9 Real-World Reasons to Own Dividend-Growth Stocks

Dividend investors seem a usually cheerful bunch. And why not? Every few months nice people at companies all over the globe send them money, just for owning their stocks. Stock went up? Here's your money. Stock went down? Here's your money. You own the stock, you get the money. Cheers!

But not everyone likes the party at this particular punchbowl. Now and then some persistently stubborn soul takes a dusty book from the shelf, pulls out an adding machine and some green eyeshades, and figures that investing in dividend stocks violates the most sacrosanct rules of book value, business management and common sense.

When companies pay dividends, these party poopers bluster, it technically reduces the companies’ value. On top of that, the companies could have used the money themselves. Continue giving it away, the sharp pencils warn, soon enough the business will suffer. And how much will the stocks be worth then? It all adds up. Case closed.

No doubt, businesses need to retain some portion of their profits to reinvest for future growth. And dividend growers do that. Moreover, decades of real-world experience make clear that dividend stocks, especially those with growing dividends, are stellar investments for income strategies as well as total returns.

So for the benefit of those less interested in numbers from book theories than from their brokerage accounts, here are nine real-world reasons to own dividend-growth stocks, presented in plain language and backed up by broad-based data. (Click the accompanying links for details.)

These stocks simply go up more. Study after study shows total returns from dividend stocks, especially dividend growers, clobber the market and cream non-dividend payers, decade upon decade. How is this remotely possible if paying dividends detracts from companies’ real value while not paying dividends enhances it?

Dividend stocks deliver above-average returns with below-average risk. Meanwhile, non-dividend payers trail the market, yet expose investors to above-average risk. The standard statistical measure of risk-related returns (known as “alpha”) shows dividend stocks’ clear superiority. Higher returns, lower risk. How sweet is that?

When you own dividend-growth stocks, you own stakes in superb businesses. These tend to be profitable companies (pdf) with strong business models and disciplined management. Weak companies can’t and don’t raise dividends for decades. Return on Equity and Return on Assets provide good measures of this. Dividend stocks trounce non-dividend payers on both.

Dividends provide cash income that doesn’t require selling assets in weak markets; income strategies based on asset sales create a real risk of running out of money in retirement. Bottom line: it may be true that selling 4% to 5% of capital annually is safe 80% to 90% of the time. But those are roughly the same odds you get in Russian Roulette. In both cases, you won’t like what happens if you lose. Put another way, risk is not defined solely by the probability of success, but also by the consequences of failure.

Dividend growth means cash income grows to offset inflation. Contrast this with fixed income strategies, which ensure lost purchasing power to inflation over time. For example, the CPI calculator shows that for every $100 of income ten years ago, you need $125 to buy the same stuff today. Or you could take a 25% haircut on your quality of life every decade.

Related to this, growing dividends mean the yield on one’s original investment, called yield-on-cost, keeps rising. Money invested at a 3% yield and 7% dividend growth will yield nearly 12% after 20 years. And while a bond will always yield the same coupon rate and dollar amount you start with, 7% dividend growth means $100 of income doubles to $200 after 10 years.

Dividend-growth investors can diversify across sectors, market caps and style boxes, tailoring their portfolios to their own goals and outlook. So don’t just think of stalwarts like Abbott Labs (ABT), McDonald’s (MCD) and other classic choices. For example, the Dividend Champions, Contenders and Challengers, comprising roughly 450 stocks with at least 5 years of dividend growth, include smallcap rockets like Atrion (ATRI), midcap technology growers like Factset Research Systems (FDS), international names like Unilever PLC (UL) and diversifiers like Kinder Morgan Energy Partners (KMP), Realty Income (O) and even Royal Gold (RGLD).

Because dividend growers tend to be above-average (pdf) companies with above-average returns, investors enjoy a powerful statistical advantage that amplifies their stock picking. To illustrate, suppose a fisherman can choose a lake filled mostly with big fish or one filled mostly with little fish. At any level of skill, the fisherman’s chances of catching big fish are much better at the first lake. Statisticians call this phenomenon “baseline probabilities.”

Finally, despite what we might think after the 2008-2009 meltdown, a dividend income strategy generally runs a low risk of dividend cuts. In normal times, dividend cuts among high quality companies are rare. Of forty-two 2010 Dividend Aristocrats, only one cut its dividend. Just four S&P 500 companies cut their dividend in 2010 and only twelve in 2007. That’s out of 300+ dividend payers in the index. Of 200+ Dividend Achievers last year, just two cut dividends. (For research on factors that help predict dividend cuts, click here.)

So there you go. Nine real-world reasons to own dividend-growth stocks. Certainly, some investors will prefer other strategies and are welcome to them. Your money, your call. But for income investors facing a choice between green eyeshade theories and green cash in their pockets, dividend-growth stocks make real sense.

And of course, nothing in these nine reasons says every dividend grower makes a good investment, or every non-payer a poor one. As always, doing your due diligence makes all the difference.

Disclosure: I am long ABT, FDS, O.