Dividend Investing: It's Not Just About Yield

After more than a decade of has-been status, once-dowdy dividend stocks are back in the limelight. Three dividend-focused exchange-traded funds ranked among the top 10 ETFs with the strongest cash flows for 2011. Even the bond king, Pimco’s Bill Gross, has been talking up dividend-payers in investment missives.

You’ve probably heard the killer dividend pitch plenty of late: “Hey, you can get a higher yield on quality blue chips than on the 10-year Treasury.” In fact, classic dividend-payers such as utilities and telecoms have yields double the 1.99 percent payout on the Treasury note.

Getting all wide-eyed over a stock’s dividend yield, however, misses the bigger picture. “What you are getting paid today in a dividend is not what’s important,” notes George Fraise, manager of the $3.1 billion Sustainable Growth Advisers, sub-adviser for the John Hancock U.S. Global Leaders fund. “The key to dividend investing is to focus on companies that will be able to grow that dividend payout over time.”

According to Ned Davis Research, over the past 40 years stocks in the Standard & Poor’s 500 index that increased their dividend payout annually averaged a 9.4 percent annualized return. Companies that paid a dividend but didn’t increase that payout had an annualized return of about 7 percent. And a T. Rowe Price study that sliced and diced 25 years of data on the Russell 1000 into quintiles based on dividend yield and dividend growth produced intriguing results. The tongue-twisting takeaway: The study found that the high-yielding stocks with the lowest dividend growth rates underperformed high-yielding stocks with the highest dividend growth by about 1 percentage point.

Some added icing on the cake: Dividend-growers often deliver a smoother ride. A Mergent index of dividend growth stocks was 20 percent less volatile than the S&P 500 over the past 10 years. A growing dividend is also a valuable inflation hedge compared with the fixed payout of a bond.

Follow the money

Focusing on dividend growth helps keep your stock portfolio trained on high-quality firms. “Earnings are the raw material that provide dividends, so if you can identify a firm with a history of rising dividend payouts you’ve probably found a well-run business with a competitive edge,” says Eric Warasta of Cambridge Trust’s wealth management division, which runs an equity-income strategy that drills down on dividend growth.

A rising dividend can also be “a byproduct of a company that has sustainable growth in free cash flow,” notes SGA’s Fraise. That’s another good character trait. “Free cash flow opens up the opportunity for a company to return money to shareholders, and dividends are one way to return that money.”

Josh Peters, director of dividend investing at Morningstar, believes a dividend growth rate in the mid- to upper single digits is the sweet spot. “When you start seeing much higher growth rates you have to start asking yourself if you’ll continue to get what you’re seeing. You want to find a good balance between current yield and growth potential.”

The team running the $9.6 billion Vanguard Dividend Growth fund (1.9 percent yield; 0.31 percent expense ratio) likes to home in on companies with a growth rate three percentage points above the inflation rate, or about 6 percent these days. That fund's 4 percent annualized gain over the past five years is 4 percentage points ahead of the S&P 500. The $10.1 billion Vanguard Dividend Appreciation ETF (2 percent yield; 0.18 percent expense ratio) tracks an index of firms with at least a 10-year record of dividend growth. Its 3.2 percent annualized gain over the past five years is 2 percentage points better than the return for the S&P 500.

Parsing the payout

The other key dividend variable is what's known as the payout ratio: the percentage of a firm’s earnings being forked over to cover the payment. A high ratio can make it harder for a firm to keep increasing its payout at a meaningful pace. For example, utilities, with payout ratios that can often top 75 percent, already churn out most of their earnings to cover dividends. Warasta says as a general rule a payout ratio below 50 percent gives a firm plenty of room to keep growing the dividend.

Nuveen Investments found that in the 10 years through 2011, S&P 500 companies with the lowest payout ratios delivered higher total returns than stocks with higher payout ratios, regardless of their nominal yield. The $10 billion IShares Dow Jones Select Dividend ETF (3.4 percent yield; 0.40 percent expense ratio) has about 30 percent invested in utilities; by comparison, the S&P 500 Index has 4 percent riding on the utility sector. For the past five years, the utility-heavy ETF has an annualized loss of 1.5 percent, which lags the S&P 500 Index by two percentage points.

The other Buffett rule

Warren Buffett has refused to pay a dividend to Berkshire Hathaway shareholders on the premise that he can find better uses for the cash. But make no mistake, he’s a fan of dividend growth.

In Berkshire’s 2011 annual report, Buffett pointed out that when he'd finished building BRK’s position in Coca-Cola in 1995, the dividend payout to Berkshire that year was $88 million. He noted that he expected his 2011 dividend check from the soft drink maker to be a tidy $376 million, and for that to double in 10 years. “By the end of that period, I wouldn’t be surprised to see our share of Coke’s annual earnings [the dividends paid] exceed 100% of what we paid for the business.”

That’s all about dividend growth. For the past five years, Coca-Cola, whose stock yields 2.8 percent, has increased its dividend payout at an 8.7 percent rate. Moreover, Coke's 10 percent annualized return over that stretch beat the S&P 500 by 9 percentage points. Not exactly dowdy.

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