Dividends are key to market-beating performance, especially during these times, says John Buckingham of The Prudent Speculator. Here, he describes his methodology for identifying stocks with high returns and low volatility.

Kate Stalter: I am speaking with John Buckingham of Al Frank Asset Management. John, we have talked before for MoneyShow, but it was brought to my attention that you recently wrote a paper about dividends. Say a little bit about how you are looking at the dividend space right now.

John Buckingham: You know, dividends are certainly attractive these days, given the low interest-rate environment. You can build a nice, diversified portfolio of quality companies, but it can yield you well above what you would get on the ten-year Treasury. So dividend stocks are extremely attractive from a yield perspective.

Also, and of course, we are not just tied and interested in dividends, we want to buy companies that are inexpensively priced. So we combine affection for dividend-paying stocks with the desire to buy undervalued companies.

These days, given the performance of the equity markets in 2011, there are quite a few stocks that are attractively priced from a valuation perspective. So we really do like dividends.

One of the interesting things that we point out in this paper, called "The Value of Dividends,” is that dividend-paying stocks have historically been higher return generators—higher total return generators—and they have done so with less volatility.

So, higher return, lower risk—we like to joke that that is sort of the Holy Grail of investing, and it is right there under your nose for so many investors.

Kate Stalter: I’ve heard a number of pundits in recent months say that dividend investing became pretty popular, to help people weather all the market volatility. I am hearing some of these pundits now saying they believe the trade is crowded. What is your view of that?

John Buckingham: Well I certainly know that I’m not the only one who is suggesting dividend-paying stocks are attractive.
But what we’ve seen with mutual fund flows into equity funds, or strategists and asset-allocation calls, or just our own business at The Prudent Speculator, and here at Al Frank Asset Management: There is far more interest these days in capital preservation than there is in capital appreciation.

So yes, you do have folks that are in equities that are gravitating toward dividend-paying stocks, but there is a mountain of money that has exited the equity space and has frankly piled into the fixed-income arena, and primarily into US Treasuries.

If, and when—maybe a better term is when—we get some stability in the European situation, and US economic growth looks like it is going to continue and not head off into another recession, I do think you are going to start see some of that money flow back out of fixed income and into equity markets.

Kate Stalter: I’m looking at The Prudent Speculator, and this particular paper we have been discussing, and I notice that you did select 12 stocks that you call Dividend Favorites. Can you tell us a little bit about some of those?

John Buckingham: In conjunction with the report, we didn’t want to just talk about the strategy, we also wanted to give some actionable investment advice. So we put together a diversified portfolio of stocks that were all yielding more than what you could actually get on not just the ten-year Treasury, but on the 30-year Treasury at that time.

The 30-year Treasury then was about 2.8%, and these days it is about 2.9%. So some of these stocks have appreciated in price since the report was generated, but all of them are still boasting pretty high yields.

A couple of the names in the report that are still very attractive in our mind are Freeport McMoRan (FCX). The stock has performed pretty nicely thus far in 2012, but it was an absolute dog in 2011, and the price of copper is very important to the share price here.

We have certainly seen some good news coming out of China here this week in terms of economic growth, and it seems as China goes, the copper market goes. More importantly in our mind, Freeport is a company that has tremendous free cash flow and has been very active in rewarding shareholders through special dividends in addition to a regular dividend.

An investment today in Freeport comes with a single-digit P/E ratio, and the dividend yield is close to 5% when you factor in all the special ones.

For those who are interested in getting a little more speculative, a name that has not performed that well yet since the report was published is Credit Suisse (CS).

If you want financials and you want Europe, kind of the two pariahs these days of the investment world, you can combine them in that particular space. There you get a quality company, obviously a Swiss-based investment bank, in our mind a quality company with pretty strong capital ratios and a generous dividend yield.

And yes, you have to have a strong stomach to navigate the daily fluctuations in the European sovereign debt situation. We think that the current share price, which is down substantially—it has been cut in half since early 2011—is already discounting the worst-case scenario that may not actually occur.

Those would be two names, and of course we do believe in broad diversification. I would like to see at least 50 stocks in a portfolio that follows our strategies.

Kate Stalter: Good to know, because it does sound like what you are talking about is that individuals should be aware of avoiding some of the conventional wisdom, or what they are hearing in the news every day.

John Buckingham: Well, yeah. Our mindset is: If everybody is reading about something in the newspaper—and that is the concern about dividends being a crowded trade, of course—but if everybody is reading that Europe is not a place you want to invest in, or financials are another area, that tends to attract our interest.

We’re contrarian. We like to see a lot of people not that enthused about equities and that makes us more enthused about stocks.

I know it sounds a little strange, but history will show that when the masses are optimistic about things, it is often when you don’t want to be committing new money towards equities and vice versa. You can look at market history and go back and see some of the investor sentiments and statistics.

March 2009 was perhaps when investors were the most pessimistic about stock prices. If you want to go back to early 2007, they were extremely optimistic right before the markets, of course, proceeded to go south.

I have written here recently, a tale as old as time, it is the way it is. Investors find nothing more exciting than a market going up and nothing more scary than a market going down.

If you could do the opposite, the timing is always difficult to get right, but history will show that buying when there is blood in the streets, so to speak, is where you make your big money.