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Some investors consider dividend-paying stocks to be the territory of boring, low returns. I strongly disagree. I think they can be pretty exciting.

Yes, dividend-paying stocks are usually more predictable. But after the gut-wrenching 12 months we have been through, "dull" suddenly becomes attractive. And it can be profitable as well. Studies of historic stock returns show that the combination of consistent dividends and an increasing stock price can offer powerful returns that out-strip the market averages.

When I search for stocks, I am always more interested in solid dividend payers that reward owners with cash. One of my favorite mantras is "show me the money." And it's why the pharmaceutical sector is particularly interesting right now…

Pharmaceutical Company Dividends

Fat dividends have attracted me recently to the largest pharmaceutical companies. Ten years ago, these firms were the darlings of growth investors. When Bill Clinton's plan to reform and socialize medicine was defeated in the early 1990s, the shares of these firms rocketed higher.

However, near the end of the decade, shares of many of these stocks stalled, and, as a group, their prices have remained stable. But in the following decade, regular increases in the dividends and earnings of the shares have compressed the price-to-earnings and dramatically boosted the dividend yields.

When you approach dividend-paying stocks or companies, gauging their strength is sometimes difficult. Here is one way to know if they are actually going to pump up your returns:

  • A common misconception is that a high dividend yield is the most important measure.
  • But a yield that is higher than that of other stocks in a sector could actually be a sign of weakness.
  • If the firm is in trouble, they could be preparing to cut, or in some cases, cease to pay a dividend.

A high yield preceded major downturns in financial stocks that had gotten in trouble with subprime and other bad loans. The dividends were slashed to improve the liquidity and cash position of the businesses.

The Dividend Payout Ratio - An Important Indicator

The important indicator for you to watch is not just dividend yield, but the dividend payout ratio. This is the percentage of earnings directed to paying stock dividends, and it shows us if a company can maintain a level or growing annual payment.

For example, Pfizer (PFE) currently has a 6.6% yield. With a stock price of $19.11, the firm must pay a dividend of $1.28 to maintain that yield. Since last year, Pfizer earned $1.33, and it has a payout ratio of 92% of earnings.

Pfizer generates more than enough profit to continue to pay the dividend, but if the company should stumble more - and make less than $1.28 next year - it would not have the earnings to cover dividends. Then the firm would have to dip into reserves or borrow money to pay the dividend. In such a case, the dividend would be at risk.

The best dividend paying stocks are those that hold the yield steady as they grow. In this case, the dividends are growing year after year, and you benefit from both the capital gains and the cash.

The Top 5 Dividend-Paying Stocks

For decades, buying shares of such franchise players as Coca-Cola (KO), Johnson & Johnson (JNJ), Altria (MO) and General Electric (GE) have been great dividend-paying stock plays.

In the current market, I like pharmaceutical stocks because the largest have become virtual cash machines. The dividends offer a protection against dramatic drops in share price. In addition to Pfizer…

  • Johnson & Johnson yields 2.6%
  • Novartis (NVS) yields 2.6%
  • Glaxosmithkline (GSK) yields 4.4%
  • And Eli Lilly (LLY) yields 4.0%.

All these are outstanding yields for growing firms. Pfizer grew revenue 9.4% last quarter. JNJ grew 8.7%, Novartis grew 14.7%, Glaxo grew 3.5% and Lilly grew 11.20% in the last quarter.

While a number of these drug firms have been under pressure from market perceptions of slow growth, shallow pipelines of new drugs and patent expirations, these negatives are already priced into the shares. 

Investing in dividend stocks is not a sexy investment strategy, but it can be one of the most profitable. By following the "show me the money" mantra, these cash machines can start improving your portfolio and deliver outstanding returns.

JNJ vs. LLY vs. NVS vs. GSK vs. PFE 1-yr chart:

Source: 5 Big Pharma Cash Machines