Wednesday, November 10, 2010

Dividend Growth Stocks – The best kept secret on Wall Street

When considering dividend stocks, many investors consider the companies with the highest yields to be the best picks. In a zero interest rate environment however no one can blame investors who want to maximize their yield in order to generate enough income.
One thing that yield hungry investors tend to forget is total returns. Another thing that yield hungry investors forget is inflation. Talk to them about companies raising dividend payments for 50 years in row and you get blank stares. Many investors ask how a company could raise dividends each year for many decades, yet the yield is 3%. In order to understand the dividend growth strategy however, investors have to get back to basics.

Dividend yield is calculated by annualizing the latest dividend payment and dividing it by the stock price. If we look at Johnson & Johnson (JNJ) whose latest quarterly dividend payment is 54 cents/share and which trades at $64, its current annual dividend is $2.16/share. Its current yield is thus 3.30%.

The yield on cost is calculated by dividing the most recent annual dividend payment to the price that you paid for the shares that you own. If you purchased Johnson & Johnson (JNJ) at the very end of 1990, when the stock was trading at $8.97/share, and the annual dividend was 17 cents/share, your current yield would have been 1.90%. Your yield on the $8.97 cost would have also been 1.90%. This was a particularly low yield, given the fact that 30 year treasuries delivered 8.25% and the yield on the S&P 500 was 3.74%.

The company was able to grow earnings over the next 20 years, and as a result was able to increase dividends every year since the hypothetical purchase. While the company didn’t have any control over its stock price, which was one of the determinants of its dividend yield, it had control over the actual amount of the quarterly dividend payment. The dividend yield fluctuated wildly over the past 20 years, while the dividend payment increased steadily for 20 years. Actually the dividend payment had increased steadily for 28 years before that!

The yield on cost on an investment in Johnson & Johnson (JNJ) steadily increased with the increase in dividends each year and reached 23.50% in 2010. This income stream was three times higher than what investors who purchased treasuries in 1990 generated. The growth in this income stream has also exceeded inflation for the period studied.

Last but not least a $100 investment in Johnson & Johnson (JNJ) at the end of 1990, with dividends reinvested would be worth $9646 by August 2010. Investors who spent all the dividend income would only have accumulated $6592 by August 2010.

This was not really an isolated incident. Many of the original dividend aristocrats of 1989 managed to deliver very good total returns over the next twenty years, coupled with solid yields on cost. Investors who were able to understand the power of dividend growth stocks were able to generate a dividend income stream that exceeded inflation as well as total returns, which at least matched market returns in aggregate.

Other quality stocks which could result in double digit future yields on cost include:

Medtronic, Inc. (MDT) develops, manufactures, and sells device-based medical therapies worldwide. This dividend champion has increased distributions for 33 years in a row. Over the past decade, the company has managed to increase dividends by 18.40% annually. Yield: 2.50% (analysis)

Becton, Dickinson and Company (BDX), a medical technology company, develops, manufactures, and sells medical devices, instrument systems, and reagents worldwide. This dividend aristocrat has increased distributions for 37 years in a row. Over the past decade, the company has managed to increase dividends by 14.50% annually. Yield: 1.90% (analysis)

Aflac Incorporated (AFL), through its subsidiary, American Family Life Assurance Company of Columbus (Aflac), provides supplemental health and life insurance. This dividend aristocrat has increased distributions for 28 years in a row. Over the past decade, the company has managed to increase dividends by 22.70% annually. Yield: 2.10% (analysis)

Family Dollar Stores, Inc. (FDO) operates a chain of self-service retail discount stores for low to lower-middle income consumers in the United States. This dividend aristocrat has increased distributions for 34 years in a row. Over the past decade, the company has managed to increase dividends by 10.50% annually. Yield: 1.30% (analysis)

In conclusion, a company yielding 2-3% today that has raised dividends for many years has rewarded early shareholders with yields on cost, which are higher than what most high yield stocks could have generated at the time of purchase. Investors who buy stock in companies which regularly raise dividends would enjoy higher dividend income over time and solid capital gains as well.

Full Disclosure: Long all stocks listed

This article was included in the Carnival of Personal Finance #283

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- Dividend yield or dividend growth?
- Are High Dividend Stocks worth it?
- Where are the original Dividend Aristocrats now?
- Dividend investing timeframes- what's your holding period?

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