FUND WATCH


In Pursuit of Rising Dividends

Looking for companies that actually are boosting distributions in this economic slump? You'll find plenty in Vanguard Dividend Growth's portfolio.



Dividend cuts have humbled many blue-chip companies, ranging from Bank of America and General Electric to Pfizer and Wells Fargo. David Kostin, strategist at Goldman Sachs, projects that dividends per share among stocks in the Standard & Poor's 500-stock index will drop 22% this year. That would be the most severe decline since 1938.

Financial concerns are doing most of the slashing. Kostin estimates that financials' share of total S&P 500 dividends, 29% as recently as 2007, will collapse to just 8% this year and fall to 5% in 2010.

Amid this carnage, should you still consider investing in dividend-paying stocks? Yes, particularly in companies with the wherewithal and stamina to keep raising their dividends amid the economic slump. We'll tell you how soon. First, consider some historical data on dividend payers.

From 1928 to 2008, dividends generated 37% of annual stock returns, according to Goldman Sachs. Ned Davis, a stock-market-research outfit, separates stocks into three categories: dividend growers, dividend payers that don't boost distributions and non-dividend-paying stocks. From January 1972 through February 2009, dividend growers returned an annualized 8.2%, dividend payers returned 5.5% and non-dividend payers actually lost 0.1% a year, Ned Davis calculates.

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A fine way to invest in dividend-growth stocks is through Vanguard Dividend Growth (symbol VDIGX), which holds a portfolio of 49 such stocks. Managed by Don Kilbride, of Wellington Management, Dividend Growth lost 1% annualized during the five years through March 12, five points better than the S&P 500.

Here's why dividend growers appeal to Kilbride, who looks out three to five years when he invests in stocks: "Companies that can grow dividends the next three to five years are fundamentally very strong. A dividend hike is [management's] most powerful signal of confidence in the future." Kilbride, who holds his stocks for five years on average, thinks that dividend increases demonstrate a company's loyalty to shareholders. After all, when the company cuts a dividend check, it's distributing cash that it won't see again.

But the odds are strong you will see more payments. Kilbride says that the average age of the companies in his portfolio is 95 years. "Companies that are old are good at adapting," he says.

Kilbride's pursuit of strong profits and cash flows and sustainable business models leads him to several areas. One of his favorite sectors is oil (he was formerly an oil analyst), where he holds giants including ExxonMobil (XOM), Chevron (CVX), Total (TOT) and BP (BP). He notes that companies such as these have extremely strong balance sheets and cash flows and long histories of paying dividends.

His second-largest holding (after Total) is Automated Data Processing (ADP). The company's high client-retention rate in its payroll-processing business contributes to consistency and steady dividend growth. He also likes Johnson & Johnson (JNJ), Abbott Laboratories (ABT) and Accenture (ACN), which, like ADP, benefits from the outsourcing of business services.

Kilbride calculates that his portfolio's dividends swelled by 15% in 2008. He figures that growth will decline to the high single digits this year. That's still quite a bit higher than annual inflation, a comparison he says was one of the key reasons Vanguard set up the fund in 2002, targeting baby-boomers rolling over retirement savings from 401(k) plans to IRAs.

Vanguard Dividend Growth yields 3% to shareholders, partly reflecting a low annual expense ratio of 0.32%. This is a fine long-term core stock fund, especially for retirees seeking to stay ahead of inflation, that scourge of purchasing power.



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