A Winning Investment Strategy — For Life

They still make themselves heard on the street, and with good reason…

Bull market, bear market, overall market — this class of stocks consistently outperforms its peers over time.

I’m referring, of course, to companies that pay dividends to stockholders.#-ad_banner-#

The Dutch East India Company threw off the first-ever dividend payment to shareholders in the year 1602. Since then, thousands of companies have used the tactic to attract investors. And investors, for their part, have found such payouts to be effective income generators — not to mention overall market beaters.

Fast-forward 411 years to this headline from The Wall Street Journal last week: “Even With Dow at Record High, Dividends Still Matter.”

During the past four decades, the Journal reported, “dividend-paying stocks have either outperformed or limited their losses compared to the broad market when measuring either bull markets, bear markets or overall market performance.”

As evidence, the Journal cited data from investment manager BlackRock and Ned Davis Research covering the 40 years ended last December. Their findings are reflected in the chart below.

During bull markets, S&P 500 dividend payers have averaged a 20.5% gain, compared with a 19.5% gain for the S&P 500 as a whole. Non-dividend payers in the S&P 500, by contrast, advanced an average of 17%.

In bear markets, the non-dividend paying stocks fell by almost twice the rate as the dividend stocks.

Here’s another way to look at the power of dividends…

According to research by Morgan Stanley U.S. Equity Strategist Adam Parker and others, dividends have accounted for more than 40% of the total market return since 1930. When broken down by decade, in fact, there have been two 10-year periods — the 1930s and the first decade of the current century — when dividends accounted for all of the market’s returns. And this could be just the beginning.

StreetAuthority co-founder Paul Tracy has gone on record saying he believes dividends will account for 100% of the market’s return in the current decade as well.

Thanks to what’s likely to be an extended period of slow growth in the U.S. economy, “it’s obvious that dividends will account for an even larger share of the market’s returns” for years to come, says Paul.

That’s not to say there won’t be opportunities to make money in the current “dividend decade,” as Paul refers to it. “You just have to position your portfolio to take advantage of this new reality,” Paul says.

Say hello to Carla Pasternak, Director of Income Research and Chief Investment Strategist for StreetAuthority’s High-Yield Investing, one of the leading income advisories in the United States.

Carla has captured more than her fair share of income and capital gains for her subscribers over the past few years. As of March 14, 34 of the 36 holdings in Carla’s High-Yield Investing model portfolio were in the green, with an average total return on all holdings of 39.4%. The average yield of 7.6% was more than three times the average yield of the 396 stocks in the S&P 500 that pay dividends.

One of the most impressive market-beaters in Carla’s portfolio is also the oldest — more proof that the right income stocks can deliver extraordinary returns over time. Carla added Magellan Midstream Partners (NYSE: MMP), a master limited partnership (MLP) that currently operates the nation’s biggest refined petroleum products pipeline, on Sept. 15, 2005. Since then, Magellan Midstream Partners has delivered total returns of 255.1%, more than five times the adjusted returns in the S&P 500, as measured by SPDR S&P 500 (NYSE: SPY).

Enterprise Products Partners (NYSE: EPD)
, another energy MLP, has risen 136.3%, including distributions, since Carla added it on February 20, 2007. That’s more than six times the gain in the S&P 500.

Note: We believe the strategy in High-Yield Investing will continue to produce winning returns over the long haul. For that reason, for the first time ever, StreetAuthority is offering a lifetime membership in High-Yield Investing. For a one-time fee, you’ll receive the advisory for life — and the benefits are fully transferable to any family member, whenever you want. That means even your heirs can benefit from the recommendations in High-Yield Investing. For more information, follow this link. (There’s no video, no 20-page report — just a one-page description of the benefits.)

As you’ll see in the interview below, there’s much more to the art of picking income stocks than simply looking at the amount of cash they dispense…

Bob: Is it too late to climb aboard the dividend bandwagon?

Carla: It’s never too late for assets (be they debt or equity) that pay regular income and generate solid returns on your cash savings. The trick is finding securities that will both preserve your capital while growing your income stream. These securities can be found in every sector, but a good place to start is with so-called pass-through entities. These vehicles are required to pay out most of their taxable earnings (which includes both income and capital gains) to investors in order to remain exempt from corporate income taxes. Examples include MLPs, limited liability companies (LLCs), real estate investment trusts (REITs), business development companies (BDCs), and closed-end funds.

Preferred shares, exchange-traded notes, and convertible shares are also good places to look. If you can find high-enough coupon rates among these fixed income classes, you can remain relatively immune to rising rates in many cases. While prices have been driven up in the recent market rally, you can still find good value in some of the partnerships and preferred shares that I’ll be talking about in the next issue of High-Yield Investing, due out on Monday.

Bob: What qualities do you look for when recommending a stock?

The number one question I ask myself when investing personally and for subscribers in High-Yield Investing is, “How Safe is the Dividend?” A long track record of paying out dividends at a steady or increasing rate is one guideline for dividend safety. A payout ratio — the dividend as a fraction of earnings or cash flow — of less than 100% is another. What I call “Pasternak’s Dividend Safety Indicator,” or PDSI — the dividend as a fraction of free cash flow to equity holders (FCFE) — is another handy measure.

In addition, management’s stated commitment to maintaining or growing the dividend sometimes can help in determining dividend safety.

But even with all these guidelines pointing in the right direction, you can be taken by surprise. Remember, dividends are discretionary and no amount of analysis can completely remove the risk factors of investing in equities. Fixed income is generally safer because payments are a contractual obligation and failure to pay can affect a company’s credit rating, which in turn increases its cost of raising capital. But even here there are risks that inflation and rising interest rates reduce the value of your asset and the income it throws off.

So it’s important that you not only look for qualities in a stock but also look at what qualities define you as an investor: Are you willing to take risks to receive higher potential rewards or do you prefer to aim for lower risk/reward investment ideas? How much of your capital will you allocate to higher-risk ideas and how much will you preserve in cash or CDs? Do your instincts and due diligence support what an analyst is saying? These are the types of questions every serious investor needs to answer for themselves.

Bob: Can you give us one of your top picks?

Carla: My top pick right now is the “High-Yield Security of the Month” that will be showcased in Monday’s issue. In fairness to subscribers, I don’t want to take the wraps off entirely, but just to give you a peak, it’s a convertible stock of a company that’s been going like gangbusters. I think convertibles, or converts for short, are perfect for a market like we have today, where there may be more upside to this rally, but no one can say for sure if the bull hasn’t run its course. I’m concerned, for example, when the Federal Reserve removes the proverbial punchbowl and money isn’t so easy to get, that the party could suddenly end. That may or may not happen, but meanwhile, convertibles give you the best of both worlds. You can keep holding them as bonds and collect the fixed income, or you can convert them into shares of the underlying company stock, if the rally continues unabated. You have to be careful, though. Convertibles are complex instruments and there are certain metrics you can use that I talk about in the upcoming issue to help identify those offering good value.

Investing in dividend stocks never goes out of fashion, but you have only five more days to take advantage of the lifetime membership offer in High-Yield Investing. In addition to receiving the advisory for life (and remember, the membership is fully transferable), you’ll get access to five premium members-only research reports, among other benefits. The deadline is Wednesday, March 20, at midnight. Click here for the details.

Further Reading

 I last featured Carla Pasternak in StreetAuthority Insider a month ago. At that time Carla was recommending Associated Estates Realty (NYSE: AEC), a real estate investment trust (REIT) that she described as “a relatively conservative play on the multifamily housing recovery.” Since then, AEC has risen more than 5%.

 Invest like the 1% — Carla also recently found two high-quality private equity firms yielding more than 6%. Read about them here.