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The Dow Loves Dividends

Adding stocks such as Visa and Nike reflects a trend toward companies capable of big dividend hikes.

The Dow Jones industrial average is morphing into a powerful dividend-growth machine. Want proof? Check out these numbers: 50%, 34%, 32%, 27%, 25%, 22%, 21%, 18%, 17% and 15%. They represent the size of the ten largest dividend hikes announced over the past year or so by members of the Dow. Not bad for an index that represents some of America’s largest companies.

See Our Slide Show: 8 Smart Ways to Profit From Dividend Stocks

That 50% boost came from Visa (symbol V), which, along with Goldman Sachs (GS) and Nike (NKE), joined the Dow in September. Visa is likely to declare another fat raise soon, to be paid in December. Nike hiked its rate by 17% last year and is set to announce another double-digit increase. Goldman’s last raise, which came a year ago, was only 9%, but it followed a 31% increase. All told, the investment bank has boosted its payout by 43% in 18 months.

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These increases (and more to come) do not strain this trio’s resources. Visa pays out only 15% of its earnings; Nike, 30%; and Goldman, 12%. If you look at free cash flow (the cash profits left after the capital expenditures necessary to maintain a business), you can sense bigger paydays. None of the newcomers is as capital-intensive as Alcoa (AA) and Hewlett-Packard (HPQ), which, along with Bank of America (BAC), were ousted from the Dow.

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I asked the people at Standard & Poor’s, which runs the Dow, how they weigh dividends when they consider membership changes. The key criteria, they say, are a history of sustained growth, a company’s reputation and a wide following among investors. Well, because 15% dividend raises enhance a company’s reputation, and as you need sustained growth to support such distributions, you won’t see the Dow enroll deadbeats or firms that will struggle to lift their payouts. You will see more additions such as Cisco Systems (CSCO), which paid out nothing when it joined the average in 2009 but began making disbursements in early 2011 and has since tripled the rate.

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The addition of these kinds of growth stocks underscores the changing dynamics of Dow dividends. For decades, the best-known Dow income strategy has been to invest in the Dogs of the Dow—buying the average’s ten highest yielders, holding them for a year, then repeating the procedure (which in practice usually means replacing a couple of the ten initial mutts). The presumption is that the Dogs are undervalued and that their prices will rise, lowering their yields to more-normal levels.

Neck and neck. The Dogs have had some good runs. Stocks of big drug companies, which pay high dividends, and commercial banks, which used to, had a grand time in the 1990s. Over the past ten years, though, the Dogs have returned just a smidgen more than the full Dow (all returns are through October 4). The Dogs have roughly matched the overall market so far in 2013, delivering a total return of 17.9%. But that figure was inflated by Hewlett-Packard’s, er, dead-dog bounce. HP soared 52% for the year through September 20, its last day in the index.

As I write this, the Dogs, with Chevron (CVX) substituting for HP, yield 3.7%, on average. If you were starting a Dogs port­folio today, you’d buy wireless giants AT&T (T) and Verizon Communications (VZ); the drug trio of Johnson & Johnson (JNJ), Merck (MRK) and Pfizer (PFE); two echoes of heavy industry, DuPont (DD) and General Electric (GE); and Chevron, Intel (INTC) and McDonald’s (MCD). The dividends are reliable. But most of the Dogs’ payouts exceed 50% of earnings, squeezing their capacity for raises. If you’re looking for above-average yield, you won’t be barking up the wrong tree with a portfolio of Dogs. But if you want stocks with potential for higher total returns, look to the newer breed of Dow dividend hikers.

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