Dividends offer outstanding returns during a bear market.

One benefit of a stock market downturn is stock prices for companies that pay consistent dividends are down and the dividend yields are up. A dividend is a payment the company makes to its owners (stock holders)—allowing them to participate in the profits of the company. In a time before the Tech Bubble of the late 1990s, investors used to determine the value of a stock primarily on the dividend the company was paying and the dividend investors expected the company to pay in the future. The higher the dividend the company paid, the more the stock was worth. The lower the dividend the company paid, the less the stock was worth.

Video Analysis: Dividends in a Bear Market

Although valuing a stock based on it’s dividend may have fallen out of style for a while, let’s take a look at some of the benefits of investing in stocks with high dividend yields versus investing in high growth stocks. To get started, let’s begin with an analogy. Then we can take a look at how Altria Group (MO) stacks up as a dividend-paying stock.

Flipping vs. Buying and Holding

During the housing boom of the last few years, a new term made its way into the collective vocabulary of people everywhere: flipping. Flipping a house involves buying a house, possibly doing a little fix-up work and then selling it a short time later for a profit.

Most real estate investors who flip homes rely on appreciation in the general real estate market more than anything else. If the real estate market is going up, the value of most homes will also go up—even without doing anything to the property to increase its value. Flipping homes works well when home prices are increasing. Unfortunately, it doesn’t work so well when home prices are decreasing. When home prices are decreasing, a real-estate investor who buys a home hoping to flip it may wind up three months from now with a home that is worth less than he paid for it.

Now let’s take a look at a different kind of real-estate investor: the buy-and-hold investor.

Buy-and-hold real estate investors buy homes and then rent them out to tennants. Buy-and-hold investors know that the value of the home is going to fluctuate and that it will most likely increase in value over time, but they are not going to rely solely on the home value appreciating to make money. They make money month in and month out by renting the homes. Every month, when the rent checks come in, the net worth of buy-and-hold investors goes up. They also get great tax deductions from buying and holding the home. In the end, the buy-and-hold investor can also sell the property for a gain.

During good markets when real-estate values are appreciating, both flippers and buy-and-hold investors make money. During bad markets when real-estate values are declining, only the buy-and-hold investors seem to do well. It’s not much different in the stock market.

Growth vs. Dividends

Growth stocks are the sexy stocks in the stock market. You never see the stodgy utility companies that pay great dividends on the covers of magazines or as the topic of conversation on the trendy blogs. Nope, instead you see high-flying stocks like Google (GOOG), Apple (AAPL) and Research in Motion (RIMM). After all, stocks that can appreciate a few hundred percent in a year are the stocks we all want to be in on, right?

Growth stocks are great investments when the market is growing. Everyone is bullish on the market, and growth stocks keep rising higher and higher. Unfortunately, growth stocks are typically the first to suffer during bear markets. Because of their inflated prices, growth stocks have farther to fall when the rug gets pulled out from under them.

Stocks that pay dividends, on the other hand, tend to do a little better during bear markets. While the value of dividend paying stocks will most likely decline during a bear market as well, the company behind the stock should still continue paying a dividend. Just like owning a rental property allows the owner to collect regular rent payments, owning a dividend paying stock allows the owner to collect regular dividend payments. Dividends also currently enjoy preferential tax treatment. Until the end of 2010, dividends are only taxed at a 15 percent Federal tax rate—instead of at your regular income tax rate.

During bull markets when stock prices in general are rising, both growth-stock investors and dividend investors make money. During bear markets when stock prices in general are falling, dividend investors seem to do better than growth-stock investors.

Dividend Paying Stocks for the Long Haul

Dividend paying stocks seem to perform well over the long term. Let’s take a look at Altria Group (MO) as an example. In his book The Future for Investors, Jeremy Siegel conducts a study on the performance of all of the stocks that originally comprised the S&P 500 when it was created in 1957. Looking at all of the stocks that were part of the original S&P 500 and still existed as of 2003, Dr. Siegel made an interesting discovery. Dr. Siegel states, “From 1897 through 2003, 97 percent of the total after-inflation accumulation from stocks comes from reinvesting dividends. Only 3 percent comes from capital gains.”

He also discovered that the best performing stock during those 46 years was MO. According to Dr. Siegel, if you had invested $1,000 in MO in 1957 and reinvested the dividends in more MO stock over the years, you would have had $4,626,402 by 2003. That is an incredible 19.75 percent annualized return. To put this in perspective, the S&P 500 only delivered a 10.85 percent annualized return during that same period—which means a $1,000 investment in the S&P 500 in 1957 would have only turned into $124,486 by 2003.

Thanks to the magic of compounding, you would have made $4,501,916 more investing in MO than you would have investing in the S&P 500 ($4,626,402 – $124,486 = $4,501,916).

Currently, MO has a dividend yield of 7.9 percent. If you are looking to buy a stock and hold it for a while, MO is a great candidate.

Could MO continue to decline in value? Sure. All stocks are at risk of declining in value. If it does though, it will be easier to reinvest your dividends and buy even more shares of MO. Plus, when the market eventually turns back around and starts moving higher, MO is likely to move up right along with it.