Do you want to succeed in the stock market? Then I've got good news and bad news for you today. A column in The Wall Street Journal recently described a theoretically simple way to crush S&P 500 annual returns -- although that could be a lot harder than it looks in practice. (But don't fret.)
The idea goes like this. Historically, if you invest in a basic index mutual fund or exchange-traded fund (ETF) that tracks the S&P 500 -- such as the Vanguard S&P 500 Index ETF -- you can expect to earn around a 10% annual profit before inflation. That's a great number, and more than you'll make investing in bonds or earning interest on your bank account.
But according to this theory, you can do even better than the average S&P 500 returns with one simple trick: investing only in dividend stocks. And more specifically, investing in dividend stocks that pay almost, but not quite, the best dividend yields.
Image source: Getty Images.
The first shan't be last, but it's only second best
This may sound counterintuitive. I mean, the idea that you make more money investing in stocks that pay you dividend income, than those that don't, seems clear enough. But logically, to make the most money, you should buy stocks with the biggest dividends, right?
Except it doesn't work that way. According to the The Wall Street Journal, $1,000 invested in the S&P 500 in 1930 , and left there, would have grown to $8.56 million by 2024. And $1,000 invested in the 20% of S&P stocks paying the best dividends would have grown more than twice as much, to $19.37 million.
So far, so good. It makes sense that stocks plus dividends would outperform stocks, period. But here's the surprising bit: $1,000 invested in the 20% of S&P stocks paying the next best dividends (the second quintile of dividend payers) would have grown to a cool $31 million.
That's 262% better than the S&P 500 performance alone, and 60% better than the top quintile.
Image source: Getty Images.
Time to do some research
I don't know about you, but I was surprised by these results.
Perhaps I shouldn't have been. As the Journal warns, stocks with too-large dividends "really could be dogs." Their dividend yields may look big because their businesses are bad, their stock prices have declined, and as a result, their dividends look bigger relative to their stock prices. By investing in second-quintile dividend payers, you may dodge the bullet of buying into a seriously injured business.
But what do these "second quintile" businesses look like? Running a screen on S&P 500 stocks on finviz.com, I determined this second quintile comprises 72 separate stocks, and from essentially all sectors of American industry. Buy into this second quintile, and you'll own shares of energy companies like ConocoPhillips (NYSE: COP), popular consumer brands such as Hershey (NYSE: HSY) and Starbucks (NASDAQ: SBUX), retailer Dollar General (NYSE: DG), and megabank Citigroup (NYSE: C).
Dividends within the group are respectable, yet without looking extreme. Ranging from 2.5% to 3.7%, they all pay at least a full 1% better than the S&P 500 as a whole.
How to buy second quintile dividend stocks?
Despite the clear outperformance of second-quintile dividend stocks, there doesn't appear to be a single S&P index or ETF that tracks this particular group of 72 stocks. You can buy them each individually of course, but this would make for a rather unwieldy portfolio.
The good news for me, your humble financial writer, is that it's easy to note down the tickers and form at least a virtual portfolio of these stocks, to keep track of how they perform. Individual investors, meanwhile, might want to pick just a good handful of the best-known names from these 72 stocks, and invest in them instead. You might, for example, start with the five stocks named up above: Conoco, Hershey, Starbucks, Dollar General, and Citigroup, which on balance I believe should make for a nice, dividend-rich, modestly priced portfolio.
Paying from 2.6% (Dollar General) to 3.4% (Conoco and Hershey), they cover basically the same range of dividend payout as the larger second quintile. And their dividends look pretty safe. On average, across the five stocks, their dividend payout ratio is a modest 55%, according to data from S&P Global Market Intelligence.
Valuation-wise, Starbucks is the only one exceeding the "average" value for an S&P 500 stock (31.5 times earnings). The others are all bargain-priced, ranging from Citi and Conoco costing less than 12 times earnings, all the way up to Hershey at a still-modest multiple of 20.
Great dividend yields at bargain prices? Sounds like a good way to beat the market to me. Now let's put the idea to the test -- together. Check back here in three months, and I'll tell you how the portfolio is performing. And if the strategy seems to be working, I'll plan to keep the experiment going.
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Citigroup is an advertising partner of Motley Fool Money. Rich Smith has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Hershey, Starbucks, and Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.
