These Top Dividend Stocks Outperform the Market
This Investment Formula Identifies Top Dividend Stocks
“Quiero mariposas.” I told the waitress.
She raised an eyebrow. In my mind, I just ordered seafood (mariscos). Instead, apparently, I had asked for a plate of butterflies.
Five years ago, I moved to Granada, Spain. The city, nestled in the Sierra Nevada mountains, features an odd mix of Arab-style street life with tapas bars and graffiti art. But to settle in, my grade-five Spanish needed an upgrade.
One trick I learned: The 2,000 most frequently used words, about 20% of the language, cover about 80% of most texts and conversations. Smart learners, therefore, focus their attention on the important few phrases over the trivial many. And by exploiting this principle, I achieved some degree of fluency in a few months.
You can find parallels to investing. In any industry, 20% of activities yield 80% of the profit. Savvy companies, therefore, cherry-pick; they identify the most profitable part of the value chain and focus exclusively on that. And these businesses, it should come as no surprise, often rank as the top dividend stocks.
Take McDonald’s Corp (NYSE:MCD), for instance. For the most part, fast food joints are awful businesses to run. Low barriers to entry mean chains have saturated the market. Operating costs—rent, labor, ingredients, equipment, storage, etc.—keep margins tight. And if you try to raise prices, your customers will eat elsewhere.
This reality explains why nine out of 10 restaurants fail within the first five years.
So how does McDonald’s get around this problem? Rather than running restaurants itself, the company outsources all of these tasks to franchisees.
Partners, not McDonald’s shareholders, have to bear the costs of building and running stores. McDonald’s executives can then kick up their feet and collect steady royalty checks. In effect, McDonald’s has cherry-picked the 20% of the business (branding and marketing) that generates 80% of the profits.
For investors, this has turned the company into one of the world’s top dividend stocks. MCD shares have crushed the broader stock market over the past decade, delivering a total return of 382%. Today, McDonald’s pays total shareholder yield, dividends plus buybacks, of five percent—twice as large as the payout on a typical U.S. Treasury bond.
Or consider Coca-Cola Co (NYSE:KO). Many people assume the company makes money by selling soda. But in fact, Coca-Cola makes its money by selling syrup to bottlers.
You might be wondering, “Why is this distinction important?”
In effect, this model puts most of the costs of actually running a soda business on partners. Bottlers pay most of the cost for plants, trucks, and employees. Retailers do most of the grunt work of selling the product to customers. Coca-Cola, meanwhile, fronts 20% of the capital and effort but collects 80% of the profit.
Once again, this formula explains why Coca-Cola has long topped the list of top dividend stocks.
Because management has to invest so little money in operations, they have lots of funds left over to reward shareholders. Since 1970, Coca-Cola executives have boosted the dividend to investors every single year. And over that period, KO shares have generated a total return of 25,140%.
Chart courtesy of StockCharts.com
Alternatively, you can use the 80/20 rule to filter out bad investments.
Resource companies front 80% of the capital to build a new mine, but the industry collects less than 20% of the profits. Hardware manufacturers perform the majority of physical activity in the personal computer business but survive on razor-thin margins. Airlines, which have long represented a furnace of shareholder capital, do most of the donkey work of flying customers from place to place.
Yet in all of these industries, you can find 80/20 businesses creating fortunes for investors.
Royalty companies, for instance, earn more money by financing new gold mines than by building them. Microsoft Corporation (NASDAQ:MSFT) became the largest company in the world by selling software, which requires nothing in the way of properties, plants, and equipment. TransDigm Group Incorporated (NYSE:TDG) makes more money in a year making parts than the entire airline industry has made since Wilbur and Orville Wright took flight at Kitty Hawk.
That’s the 80/20 rule in action.