Dividend-Paying Stocks Outperform The Market
Today, speculators often look to make a quick fortune on the next Microsoft (Nasdaq: MSFT) or some other fast-growing company operating in an exciting new industry. But it would be misguided to focus entirely on volatile, unproven industries or companies while overlooking the numerous benefits offered by well established, dividend-paying companies.

While many investors in search of market-beating gains consider the current sub-3% yield offered by the S&P 500 to be trivial, it would be a huge mistake to dismiss dividends entirely. In fact, a look back at statistical data shows that nearly half of the market's total returns have come in the form of dividends.

Between 1926 and 2004, dividends represented about 42% of the total return delivered by the S&P 500. During that same span, it's been calculated that $1,000 invested in the S&P would have grown to $2.3 million if reinvested dividends are included, but to only $90,000 without the dividends!

If history is any guide, then dividend-paying stocks should perform better than their non-paying counterparts over the long haul. Contrary to conventional wisdom, studies have shown that dividend payers handily outperformed non-payers from 1970 to 2000. At the same time, those dividend-paying stocks experienced far less volatility. They could also be counted on to deliver stronger relative returns in difficult market environments.

Tax Changes Favor Dividends
Better still, investors now receive more bang for their buck from most dividend-paying stocks thanks to tax changes. Until 2003, dividends were taxed as ordinary income and were thus subject to an investor's regular income tax rate. At the time, that was up to a staggeringly high 38.6% maximum.

Capital gains, by contrast, were taxed at a much lower 20% rate. That advantageous tax treatment, combined with a roaring bull market, led many investors to gravitate toward high-growth, non-dividend-paying stocks in the late 1990s. 

But thanks to legislation that took effect in 2003, the playing field has now been leveled. A uniform 15% tax rate applies equally to dividends and long-term capital gains. The happy side effect to this has been that income-oriented investors now retain a much larger chunk of their gains. That's a powerful change for investors who reinvest dividends and allow the miracle of compound interest to work its magic.

Another upside: Thousands of companies have been quick to take advantage of the favorable new tax law over the past several years. Instead of buying back shares to boost stock prices, an increasing number of firms have opted to return excess cash to shareholders in the form of dividends. More than 1,700 companies announced dividend increases in 2004 alone (the first year after the legislation), and many firms, including a number of formerly tight-fisted technology companies, initiated new corporate dividend policies for the first time.

This trend has not only lifted the payouts that most income investors receive, but it has also expanded the pool of quality income-paying candidates to choose from.

(1.)  Zeroing In On the Winners

The goal of this report is to introduce you to a few select income securities that are poised to deliver market-beating returns in the years ahead. All three of the high-quality investment ideas we'll profile are established and have solid fundamentals. They also share certain key characteristics that should enable them to pay sizable dividends, plus deliver steady share price gains in the coming years.

These characteristics include the following:

High/Stable Dividend Yield -- Because dividend yields are constantly changing and payments can be raised or lowered at any time, it's important to look at historical performance to ensure that we invest in companies with stable dividend track records. The good news is that all three of the securities we'll profile in today's report have consistently delivered above-average yields over the past several years. In addition, each currently offers a yield at least triple the S&P 500's average yield.

Although some stocks offer even more tempting yields, keep in mind that the most promising stocks aren't necessarily those that offer the highest yields. After all, dividends represent just part of the total return picture, and even 10% or 15% dividend yields can be more than offset by poor stock performance. Therefore, instead of blindly looking for the market's highest-yielding stocks, investors should focus their search on solid companies with sustainable and/or growing dividend payments.

Long-Term Commitment to Shareholders -- Unlike bond payments, corporate dividend payments aren't legally required. And contrary to what many novice investors often think, they certainly aren't guaranteed. In fact, companies can cut or even eliminate their dividend payments altogether at any time. With this in mind, we always look for firms that exhibit long track records of consistent dividend payments. We also prefer to invest in securities that have boosted their dividend payouts consistently over time. Both of these patterns are reflective of real financial strength.

The securities featured in today's report have paid regular, uninterrupted dividends for many years and have consistently raised their dividend payouts along the way.

Strong Cash Flows -- When searching for high-quality income stocks, we pay particularly close attention to each firm's cash flow. After all, that is what a company uses to pay out dividends. Cash flow is the actual money that flows into a company's bank account. This metric often provides a better picture of a firm's profitability, especially when compared to earnings, which incorporate the impact of non-cash items such as depreciation and amortization. As cash flow grows, so does the pool of assets that is used to fund dividend payments.

Total Return -- As we said earlier, 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 really a combination of its dividend yield and share price appreciation. A stock may pay a decent annual dividend, but if its share price declines steadily year after year, then the net effect could be a flat or possibly even negative investment. Although income investors are typically willing to trade significant capital gains potential 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.

(2.)  And the Winners Are...

In the end, our search for high-quality income stocks led us to three top picks. We'll devote the remainder of today's report to an in-depth analysis of these three companies...