Simple formula pays sweet dividends

Related topics: dividends, growth stocks, mutual funds, Fidelity, investing strategy

In a lecture to students, Aswath Damodaran of the Stern School of Business at New York University compared the old-school practice of rewarding shareholders with dividends to the relatively recent corporate phenomenon of stock buybacks.

"Dividends are like getting married," the finance professor told his students, while "stock buybacks are like hooking up."

Damodaran has a point. Dividend payments represent a long-term commitment, requiring consistency and discipline from management.

And that's exactly how they're treated, according to a recent report from mutual fund manager Fidelity Investments. "Companies are loath to cut dividends, even during hard times, out of fear that reducing or eliminating the payment will cause investors to flee their stock," the Dec. 15 report said.

Neither party, it seems, wants the marriage to end. But end it does, which is why prospective suitors need to be diligent in their research. Last year, 145 companies reduced or eliminated their dividend payments. At one level, that's encouraging news that suggests a strengthening economy. Roughly 800 companies cut or ditched their dividend payouts in 2009 after 600 companies did so the previous year.

But you'd be wise to consider packing your portfolio with shares of companies that are increasing their dividends, and there's a simple formula you can use to find such companies.

It's called the 10-10 formula, aqnd it can lead to companies that have raised dividends for at least 10 consecutive years and have increased those dividends by an average of at least 10% each year.

This 10-10 test was developed by Tom Cameron, the chairman of Dividend Growth Advisors. Cameron uses the stock screen to great effect in running the Dividend Growth Trust Rising Dividend Growth (ICRDX). Over the past five years, the fund has outperformed the Standard & Poor's 500 Index ($INX) by an average of more than 4 percentage points a year, placing the fund in the top 2% in its category.

Results from a study by Ned Davis Research demonstrate just how impressively "dividend growers" reward investors. For example, $100 invested in 1972 in a company that consistently raised its dividend would have become $3,214 by late 2010, the research found, while $100 invested in shares of a dividend-paying company that didn't raise its payout would have been worth $1,422.

Also, "growth in dividend payments often tends to be more reliable than earnings growth," the Fidelity researchers found. "Since 1946, dividend growth rates have had a standard deviation of just 6% compared with 16% for earnings growth rates," according to the Dec. 15 report.

Exposure to fast-growing dividend payers should excite even the most conservative investors, who might want to consider the 10-10 formula as a starting point for additional research rather than a strategy to mechanically apply.

By focusing only on the consistent growers, you score bigger checks every year (or more shares bought when reinvesting). More importantly, steady dividend increases bode well for a stock's future, as managers committed to rising dividends are more likely to carefully allocate capital to value-creating projects.

I'd like to share a few specific dividend stocks, but let me first make clear that I'm not here to proselytize on behalf of Rising Dividend Growth. Although a spokesman for the fund told me that fees would decline as economies of scale are realized with things like back-office costs, the fund's fees are higher than the Morningstar category average. Plus, the A shares have a front-end load. Nonetheless, I'm impressed by the fund's performance, and I love its 10-10 formula.

Application of the formula yielded these five stocks, which are among core holdings of Rising Dividend Growth.