If I am achieving my goal of creating an ever-increasing income from dividend investment, I would not drastically change my investing strategy if I were to under-perform the S&P. However, the opposite isn’t true.  If I were not consistently growing dividend income, but nearly always beating the S&P, it would be time for me to totally rethink my strategy.

A person that tries to please everyone, usually ends up pleasing no one. In the same vien, trying to achieve your goals and desires may lead you to achieving neither. Consider the following dividend stocks and S&P 500 return YTD through June 30:

• Vanguard 500 Index (VFINX) – June YTD Return: +3.2%
• Procter & Gamble Co. (PG) – June YTD Return: -8.5% – Analysis
• Wal-Mart Stores Inc. (WMT) – June YTD Return: -4.1% – Analysis
• McDonald’s Corp. (MCD) – June YTD Return: -1.4% – Analysis
• Johnson & Johnson (JNJ) – June YTD Return: -1.4% – Analysis

Note, my returns may be different than your due to additional share purchases.

So far this year each of the above companies have under-performed the S&P. Yet, I consider each of these stocks one of my top-shelf dividend stocks. Last year in the face of a significant downturn, MCD and WMT posted gains. I will continue to hold any dividend stock as long as it continues to increase dividends at a respectable pace, irrespective of its performance against the S&P.

My goal is to generate an ever-increasing income stream from dividends. As noted in Saturday’s Progress Report, I have done this in the last 18 of 19 months. My desire is to beat the S&P 500 over time. I beat it by double digits last year. I am trailing slightly this year, but over the last 18 months I am still up. In the end, I will not sell a great dividend stock for under-performing the S&P.

Full Disclosure: Long VFINX, JNJ, MCD, PG, WMT. See a list of all my income holdings here.

I came across Kimberly Palmer’s article titled “The Future of Social Security: Not Good“. My first response was ‘No duh!’  After giving it more thought, I came to the conclusion that my reaction is probably in the minority.

I suspect most people believe that the U.S. government will not let Social Security fail. This is the same government that deemed certain large companies ‘too big to fail’ and dragged other unwilling participants into the fray.  BB&T’s (BBT) Chairman and CEO, Kelly King has been very outspoken on how the government has managed the TARP debacle. And now the government is ‘helping’ the auto industry. Watch out Detroit!

The U.S. government has become too big and too ‘helpful’ to the detriment of its citizens. The government should spend more time providing for the common defense and less time promoting the general Welfare (pun intended).

So, what are your retirement plans? Are you going to rely on the government to print your social security check and the money backing it up, or will you choose to take charge of your future and prepare for it? As it is with most things in life, those that prepare for retirement will find more success than those that don’t.  It is really not that hard when you start young.  Here are three simple steps:

1. Live on less than you earn. (another ‘No duh!’ statement)
2. Invest the rest using a sound asset allocation model.
3. Pick solid, conservative, low-cost investments.

Number 3. on first blush may seem complicated, but it doesn’t have to be. For those that don’t want to make investing their hobby, they can focus on a few good funds like Vanguard’s S&P Index Fund (VFINX) and Vanguard’s Long-Term Bond ETF (BLV).

For those a little more adventurous, a strategy based on an article by Richard Jenkins titled “A simple ETF strategy for beginning investors“ has been quite effective over time. Don’t let the “beginning investors” term scare you away. The goal of this portfolio is to provide diversification over a broad allocation of stocks and bonds by holding five ETFs:  iShares Lehman Aggregate Bond Fund (AGG), iShares MSCI EAFE FD (EFA), Vanguard Total Stock Market ETF (VTI),  iShares DJ Real Estate Index (IYR) and iShares DJ Basic Materials (IYM).

For those comfortable in selecting and holding individual stocks, there is nothing like Dividend Stocks to provide a growing income into the future. Dividend stocks found in many dividend investors’ portfolios include companies such as: McDonald’s  Corp. (MCD) [analysis], Johnson & Johnson (JNJ) [analysis] and The Coca-Cola Company (KO) [analysis].

Finally, you can choose not to prepare. In June 2008, I wrote about a retirement-age couple that would never retire because they chose to live life on the edge and always spent a little more than they made. Over the last year the noose has continued to tighten on Bill and Jackie (not their real names).  Due to the economy and health issues work has been hard to come by. Their house is one step away from foreclosure and on the market with no buyer in sight. Bill needs surgery and the family continues to grow weary of providing for them.

Life is a choice. You can choose how you live, but you cannot choose the consequences of how you live.

Full Disclosure: Long AGG, BLV, EFA, IYM, JNJ, KO, MCD, VFINX, VTI. See a list of all my income holdings here.

Cash/Money Markets/CDs – “Cash Investments”
I have always considered “Cash Investments” an oxymoron. Cash is where some investors park their money when they believe the investment risk is greater than the potential return – their sole focus is capital preservation. Unfortunately, some people consider Cash/Money Markets/CDs et.al. as investments. This is a dangerous assumption. Their slow and predictable growth is generally always below inflation, but since it is growing the “investors” often lulled into a false sense of security and do not notice that they are actually losing ground each year until it is too late.

Land/Real Estate – “They aren’t making anymore land.”
Many investors have discovered the hard way that bubbles can also occur in the real estate sector. What was once seen as a safe place to put your money and forget it is now in the midst on an ugly down-turn. According to S&P, home prices tumbled by 19.1 percent in the first quarter, the most in its 21-year history. Home prices have fallen 32.2 percent since peaking in the second quarter of 2006 and are at levels not seen since the end of 2002. Still, there are no signs home prices have hit bottom. “We see no evidence that a recovery in home prices has begun,” said, David M. Blitzer, chairman of the S&P index committee.

Gold/Precious Metals
If you look at a historical chart of gold prices, you will see a pattern, gold spikes to a new level during a crisis, then comes down to a level above the previous steady state. It then trades sideways until the next crisis. It would be hard to time your retirement to coincide with a crisis/spike.

Professionally Managed Equity Mutual Funds
Every year several professionally managed mutual funds out-perform the market. Unfortunately, it is rarely the same funds each year. It has been well documented that over time, most professionally managed funds under-perform the market.

Treasuries/Bonds
Treasuries and bonds tend to be less risky than equity investments, but have historically under-performed equities. It is important to note that there is risk associated with them. For corporate bonds, the companies could default and not pay them. For all bonds, including those issued by government, there is an interest rate risk – rising interest rates drive the price of bonds down. I do consider bonds an important part of my asset allocation. You can purchase bonds directly in the open market or bundled in funds/ETFs. Below are some low-cost Vanguard bond ETFs:

• Vanguard Short-Term Bond ETF (BSV) – Yield: 3.38%
  The Fund seeks to track the performance of the Barclays Capital 1-5 Year Government Index. This index includes U.S. Government, investment-grade corporate, and international dollar-denominated bonds, with maturities between 1 and 5 years.
• Vanguard Intermediate-Term Bond ETF (BIV) – Yield: 4.67%
  The Fund seeks to track the performance of the Barclays Capital 5-10 year Government/Credit Index. This index includes U.S. Government, investment-grade corporate, and international dollar-denominated bonds with maturities between 5 and 10 years.
• Vanguard Long-Term Bond ETF (BLV) – Yield: 5.60%
  The Fund seeks to match the investment performance of the Barclays Capital Mutual Fund Long Government/Corporate Index.
• Vanguard Total Bond Market ETF (BND) – Yield: 4.55%
  The Fund seeks to generate returns that track the performance of the Barclays Capital Aggregate Bond Index, and will maintain a dollar-weighted average maturity consistent with that of the index. The Index measures investment-grade, taxable fixed income securities in the U.S.

Also, if you live in the U.S. you can purchase Savings Bonds via TreasuryDirect.gov. However, recent changes in this program have made it less appealing.

Index Funds/ETFs/CEFs
For most people, indexed investments including mutual funds, exchange traded funds (ETFs) and closed end funds (CEFs) should make up the core of their investment allocation.  In effect, you are aligning your investment risk with what the index fund tracks. If you believe that over time that certain index funds, such as the  S&P 500, will outperform the the various approaches listed above, you should have money invested in it.  Index funds allow you to easily track any sector, market cap or index. Here are some varied funds in this category:

• Vanguard 500 Index Fund Investor (VFINX) – Yield: 2.90%
  The Fund seeks to track the performance of a benchmark index that measures the investment return of large-capitalization stocks. The Fund employs a “passive management” approach designed to track the performance of the Standard & Poor’s 500 Index.
• IShares MSCI EAFE Index Fund (EFA) – Yield: 3.94%
  The Fund seeks to provide investment results that correspond generally to the price and yield performance, before fees and expenses, of the MSCI EAFE Index.
• IShares Trust DJ US Basic Mat Sector (IYM) – Yield: 2.58%
  The Fund seeks investment results corresponding to the price and yield performance, before fees and expenses, of the Dow Jones US Basic Materials Sector Index. Component firms are involved in the production of aluminum, chemicals, commodities, chemical specialty products, steel, and other goods and resources.
• IShares Trust DJ US Real Estate Index (IYR) – Yield: 8.69%
  The Fund seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the Dow Jones US Real Estate Index. Uses a representative sampling strategy. Component firms include hotel and resort firms and REIT’s.

Individual Stocks
Inherently, individual stocks will carry higher risk due to the lack of diversification when evaluated on a stand-alone basis. You can mitigate this risk to a degree by selecting solid dividend paying companies with a track record of increasing their dividends each year. Some of my personal favorites in this category are:

• Johnson & Johnson (JNJ) – Yield: 3.58% – Analysis
• Procter & Gamble Co. (PG) – Yield: 3.32% – Analysis
• Sysco Corp. (SYY) – Yield: 4.12% – Analysis
• PepsiCo, Inc. (PEP) – Yield: 3.49% – Analysis

When it comes to investing your money, there is no escaping risk. A good investor will determine the desired outcome and and invest in a way to acheive their goal with minimal risk.

Full Disclosure: Long BLV, VFINX, EFA, IYM, IYR. See a list of all my income holdings here.

Below are ten dividend stocks that have out-performed the S&P 500 this year through May 15, 2009:

10. Coca-Cola Co (KO) – Return: 0.4% – Yield: 3.76%
The Coca-Cola Company engages in the manufacture, distribution, and marketing of nonalcoholic beverage concentrates and syrups worldwide. Risk Rating: Low (1.50) – Analysis

9. Sysco Corp (SYY) – Return: 0.5% – Yield: 4.20%
SYSCO Corporation, through its subsidiaries, engages in the marketing and distribution of a range of food and related products primarily for foodservice industry in the United States and Canada. Risk Rating: Low (1.00) – Analysis

8. BP ADR (BP) – Return: 1.4% – Yield: 7.37%
This supermajor integrated oil company (formerly BP Amoco p.l.c.) is based in London and is the world’s second largest publicly owned oil company and the fourth largest U.S. refiner. Risk Rating: Medium (1.75) – Analysis

7. 3M Co (MMM) – Return: 1.8% – Yield: 3.52%
3M Co. is a diversified technology company with a presence in various businesses, including industrial & transportation, healthcare, display & graphics, consumer & office, safety, security & protection services, and electro and communications. Risk Rating: Low (1.50) – Analysis

6. Paychex Inc (PAYX) – Return: 4.1% – Yield: 4.63%
Paychex, Inc. provides payroll and integrated human resource and employee benefits outsourcing solutions for small- to medium-sized businesses in the United States. Risk Rating: Medium (1.75) – Analysis

5. Intel Corp (INTC) – Return: 5.6% – Yield: 3.69%
Intel Corporation engages in the manufacture and sale of semiconductor chips, as well as in the development of advanced integrated digital technology platforms for the computing and communications industries worldwide. Risk Rating: Medium (1.75) – Analysis

4. Canadian National Railway ADR (CNI) – Return: 7.0% – Yield: 2.24%
Canadian National Railway Company (CNI) operates Canada’s largest railroad, linking customers in Canada, the U.S., and Mexico through approximately 20,400 miles of track. Risk Rating: Low (1.25) – Analysis

3. Manulife Financial Corp ADR (MFC) – Return: 8.0% – Yield: 4.78%
Manulife Financial Corporation is a life insurance company with customers in the United States, Canada and Asia. It is the holding company of The Manufacturers Life Insurance Company and John Hancock Financial Services. Risk Rating: Medium (1.75) – Analysis

2. CenturyTel Inc (CTL) – Return: 13.5% – Yield: 9.27%
CenturyTel Inc. provides a range of telephone services in 25 states, with operations concentrated in Alabama, Arkansas, Louisiana, Missouri and Wisconsin. Risk Rating: High (2.50) – Analysis

1. Royal Bank of Canada ADR (RY) – Return: 22.8% – Yield: 4.47%
Royal Bank of Canada (RBC) offers a range of banking and financial services in North America and internationally. Risk Rating: Low (1.50)

Over the same period the S&P 500 (VFINX) was down 1.2%. The returns were calculated using Yahoo’s dividend adjusted stock price for December 31, 2008 as the starting point. Some interesting items to note: The list contains four ADRs (3 Canadian, 1 British). RY’s dividend has been frozen since November 2007. CTL is the only High Risk stock to make the list based on my risk rating. The top five were less traditional dividend stocks that had been beaten down to low levels.

Short-term performance is never the sole reason for long-term investors to buy. What goes up significantly usually comes back down. Case in point, last years two dividend darlings, Wal-Mart (WMT) and McDonalds (MCD), found themselves in the bottom ten of this list, each down 13.2%.

Full Disclosure: Long in all the aforementioned securities. See a list of all my income holdings here.

Recently, Steven F. Shepich, a professional money manager with Ameriprise Financial sent me a white paper he wrote back in April titled “Dividend Investing in a Bear Market.” I found it very interesting and when asked if I could share it with my readers, Steven graciously consented. Below are some highlights of the white paper:

We are currently in a cyclical bear market (since October 2007) and a secular bear market (since 2000).

As of March 31, 2009 the price level of the S&P 500 Index was down 40% over the last year and 38% below the level it traded at ten years earlier. This is a strong indication that we are in both a cyclical bear market and a secular bear market. A secular bear market will begin at historic high earnings multiples and usually occurs during long-term periods of stress, turmoil, and political changes. Historic events such as World War I, the Great Depression, World War II, the Vietnam War, the fight for civil rights, and the 1970s oil embargo, all occurred during secular bear markets. In periods like this, investors’ long-term views are less optimistic, which results in a long-term downward trend in market valuations. A secular bear market will usually contain one or more major market corrections. Secular markets are different than cyclical markets which are shorter-term (one to five years) and usually revolve around the rise and fall of the economic cycle. Cyclical markets reflect economic changes in corporate earnings, while secular markets reflect long-term trends in valuation. Secular markets often contain multiple cyclical markets. For example, the crash of 1987 and the 90-91 recessions occurred during our last secular bull market (1982 – 2000).

We believe a dividend-based investment approach can be an effective strategy in secular bear markets for long-term investors.

We have just experienced the largest single year market decline since the Great Depression; the economic news appears to be moving from bad to worse; and there is a large degree of uncertainty going forward. Couple with this the fact that we are in a long-term secular bear market which could last another 10 years or more; the question becomes ….Why be invested in the market at all?

A dividend based investment approach involves investing in a diversified portfolio of stocks that provide stable dividend payments at attractive yields. Dividends provide income in down and flat markets, which can be reinvested and compounded over time. Furthermore, we believe significant cyclical market declines provide a unique investment opportunity for dividend oriented investors with a long-term time horizon. Dividends provide income in down and flat markets, which can be reinvested and compounded over time.

In our opinion, significant cyclical market declines (like the current one) provide a unique investment opportunity for dividend-oriented investors:

• Market pullbacks create attractive dividend yields and new high-yield opportunities.
• Reinvesting dividends from stocks with attractive yields can have a material positive impact on long-term returns even in a flat stock market.
• Dividend reinvestment in stocks selling at depressed prices can significantly enhance capital gain potential when the market eventually moves into recovery mode.

Dividends provided a significant benefit to long-term investors during and following the Great Depression.

It took more than 25 years (1929-1954) for the market to get back to the level reached before the 1929 crash. Including dividends in the equation tells a much different story. In fact, during the 25 year period that it took stock prices to get back to break-even, an investor who invested $100K and reinvested dividends would have seen his portfolio grow to $431K (a return of 331%).

Dividend stocks have out-performed the S&P 500 since the beginning of the current secular bear market.

Over the last nine years (3/00 – 3/09), the total return for the S&P 500 was negative 37.4% (-5.1% annualized), while the DJ Dividend Index had a total return of positive 34.0% (3.3% annualized). This leads us to conclude that the core cash return that dividends provide become more of a relevant factor in periods of multiple contraction (secular bear) than in periods of multiple expansion (secular bull).

What Have You Done For Me Lately?

Investing in stocks was a bit different in the 30’s than it is today. Back then, dividends were expected by investors and payout ratios were high, relative to today’s standards. The average yield during the 20s and the 30s ranged between 5% and 9%. During the last secular bull market (1982-2000), dividend yields gradually declined to an all time low, as valuations increased and investors became more interested in capital gains, to the point that in 2000 the dividend yield on the S&P 500 was barely over 1%.

According to return data obtain from Bloomberg, over the last seventeen years (3/92 – 3/09) the S&P 500 Index provided an annualized total return of 6.1%. During the same period the Dow Jones US Select Dividend Index (DJDVY) posted an annualized return of 8.9%. Put another way, a $100K investment in the DJDVY would have grown to $424K during that period, compared to $276K had it been invested in the S&P 500.

These were just some of the highlights, you can click here to read the entire report.

So how would five select individual dividend stocks that are in most every dividends investors portfolio fared against the S&P over the last two years? This chart compares the S&P 500 (VFINX) with:

• Johnson & Johnson (JNJ) – [Analysis]
• Procter & Gamble Co. (PG) – [Analysis]
• The Coca-Cola Company (KO) – [Analysis]
• McDonald’s Corp. (MCD) – [Analysis]
• Wal-Mart Stores, Inc. (WMT) – [Analysis]

The above chart (click to view full size) only considers the capital appreciation element. The table below layers in the effect of dividends:

Good solid dividend stocks will not always out-perform the S&P 500 (see this year-to-date for example), but consistent and rising dividends certainly gives dividend stocks a head start.

Full Disclosure: At the time of this writing I was long in VFINX, JNJ, PG, KO, MCD, WMT. I received no compensation from Steven F. Shepich or Ameriprise Financial for writing this article. (view my income holdings)

(Photo Credit)

Beta is a quantitative measure of the volatility of a given security or portfolio relative to the overall market, usually the S&P 500. By definition, the market has a beta of 1.0 and securities are ranked according to how much they deviate from the market. Thus, securities with a beta above 1 are more volatile than the overall market, while those with a beta below 1 are less volatile. High-beta stocks are supposed to be riskier but provide a potential for higher returns, while low-beta stocks pose less risk but also lower returns.

Dividend stocks tend to have low betas. That means during a market downturn, they tend not to fall as much as the market in total. Hence, the term defensive stocks. It is also important to note that defensive stocks tend to be non-cyclical. Examples would include food, tobacco, oil, and utilities where demand is remains stable under difficult economic conditions. This was evidenced in my income stock’s 2008 return of -20.4% vs. the S&P 500 return of -36.3% (VFINX).

Here are some of my low beta holdings:

• Chevron Corp (CVX): 5-yr Beta 0.67 (analysis)
• Pepsico Inc (PEP): 5-yr Beta 0.58 (analysis)
• Johnson and Johnson (JNJ): 5-yr Beta 0.49 (analysis)
• Kimberly-Clark Corp (KMB): 5-yr Beta 0.40 (analysis)
• Consolidated Edison Inc (ED): 5-yr Beta 0.25 (analysis)

This of coarse works against you when the market turns up. The low beta means the stocks don’t increase as fast as the market in an upturn. As a dividend investor, I should expect to under-perform the market during significant bull markets. I have selected certain higher beta stocks to mitigate this shortfall. However, as a dividend investor my goal is an ever-increase stream of dividend income, not to maximize total shareholder return.

Full Disclosure: Long CVX, PEP, JNJ, KMB, ED, VFINX

So what would have happened if I had invested my kids’ college fund following a dividend investing strategy? It is difficult to say exactly, but I can make some assumptions and see where it takes me.

Ground Rules
For simplicity, I will select five dividend stocks and purchase $1,000 in each and put $5,000 in VFINX using the closing price on September 30, 1997. Dividends will be held and reinvested on the last day of the year at the closing price. I will ignore commissions and taxes. Final valuation date is as of the end of November 2008, except for BAC (see below). Information was pulled from Yahoo Finance.

Stock Selection
This obviously is the most difficult portion and requires the most self-honesty. I will try to reason what stocks I would have purchased in 1997 without looking at their performance. Since it was for my kids’ education, I intentionally avoided the more risky stocks, including REITs. Here are the five stocks I selected and my thoughts as to why:

• Johnson & Johnson (JNJ): For me the selection of JNJ and PG were no brainers. JNJ and PG are two stocks that have been cornerstones in virtually every dividend portfolio for decades.
• Procter & Gamble Co. (PG): See above.
• The Coca-Cola Company (KO): This was a little more difficult form an honesty stand-point. Without looking I suspect that Pepsi (PEP) out-performed KO during this period, but I owned KO in the past and would have likely chosen it over PEP.
• Bank of America (BAC): Knowing that BAC cut its dividend, it was another difficult selection from an honesty perspective. Knowing what I know now, I would have selected BB&T (BBT), but BAC was the first bank I purchased, so I will go with it. BAC’s ending valuation date will be October 7th when I actually sold it.
• Consolidated Edison, Inc. (ED): Having exhausted the no-brainers and likely choices, this was by far the most difficult selection. Since it was for my kids’ education, I targeted a safe stock. As such, I went with the first utility that I bought.

One other stock I considered was General Electric (GE). However, in the late 90′s I viewed it more as a growth stock. Let’s build the spreadsheet and crunch some numbers.

Results
First let me say that there is nothing definitive you can draw from this analysis – the scope is much too narrow. However, there are some interesting items to consider that could lead to a deeper analysis. With that said, I was somewhat surprised at the results. It was not a good decade for any of the investments that I looked at. The ones I thought would perform well, did not. Here is a summary of the S&P and the five dividend stocks:

S&P 500 (VFINX)
Appreciation as a % of Invested Basis: -10.44%
Total Shareholder Return: 0.90%
Total Dividends Reinvested: $1,168.53

Dividend Stocks In Total
Appreciation as a % of Invested Basis: -13.10%
Total Shareholder Return: 1.25%
Total Dividends Reinvested: $1,609.95

The dividend stocks earned more dividends than the S&P, but also lost more on invested capital. Overall, the return for the dividend stocks was a little over a quarter percentage point higher than the S&P 500. That somewhat surprised me; I expected it to be more. Looking at the individual stocks was quite interesting and not entirely what I expected:

Johnson & Johnson (JNJ)
Appreciation as a % of Invested Basis: -0.12%
Total Shareholder Return: 1.47%
Total Dividends Reinvested: $177.96

Procter & Gamble Co. (PG)
Appreciation as a % of Invested Basis: -7.41%
Total Shareholder Return: 0.46%
Total Dividends Reinvested: $136.52

The Coca-Cola Company (KO)
Appreciation as a % of Invested Basis: -20.77%
Total Shareholder Return: -0.73%
Total Dividends Reinvested: $163.21

Bank of America (BAC)
Appreciation as a % of Invested Basis: -52.09%
Total Shareholder Return: -4.35%
Total Dividends Reinvested: $270.61

Consolidated Edison, Inc. (ED)
Appreciation as a % of Invested Basis: 6.61%
Total Shareholder Return: 6.33%
Total Dividends Reinvested: $861.66

To be honest, I was surprised at how weak JNJ’s and PG’s performance were over the period. The entire performance of the group was carried by ED. With a -4.35% TSR, BAC actually held up better than I thought it would.

What If..
One case I looked at was substituting BBT for BAC. BBT’s performance was better than BAC’s but not dramatically. Here are the combined results with BBT in place of BAC:

Dividend Stocks In Total – BBT instead of BAC
Appreciation as a % of Invested Basis: -10.05 vs. -13.10%
Total Shareholder Return: 1.56% vs. 1.25%
Total Dividends Reinvested: $1,610.91 vs. $1,609.95

Conclusion
Contrary to my earlier statement, one valid conclusion can be drawn from this exercise. You should always analytically test your beliefs, because they may not holdup under the microscope.

If you want to see the spreadsheet I used to derive the above data, it is available on my Tools page as Div-Investing-vs-SandP.xls.

Full Disclosure: Long VFINX, PG, JNJ, KO, PEP, BBT and ED