After many dark months, investors' appetite for risk is back, prompting a buying binge that is driving up the value of some pretty speculative stocks and asset classes.
You can play the momentum game, hoping to enter and exit a hot stock at just the right juncture. Or you can ignore the siren song of quick but highly uncertain gains and instead invest for the long term, using the tried-and-true technique of identifying companies that regularly raise their dividends.
History is on the side of the dividend strategy. Howard Silverblatt, of Standard & Poor's, calculates that from 1926 through March 2009, reinvested dividends accounted for 44% of the 9.5% annualized return of the S&P 500-stock index ($INX). From 1972 through April 2009, dividend growers returned 8.7% annualized, according to Ned Davis Research, compared with 6.2% for the S&P 500 and just 0.7% for stocks that paid no dividends.
Why has a dividend-growth strategy stood the test of time? First, to commit to boosting its payout, a company must be financially strong and confident that its business plan will generate a stream of profit and cash flow. A growing payout, says Judy Saryan, the manager of Eaton Vance Dividend Builder fund (EVTMX), is the "best, most tangible signal that a company's board of directors and management have confidence in future cash flows."
Saryan notes some subtle effects of managers' commitment to boost the distribution annually. Shareholders' anticipation of that dividend check forces a company's leaders to be more disciplined with their cash and more careful in selecting capital projects. Paying dividends discourages dubious accounting: The company must have the real money to make the payments.
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The trick is to identify companies that have the stamina to keep increasing dividends for many years -- and to acquire their stocks at reasonable prices. A sustainable business model is crucial. You want a company with a strong balance sheet, robust free cash flow (the money left over after capital expenditures needed to maintain the business) and a high return on equity, which enables the business to pay out a handsome dividend while also reinvesting in its growth.One way to analyze the expected return on a dividend-growth stock is to compare it with a U.S. Treasury bond. Let's take the example of Coca-Cola (KO, news, msgs). Over the next four quarters, Coke should pay a dividend of close to $1.70 a share; based on its recent share price, that's a yield of 3.4%, slightly less than the 3.9% yield of a 10-year Treasury.
But compare the potential of the two investments over the next 10 years. Let's say that both Coke's earnings and its dividend grow by 8% per year. Over the next decade, that 3.4% yield will swell to 7.3% based on today's share price (and, for the truly patient investor, to 15.9% after 20 years), while the fixed-income Treasury will still return a bit less than 4% for someone who buys the bond today. Moreover, assuming the price-to-earnings ratio remains the same, you'll earn an annualized total return of 11.4% (3.4% annual yield plus 8% annual capital appreciation), compared with roughly 4% for the Treasury. If the P/E rises, you will earn more than 11.4%; if it declines, your return will be less.
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3 keys to dividend investingKelley Wright, of Investment Quality Trends, discusses the role of yield in a portfolio and how to select dividend-paying stocks. (May 14)
Coke, which has raised its dividend for 47 consecutive years, certainly passes the endurance test. Its iconic brands, unparalleled global distribution network and steady growth in beverage volumes generate high returns on capital and free cash. Goldman Sachs' Judy Hong calculates that Coke's cost of capital is less than 8%, compared with its return on invested capital of 18%. No wonder Warren Buffett's Berkshire Hathaway (BRK.A, news, msgs) is Coke's largest shareholder.
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