Before the days of 24 hour financial news, quants, momo stocks and alternatives like the WisdomTree Managed Futures (ARCA:WDTI), people bought stocks for one reason; to own a piece of a growing business. Somewhere along the lines, we've shifted our focus to be more about capital gains. However, as more baby boomers begin their retirement journeys and interest rates remain ultra-low, many portfolios have once again returned to the art of dividend growth investing. For investors of any life stage, growing dividends can form the backbone of any portfolio and can lead to real long-term wealth. (For related reading, see The Power Of Dividend Growth.)
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The Power of Dividends
Companies within the S&P 500 handed out about $240.6 billion in dividend payments throughout 2011. This is up from around $205 billion during 2010 and was the largest payout since 2008. However, analysts estimate that these amounts will continue to rise as corporate earnings and a variety of economic headwinds have died off. Based on the current dividend rates of 394 companies within the index, S&P estimates that 2012 will see payouts increase to around $252 billion.
This is great news for investors, especially those who follow a dividend growth strategy. At its core, the strategy involves buying stocks that regularly boost their dividend payments, and holding them for the long haul. By following a dividend growth model, portfolios gain access to businesses that generate higher revenues, profits and cash flows each year. Ultimately, these cash-rich firms will return these profits to shareholders and continually boost their dividends in a variety of economic and market cycles. This provides investors a higher yield-on-cost, more income and higher overall returns.
Finally, when not used for income, dividend payments can help smooth out returns. These payments can help cushion portfolios in falling markets and help reduce risk. Reinvesting those payments can help enhance returns when the market rights itself once again. According to Morningstar (Nasdaq:MORN), dividend-paying stocks have returned around 11% per year, beating non-payers by 3% since 1927. The end result of this has been portfolios that are nearly eight times larger. (To learn more, read The Power Of Dividend Growth.)
How to Hone in on the Strategy
For investors, instituting a dividend growth strategy is one of the easiest forms of portfolio construction. The majority of the firms that fit into this model are those that many people are familiar with and should feel comfortable owning. For investors looking for a broad approach to the tactic, the Vanguard Dividend Appreciation ETF (ARCA:VIG) tracks a portfolio of companies with a record of growing their dividends year over year. The fund's 127 different holdings include stalwarts like McDonald's (NYSE:MCD) and PepsiCo (NYSE:PEP). While the fund's current yield isn't super high (roughly 2.32%), the idea is that over time it will increase based on rising payments from these firms. Similarly, the PowerShares Dividend Achievers (ARCA:PFM) tracks a comparable basket of firms.
With 37 years of dividend growth, an impeccable balance sheet and a huge pile of cash, payroll specialist Automatic Data Processing (Nasdaq:ADP) could be exactly what investors are looking for in a dividend growth stock. The firm requires very little capital to grow its services and is one of the only AAA-rated firms in the U.S. ADP currently yields about 2.9 % and has a five-year dividend growth rate of just under 15%. Also worthy of a look is ADP's rival Paychex (Nasdaq:PAYX).
Increasing energy demand coupled with higher oil prices is benefiting producers like Chevron (NYSE:CVX). The integrated major oil company not only features a high current yield (3%), but has been growing that dividend by approximately 10% annually. Shares of stock can be had for a dirt cheap P/E of around 7.8 and should be able to continue its dividend growth as long-term energy demand rises.
The Bottom Line
With interest rates continuing to hold at super-low levels, now could be a great time to institute a dividend-growth strategy. By buying firms with good cash flows and a history of rising dividends, investors can profit over time as these payouts increase. The previous ideas, along with investing in Colgate-Palmolive (NYSE:CL), are just a few ways to adopt the strategy. (For additional reading, see Build A Dividend Portfolio That Grows With You.)
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At the time of writing, Aaron Levitt did not own shares in any of the companies mentioned in this article.