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Sean Somerville: Dividend growth strategy can avoid traps

If you learned of an investment that had returned an average of 8.6 percent over the last 25 years — through the tech bubble, the real estate bubble and the “lost” decade — you might want to learn more.

If this performance was one point higher on average than the S&P 500’s 7.6 percent and achieved with less risk than that benchmark, you’d be really curious.

But you won’t find this investment on a mutual fund all-star team or with the next hot hedge fund manager. That’s because this investment is driven by a simple two-word strategy: Dividend Growth.

“There is no more elegant single gauge of corporate health and strong governance practices than the ability and willingness of corporations to make recurring payments of cash to shareholders in the form of dividends,” wrote Robert McConnaughey, the head of equity for Columbia Management Investment Advisors. “Income from bonds is well and good, but equity dividends have one key advantage: properly managed, they can grow over time.”

Trolling with a dividend growth net, you tend to pick up all sorts of interesting things: fast-growing companies, slow-and-steady growing companies, cash-rich companies, shareholder-friendly companies. More important, you may avoid companies that are cash burners, slow growers, no-growers or poorly managed. Focusing on dividend growth, you might also avoid “value traps,” or companies that look exceptionally cheap but whose businesses might be disappearing under their noses.

It’s important to distinguish here between high-dividend-yielding companies and dividend-growth companies. A dividend-growth company may have a yield equivalent to only 2 percent of its stock price, but if it paid a dividend equivalent to a 1 percent yield in the prior year, it has increased its dividend by 100 percent (assuming a flat stock price.)  So it is the change, or delta, in the dividend that is critical.

By contrast, there are plenty of companies with yields ranging from 3 percent to 4 percent for years. But in some cases those dividends are not growing.

The upshot: If you need a lot of income now from your stocks, dividend yield might be a more useful metric than dividend growth. But if you are focused on long-term appreciation, it might make sense to use the growth in dividends as a guide to build your own dividend delta portfolio.

Many studies

There are many studies that attest to the superior returns of dividend growth companies over time. Two of them:

– The quantitative team of RBC Capital Markets Corp. found that  between January 1994 and October 2011, dividend growers returned 8.6 percent, dividend payers 8.3 percent, companies that did not pay a dividend 7.1 percent, dividend cutters, -1.5 percent.

– According to Ned Davis Research Inc., companies that raised or initiated a dividend averaged a total annual return of 9.6 percent between 1972 and 2010, versus 7.5 percent for dividend-paying companies without increases and 1.7 percent for non-dividend paying companies. Dividend-growth companies are less risky than their non-dividend paying counterparts, according to that study.

When a company increases its dividend, it is generally expressing enough confidence in a business that it can not only pay, but increase the amount it pays, to the business’ owners. To borrow a phrase from the film, Jerry Maguire, dividend growth stocks may not only “show you the money,” but may show you more money this year than last year.

Management’s decision to increase a dividend is generally an indication that a company is generating cash — not tying it all up in inventory or using it all for capital expenditures.

To be sure, there are good cash-generating companies that don’t pay dividends. Some use cash to buy back their own shares. If a buyback reduces the number of overall shares, it can add value by making the stakes of existing shareholders larger. But some companies issue shares as fast as they buy them back, so the buyback may not be adding value.

Other companies use cash to make acquisitions. But acquisitions that truly add value to shareholders of the acquiring company can be rare.

Better quality businesses

Put simply, companies that pay dividends may generally tend to be better-quality businesses than those that don’t. Consider this: Return on assets was 3.23 percent on average for dividend-paying companies between 1972 and 2010, versus .7 percent for non-dividend-paying companies, according to Ned Davis Research. Return on equity average was 13.6 percent, versus 1.7 percent for non-dividend companies.

A couple of reasons to think about dividend growth right now: dividend-paying companies tend to perform better coming out of bear markets over three-year and five-year horizons than non-dividend-paying companies, according to Ned Davis Research. And it might be good to have an income source likely to grow faster than inflation. Put another way, if the income from your investments is increasing by 10 percent and the inflation rate is 3 percent, you are outstripping inflation growth by 7 points.

So what to do? There are mutual funds and exchange-traded funds that use dividend growth as a tool to choose stocks.  Some investment firms, including RBC Wealth Management, have their own dividend-growth portfolios.  Finally, many financial advisors — including this one — have their own techniques for recommending dividend-growth stocks.

Sean Somerville is a financial advisor with RBC Wealth Management in Hunt Valley. He can be reached at 410-891-5031 or sean.somerville@rbc.com.

RBC Wealth Management is a subsidiary of RBC Capital Markets LLC, member NYSE/FINRA/SIPC.