Stocks That Pay Rising Dividends

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. 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, manager of Eaton Vance Dividend Builder fund, is the "best, most tangible signal that a company's board of directors and management have confidence in future cash flows."

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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.

The real thing

The trick is to identify companies that have the stamina to keep increasing dividends for many years -- and to acquire their stocks when they are selling 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 both pay out a handsome dividend and retain enough earnings to reinvest 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 (symbol KO). 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 ten-year Treasury.

But compare the potential of the two investments over the next ten 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-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.

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 copious free cash. Goldman Sachs's 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 is Coke's largest shareholder.

Ugly wares, nice numbers

We know many of you are averse to investing in tobacco companies. But if you're not, you'll appreciate the striking financials of Philip Morris International (PM), the world's largest publicly traded tobacco firm. Based in New York City, Philip Morris books 100% of its sales outside the U.S. The maker of Marlboro generates an eye-popping 60% return on equity, partly because its stable, predictable cash flows allow it to carry more leverage on its balance sheet. Capital-investment needs are nominal, which helps it produce $7 billion of free cash flow a year. At the current dividend rate of $2.16 per share, the stock yields a sturdy 4.9%.

Philip Morris's outlook is bright. Consumption of cigarettes is shrinking in Western Europe and Japan but growing briskly in emerging markets, where Philip Morris earns the bulk of its profits. Overall, the number of cigarettes sold is growing just 1% to 2% a year, but the company has an unusual ability to raise prices -- one of the things about selling an addictive product. Philip Morris thinks it can boost earnings per share 10% to 12% a year over the long term and has committed to paying out at least 65% of its earnings in dividends. Big, ugly tobacco companies like this one tend to treat loyal shareholders well.

Dominant food supplier

Let's move to a predominantly domestic company, Sysco Corp. (SYY). The leader in its field, Sysco distributes food to hospitals, hotels, campuses, restaurants and company cafeterias across the U.S. It has a peerless distribution system, with the most warehouses and delivery trucks through which to push growing volumes of food and related supplies (annual revenues are $37 billion).

Earnings may be flat this year because Americans aren't eating out as much. But as Cliff Remily, associate manager of Thornburg Investment Income Builder fund, says, Sysco's history suggests that it will emerge stronger after the recession because it's a serial consolidator (more than 100 acquisitions in 40 years) and by far the largest and strongest player in a fragmented industry full of mom-and-pop outfits.

Sysco has a sterling dividend record (the payout has compounded by 18% per year over the past decade) and, at a 4% yield, the shares are as cheap as they've ever been. Companies such as Sysco and Philip Morris International are in the dividend sweet spot, offering a combination of relatively high yield (4% to 5%) and the prospect of being able to boost their dividends by 10% or more annually.

Health-care giants

The medical sector has historically yielded many dividend-growth champions. Leaders tend to be mature, financially solid companies that generate relatively dependable cash flows in economies both buoyant and sour. Health care now faces more regulation, litigation, and pricing and patent issues than in the past, so the search is a bit trickier -- witness Pfizer's stunning dividend cut earlier this year.

Two standouts in health care are Abbott Laboratories (ABT) and Becton, Dickinson (BDX). Both are well diversified and should be able to boost earnings by at least 10% even this year, during the worst recession in decades.

Abbott has a handsome growth profile with products such as Humira, the leading rheumatoid arthritis medication (protected by patent until 2016); Lasik eye-surgery devices; the vascular industry's top drug-delivering stent, used to unblock coronary arteries; and hand-held glucose monitors for diabetics. The Abbott Park, Ill., company is a model of consistency, having raised its dividend for 37 straight years. It plows 9% of its sales ($30 billion) into research and development each year.

Like Abbott Labs, Becton, Dickinson makes more than half of its sales abroad. This venerable company (founded in 1897 and based in Franklin Lakes, N.J.) made its name in needles and syringes, and is also a big supplier of surgical scalpels and blades. A sticky business, to be sure, but as Larry Coats, of Oak Value fund, says, safety is paramount, so hospitals and doctors offices are unlikely to fool around with other, unknown suppliers of such skin-piercing devices. BD also has good businesses in catheters, insulin-delivery products and infectious-disease diagnostic systems.

BD is resistant to recessions. This year the firm raised its dividend by 16% -- not many companies can match that increase -- and distributions have grown an annualized 21% over the past five years. The stock yields just 2%, but the company, which pays out only 25% of its earnings, has plenty of resources to keep those dividend increases flowing.

Indeed, a successful dividend-growth strategy involves identifying low-yielding stocks with very promising growth prospects, as well as higher-yielding, more-mature companies with less-exciting growth profiles. Fast-growing companies typically retain a high portion of their earnings, which they plow back into attractive reinvestment opportunities.

High-growth consultant

Don Kilbride, manager of Vanguard Dividend Growth fund, employs a "barbell" approach in his portfolio. At one end are dividend bluebloods, such as Johnson & Johnson. At the other end of the barbell is a new generation of dividend payers with plenty of room to grow. One Kilbride favorite is Accenture (ACN), formerly Andersen Consulting, which went public in 2001 and paid its first dividend in 2005.

When you look at the financial statements of this management-and-technology consulting firm (which competes with the likes of IBM), it's clear that this is a phenomenal business. Headquartered in Bermuda, Accenture employs 181,000 workers around the globe in 200 cities and 52 countries. It has $3 billion in cash and no debt, and it generates $3 billion of free cash flow per year on revenues of $26 billion.

Because the company spends only about 10% of its cash flow each year on capital investment (the business doesn't have much to invest in except its people), it returns the bulk of its cash to investors in the form of share buybacks and dividends, which have mounted by 19% a year since their initiation. The business has held up well through the recession because clients seek Accenture's advice for improving efficiency in areas such as inventory management.

Big oil, French-style

We'll leave you with a major energy company, France's Total (TOT). Big domestic oil companies such as ExxonMobil and Chevron have outstanding records of boosting dividends over the long haul, and we expect the same from Total.

Consumers are hooked on oil. Eco-nomists call this inelastic demand, which is fairly uncommon with merchandise. When producers of inelastic goods increase prices, demand declines only slightly, resulting in a net increase in revenues. (By contrast, when producers of products with elastic demand, such as autos and furniture, try to raise prices, it leads to revenue declines.)

Total's stock serves up a generous 5.4% yield, and the company has boosted dividends at an annualized rate of 14% (in euros) over the past four years. Kilbride compares Total to ExxonMobil in terms of financial discipline, skilled allocation of capital and execution of large projects. Total is also particularly well placed in important production-growth areas, such as west Africa. Socially conscious investors, take note: Total deals with regimes in countries (such as Venezuela and Myanmar) where U.S. energy firms dare not tread.