to generate dependable earnings. These are exactly the sort of companies that investors turn to for shelter in troubled times.

Each of the securities we'll profile in today's report features yields of 10% or higher -- that is far better than the rates offered by competing money market accounts, CDs, or government bonds.

(3.)  What to Look for in a Dividend-Paying Security

While it might be tempting to invest exclusively in the market's highest-yielding securities, this shortcut approach usually leads to mediocre returns. To begin, off-the-charts dividend yields are typically the result of very depressed share prices. In many cases, the companies that offer such high yields are in poor financial shape.

In addition, poorly performing companies often see their share prices decline even further, leading to dismal overall returns. Remember that income stocks offer returns from two sources: dividends and capital gains (or losses). With this in mind, although you can hold a stock that offers an exceptional 15% dividend yield, if the underlying shares lose -20%, then your investment will end up losing money.

Furthermore, most dividends are by no means guaranteed. Companies can reduce their dividend payouts (or eliminate them altogether) whenever they like. As such, a fat dividend yield alone does not guarantee investment success.

With this in mind, we prefer to focus our research on those securities with a proven ability to not only pay dividends year after year, but also to increase their payouts. We also examine a number of other factors to ensure that our investment ideas are fundamentally sound, and look for securities with the best total return potential.

In an effort to determine whether a particular firm can be counted on to pay a sizable dividend plus deliver steady capital appreciation in the coming years, we've established a list of important investing criteria. Before investing in any dividend-paying stock, we carefully evaluate each of the following fundamental factors:

Yield -- A dividend yield indicates the annual return that a security delivers in the form of dividend payments. The yield can be calculated by simply dividing the annual dividend payment per share by the security's current stock price. For instance, let's assume XYZ Corp. is currently offering quarterly dividend payments of $0.50 per share for a total annual distribution of $2.00. Let's also assume XYZ stock is currently trading at a price of $50 per share. In this case, Company XYZ offers an annual dividend yield of 4% ($2.00/$50.00). In an effort to hone in on companies with the most impressive dividend yields, today's report focuses exclusively on securities with yields of 10% or more.

Payout Ratio -- Although we want to earn high returns on our investments, we're also careful to watch for too much of a good thing. A company's dividend payout ratio indicates the percentage of a firm's earnings that management is paying out to shareholders. The payout ratio can be calculated by dividing a stock's annual dividend payment by its annual earnings per share.

The average payout ratio for a component of the S&P 500 Index is around 30%. However, this figure varies greatly from industry to industry. Many high-tech sectors, for example, retain nearly all of their earnings to deploy back in the business. They therefore have very low (or zero) payout ratios. On the other hand, mature, slower-growing industries, such as utilities or banks, often boast payout ratios as high as 70% or more. Meanwhile, real estate investment trusts (REITs) maintain even larger payout ratios, as they are required by law to return 90% of their earnings to shareholders in the form of dividends. And finally, some companies pay out more than 100% of their earnings to shareholders. In general, we prefer to avoid such firms, as those types of payout ratios almost always prove unsustainable over the long haul.

As a rule of thumb, we generally look for securities with dividend payout ratios below 80%. However, there are certain exceptions to this rule. For example, the payout ratios of securities such as real estate investment trusts (REITs), limited partnerships, Canadian income trusts, and shipping firms can seem deceptively high if they are based on earnings instead of available cash flow. That's because these companies typically have very high non-cash depreciation expenses, which reduce earnings but don't affect the cash flow available to shareholders.

Reliability -- Companies are under no legal obligation to continue paying dividends. Therefore, we want to find those that we can count on to maintain and hopefully even increase their quarterly dividend payments. We usually look for companies that have paid consistent dividends for several years. Also, we look for firms with strong track records of increasing those dividend payments. A lengthy history of stable (or rising) dividend payments is often convincing evidence of a company's commitment to its shareholders.

Total Return -- Although dividends are certainly an important part of the picture, they don't represent the whole story. In the end, the total return that a stock delivers is a combination of its dividend yield and capital appreciation. A stock may pay a decent annual dividend, but if its share price declines year after year, then the net effect could be a flat, or possibly even a money-losing investment. Although income investors are typically willing to trade capital gains for the relative safety of predictable income, we prefer to look for stocks that offer the best of both worlds -- rich dividend payments and solid long-term growth potential.

Taxes -- Income investors should always be mindful of the after-tax rate of return they earn on any investment. A stock may pay a solid dividend, and its shares may outperform the market, but if those gains are taxed at a stiff rate, then this may neutralize them. As mentioned earlier, several years ago the tax rate imposed on most dividend distributions was reduced to 15%. One notable exception, however, are real estate investment trusts (REITs). Their distributions are still taxed as ordinary income at rates as high as 35%. On the other hand, despite the higher tax rate, many REITs still generate after-tax returns that are far superior to other income stocks. Therefore, investors may want to consider shielding REIT dividends and other unqualified dividends by placing those stocks in qualified, tax-advantaged accounts, such as IRAs.

(4.)  Companies with 10%+ Dividend Yields

With all of the above factors in mind, we recently scoured the market in search of quality securities with compelling dividend yields of at least 10%.  The following firms passed this initial hurdle . . .