Back in the "old" days, an investment was only as good as the dividend it paid. The father of value investing, Ben Graham, often counseled that only bonds or dividend-paying stocks could be classified as an "investment", while any other security was a speculative bet. Today, we know that Graham's assertion is not completely true. After all, a company that can reinvest its capital at a higher rate of return is creating greater shareholder value.
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However, the power of dividends is often vastly underestimated. For one, dividends require management to behave more prudently with the company's assets. A company that pays an attractive dividend is less likely to take on risky projects that may or may not create growth at the expense of a dividend. And secondly, a dividend is a wonderful way to gauge the operating health of a company. A dividend payment cannot be hidden because it's a cash outlay. When a company fails to pay its dividend one quarter, that is often a valuable alert signal to investors.
Not All Dividends Are Created Equal
Of course, a dividend payment is no reason to invest in a business. Just ask shareholders in Bank of America (NYSE:BAC) or Citigroup (NYSE:C) last year. At one point, both companies had dividend "yields" that exceeded 8 percent, but that was wishful thinking. Their share prices had gone down so much that the yield went up, but this was merely a mathematical function. Mr. Market had it right in that both companies had to ultimately suspend payments. (For more, see Is Your Dividend At Risk?)
Good Dividends Come from Good Companies
Investors today can lock in opportunistic dividend yields from first-rate businesses. A 3% yield is no good if the stock price tanks 50%, so I wanted to find strong companies with strong yields.
First is Kraft Foods (NYSE:KFT), a wonderful company that currently yields an astonishing 4.6%. It's very reasonably priced at a P/E ratio of 13, and the company recently reported excellent quarterly results. This performance should come as no surprise; Kraft sells food, which is a most non-discretionary household item.
Like Kraft, Johnson & Johnson (NYSE:JNJ) currently yields 3.6% and fetches a P/E ratio of 12. JNJ has been around longer than 100 years and sells things like baby shampoo, diabetic kits and Band-Aids. What mother is going to save 50 cents to buy generic baby shampoo and risk irritating her baby's eyes?
Pfizer (NYSE:PFE), one of the largest drug companies in the world, yields 4.5%. With $34 billion in cash, I doubt one of the biggest pharmaceutical companies will have any trouble paying the dividend. The company's P/E ratio is 12, but analysts have the forward P/E at 6, suggesting a nice spike in profitability next year. The opportunity to own a security with a yield of 4.5% and a P/E ratio of 6 is rare.
A Little Means A Lot
Don't underestimate dividends, especially in this market. Today, businesses that provide the most basic human needs - food and medicine - are paying above-normal rates of return. And when the market turns up, these depressed share prices should rebound nicely, giving investors another lever of value creation.
For more, see Dividend Yield For The Downturn and Dividend Facts You May Not Know.
