6 Stocks Paying Generous Dividends

U.S. stocks gained more on Monday than they typically return in a year. Last week they lost nearly two years' worth of average return.

Dizzied investors trying to calculate whether stocks are now cheap won't have an easy time of it if they rely on the price/earnings ratio. Stocks are inexpensive relative to a modern, flattered definition of earnings but still a touch rich next to the traditional way of tallying earnings, warts and all. The market is an outright bargain if Wall Street analysts are right about a strong earnings recovery next year, but it's likely to languish if academics are right that earnings have further to fall in reverting to their historic percentage of gross domestic product.

Watch dividends instead, for three reasons. First, the math is easier. I can think of a dozen ways to measure earnings but only one for dividends. Also, companies that issue only broad earnings guidance or none at all often set a precise pace for dividend payments. Second, in a prolonged bear market, discouraged investors will have an easier time sticking with fat, safe dividends than clutching low P/E ratios.

Third, over long time periods, reinvested dividends make up the bulk of stock returns. That might sound counterintuitive coming off of two decades of miniscule yields and easy gains, but the past two decades have been unusual. Consider the findings of a 2002 study by Robert Arnott, former editor of Financial Analysts Journal and founder of Research Affiliates LLC, an investment firm. One hundred dollars invested in stocks in 1802 collected an average of 4.9% a year in dividends over the next two centuries. If those dividends were spent, the dollar would have been worth $2,099, after inflation. If they were reinvested, the dollar grew to $37 million. Moreover, most of the measly growth of the first dollar occurred after 1982, as stock valuations ballooned and dividend yields shrunk.

In a separate study a year later, Arnott tackled the belief that companies that are stingy with dividends likely have better things to spend the money on. They don't, he found. Over long time periods, companies with high payouts as a percentage of profits have produced faster profit growth than those without. Far from being a sign that growth prospects have dimmed, dividends seem to demonstrate managerial confidence in the future. (In that same study Arnott noted that low payout percentages suggested coming stock returns would disappoint. Indeed, indexes are now down slightly in the five years since.)

A screen for big dividend yields right now ought to look for four other things besides. The first is plenty of free cash flow to keep those dividends paid for. The second is a modest stock price relative to income (sales) or assets (book value). (Beaten-down stocks are abundant now, so add all the frugality you like.) The last two perhaps don't lend themselves neatly to computer screening, but should affect your decisions nonetheless. Choose companies that aren't overly reliant on financing, for themselves or their customers, in case lending stays sticky for a while or consumers decide they've borrowed enough. And favor companies whose goods seem likely to keep selling well in a slow economy.

Pfizer (PFE) shares have fallen 28%, only a whisker less than the broad market, since I recommended them in January. At the time I noted that drug companies are in a difficult transition, as lucrative medicines born of chemistry gradually lose their patent exclusivity, and as biotechnology, which will spawn tomorrow's medicines, isn't yet as fertile as investors would like. Pfizer's sales could dip in 2011 when its cholesterol blockbuster Lipitor faces competition. The company's development pipeline could offset much of the potential loss, but investors don't seem especially confident, with the stock at just 7 times this year's earnings forecast.

Two things apart from the slim valuation suggest Pfizer will outperform. The first is generous research spending relative to its market value. That subtracts from today's profits but tends to add to tomorrow's. The second is the company's immodest dividend yield of more than 8%. Its size suggests investors think the company might cut payments, especially after Lipitor starts losing share. I suppose it might, but Pfizer has deep financial resources, including close to $10 billion in spare cash and well more than $10 billion more coming in each year. That's enough to afford not only dividends and share repurchases, but some promising drugs.

Have a look at all six companies that survived my screen if you like. Run it yourself anytime using SmartMoney's stock screener.