Kip 25 Update: Vanguard Dividend Growth

Benchmarks don't mean much to Don Kilbride, manager of Vanguard Dividend Growth (symbol VDIGX). "My performance against any benchmark is interesting, but at the end of the day it doesn't inform how I manage the fund," he says. So Kilbride, who is a partner at Wellington Management (which runs Dividend Growth and a number of other Vanguard funds), isn't particularly worried that his fund has trailed the market recently.

To be precise, Dividend Growth, one of Kiplinger’s 25 favorite no-load funds, returned 21.4% over the past year through April 3. That's 2.8 percentage points less than the return of Standard & Poor's 500-stock index. But Kilbride's long-term record is superb: Since he became manager in 2006, Dividend Growth has returned 9.1% annualized, an average of two percentage points per year better than the index. Even better, for the greater part of that period, Dividend Growth was about 20% less volatile than the S&P 500.

But in a soaring stock market led, until recently, by fast-growing companies that typically hang on to all their profits, it should come as no surprise that Dividend Growth lagged, says Kilbride. "I feel okay about the last 12 months," he says.

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That's partly because Kilbride focuses on established firms that are willing to raise their dividends consistently—the portfolio's 51 stocks have done so at an average rate of 10% per year over the past five years. The performance of some of the fund's positions in energy stocks held back returns, too.

Kilbride hunts in a universe of about 400 stocks. "We have a high standard—companies that will raise dividends at 10% or greater, consistently," he says. "And not a lot of companies can do that." He tends to settle on well-managed companies that carry little or no debt and that fall into one of two camps: older firms with decades of steady payments, such as Johnson & Johnson (JNJ), and firms that are new to paying dividends, such as Oracle (ORCL). Though the old, stable growers make up the majority of the portfolio, Kilbride says finding that next generation of dividend growers is an important part of his job. Dividend Growth yields 1.9%, a bit more than the S&P index.

But price is the deciding factor. Kilbride tilts toward stocks that have lagged the S&P 500 or that trade near their 52-week lows. In mid 2013, fund records indicate, Kilbride bought shares of Anheuser-Busch Inbev (BUD), which were lagging the broad market. (Although it's based in Belgium, Inbev, which bought Anheuser-Busch in 2009, has a strong U.S. component.) Dividend Growth can invest up to 25% of its assets in foreign stocks; it has 11% overseas today.

When Kilbride buys, he usually holds for a long time. His fund's annual turnover of 18% over the past year suggests an average holding period of five years. He sells part of a holding if it grows to more than 4% of the fund's assets. But he rarely unloads an entire position. Such a move, Kilbride says, would mean the nature of company's business has changed (say, it made an acquisition that he felt didn't add value), or competition has intensified, inhibiting a company's ability to grow. Fund records show that Kilbride sold all of his shares in PepsiCo (PEP) in 2013. An analysis by researcher Morningstar says Kilbride sold because of intensifying competition in the soft-drink business, concern that the stock had gotten too pricey and a desire to invest in stocks with more-attractive prospects.

Kilbride builds the fund's portfolio stock by stock, as he recently explained in an interview with the Independent Adviser for Vanguard Investors newsletter. His view of the world is "cautious" these days, given easy-money policies around the globe that he says have pushed stock prices higher and the unwinding of the Federal Reserve's bond purchases. But that hasn't changed the way Kilbride runs the fund. The characteristics of the companies in the portfolio, he says, are the same as they have always been.