The Best Dividend Stocks - Why, Where and When - Part 1

Why are income investors constantly trying to find the best dividend stocks? Where can you find the best stocks? When is a dividend too high to be safe? We'll try to answer these and other dividend questions in this article.

Dividend Yields: Income investors are always seeking to improve their dividend yield, either by searching out and investing in stocks with a high dividend yield, or by selling covered calls against their dividend paying stocks to augment their dividend income.

Why are dividends so important to the average investor?

Here are two illustrations of why dividends are very important to the average investor.

1. In a study of the period 1926 - 2004, it was shown that dividends accounted for 35% of shareholder returns. Pretty substantial, right? Wait, it gets better...

When you add in the effect of compounding and reinvesting, dividends returned over 25 times more than price appreciation during this period.

Let's look at this from a different perspective, in another time period:

2. During the period 1986 - 2005, $1.00 invested in the S&P 500 had $.45 in price appreciation. If you include reinvested dividends, however, that $1.00 would have earned $8.09, 18 times as much as mere price appreciation.

Where Can the Average Investor Find the Best High Dividend Stocks?

Certain industries tend to pay out higher dividends than others. Some examples of this are: The Shipping Industry: Because this group is so volatile, they've gravitated toward enticing investors with historically high dividend yields. However, "look out below!", as they say on the ships, because these stocks often will take you on a roller coaster ride that will make you long for dry land.

Telecoms: This group also tends to feature high dividend paying stocks. As with any stock, you have to dig deeper, to find out which ones are worth investing in. Currently, the big trend in telecoms has been toward wireless, so companies that are strictly land-based have been somewhat out of favor with investors, who feel that the customer trend toward cell phones is definitely outstripping traditional land lines.

REIT's, (Real Estate Investment Trusts), are pooled funds of money, that have been organized to invest in various types of real estate, such as shopping malls, or apartment buildings, or health care facilities. REIT's don't have to pay corporate taxes, but they must pay out at least 90 % of their earnings to shareholders.

There are many high dividend stocks in this group. Their dividend distributions don't qualify for the 15% qualified dividend tax rate. The current 2008-2009 credit and economic crises have caused many investors to flee from this group, due to financing and debt leverage worries.

Look for well-financed companies, in an industry that is more insulated from the economic cycle, such as health care.

MLP's (Master Limited Partnerships): There are many independent oil stocks, natural gas stocks and pipeline stocks in this group, which pay a high dividend yield. MLP's are obligated by law to pay out at least 90% of their earnings to "Unitholders", (shareholders), in return for not having to pay corporate income tax. Their distributions do not qualify for the 15% qualified dividend tax rate. This group holds a lot of promising dividend stocks for income investors, particularly those companies which already have or are investing in more pipeline infrastructure to handle the coming natural gas boom in the U.S.

When is a dividend yield too high?

This is a constantly evolving issue, since stock prices and yields are always changing. In fact, the market declines of 2008 and early 2009 caused many "average" dividend yields to soar, as companies' stock prices declined. In addition, many companies cut their dividend in order to save cash.

Currently, the average S&P 500 dividend yield is 2.57%. However, you should look within each group's sub-sector, and compare yields there, in addition to comparing other key metrics, such as dividend payout ratio, debt levels, and current stock valuations.

We'll cover more details of the "Where and When" for choosing the best stocks to buy, in part 2 of this series.