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There are many different approaches to investing, some of them successful.

But few attain the time-tested success of investing in stocks that consistently raise dividends. And there’s no doubt these stocks have produced astonishing returns, decade after decade.

Unbiased research shows stocks that raise dividends trounce the market, while stocks that simply pay dividends roughly match the market. In what I suppose is an obvious corollary, these stocks historically beat the snot out of stocks that don’t pay dividends, without breaking a sweat between punches. It’s really been easy for them.

OK, let’s run through the research numbers first, then move on to the more interesting discussion of what might be firing them up.

A well-known study by Ned Davis Research shows that from 1972 through April 2009 (the latest data I found) companies with at least five years of dividend growth, and those initiating dividends, punched up average yearly gains of 8.7%, compared with 6.2% for the Standard & Poor's 500.

Companies that maintained steady dividends also gained 6.2% annually, same as the market, but well below what dividend raisers scored.

And non-dividend payers? Lightweights. Beaten down to under a measly 1% a year. Right, under 1% a year for over 36 years. Same story for stocks that cut or eliminated dividends.

In another study, using a different group of stocks, time period and performance measure, AllianceBernstein researched the largest 1500 stocks by market capitalization from 1964 to 1999.

Results? In the year immediately following a dividend increase, dividend raisers’ average total returns were 1.8 percentage points higher than stocks that did not raise dividends.

Compound that over a decade or two of dividend hikes and you can head for the Porsche dealership. (Think I’m kidding? Over 15 years, an extra 1.8 percentage points pops nearly $90K more out of a $285,000 stock portfolio. You don’t have to spend it on a Porsche. But you could.)

Want some more recent numbers, from stocks with decades of dividend increases already under their belt?

Standard and Poor’s research through the end of 2009 shows their Dividend Aristocrats, stocks with at least 25 years of dividend increases, beat the S&P 500 over the trailing 3-years, 5-years, 10-years and 15-years.

And the beating was another knockout, ranging from as ‘little’ as two percentage points annually to as much as nearly five percentage points, depending on the time frame.

So it’s abundantly clear these stocks have better returns. Much better returns.

But why does dividend growth achieve such superb performance? And should investors even care why? After all, more money is more money and that Porsche is still a Porsche.

My opinion? I think there are at least three reasons, and many investors could likely benefit, if they care to look at them.

First, it takes an outstanding business to increase dividends for decades, and outstanding businesses are often outstanding long-term investments. Weak businesses simply can’t and don’t raise dividends for decades.

So if it’s true, like I think it is, that dividend increases and higher stock prices are both caused, in part, by strong businesses, then it’s vital to understand and monitor dividend-growth companies’ underlying business strength. That’s why you see successful investors evaluating these companies’ revenues, earnings, cash flows, debt levels, returns on capital, stock valuations, and so on, rather than just jumping on the dividend.

Second, I think it’s also likely that a series of dividend increases, in and of itself, eventually helps pull a stock price up.

After all, if share prices did not follow dividends upward, over time these stocks would end up with monster double-digit yields. But that doesn’t happen because if a yield gets higher than investors think the good health of the business justifies, they buy more of the stock until the yield reverts back down to a more normal range.

All other things equal, there's simply more buyer demand for Johnson and Johnson (NYSE:JNJ), McDonald’s (NYSE:MCD), Procter and Gamble (NYSE:PG) and other outstanding businesses (name your choice) at 4% yields than at 2% yields, so the stock prices move in response.

Of course, all other things aren't always equal. Stock prices are messy, impacted by companies’ outlooks, the economy, market conditions and so forth. But over time, yields that grow too high on healthy stocks revert to normal levels through the mechanism of buyers bidding up stock prices.

Finally, in all that market messiness, investors who stick with a dividend growth strategy enjoy a powerful statistical advantage that amplifies their stock picking.

This advantage is something statisticians call “baseline probabilities.” To illustrate, suppose a fisherman can choose either of two nearly identical lakes. But one lake has two big fish and eight little fish in it, while the other has the opposite: eight big fish and two little ones.

At any level of skill and experience, the fisherman’s chances of landing big fish are much better at the second lake. That’s the idea of baseline probabilities. And research studies show there are lots more big fish in the pool of dividend raisers than in the other pools, especially the pool of stocks that don’t pay dividends, filled with so many little fish its average returns approach starvation.

All that said, a dividend-growth strategy isn’t for everyone. (It’s only for people who want to make money … kidding, just kidding!)

For example, skilled traders, technical analysts and investors who’ve simply developed unique expertise in other areas of the market certainly might decide that dividend growth is irrelevant to their investing approach.

As might those who believe corporate America brims with budding Warren Buffetts, all doggedly toiling away at brilliant but so far unrewarded capital allocation programs that make far better use of company cash than dividends would.

And on that note, oddly, some investors seem to delight in arguing that dividend raisers are inferior businesses and, despite the numbers, inferior investments. This, because finance theory says ever-higher dividends waste capital these companies could reinvest back into their business, as non-dividend payers do.

I say “oddly” because the most rudimentary logic tells you that if dividend raisers as a group were capital wasters, and non-payers were capital multipliers, the market wouldn’t reward the raiser-wasters with such monumentally higher returns.

For an in-depth look at the pros and cons of dividends, one that generated a geyser of often coherent comments, check out David Van Knapp’s Seeking Alpha article “Why I Love Dividends.”

And for profiles and analyses of a number of dividend-growth stocks, click this More Articles link and take your pick.

Finally, investors who prefer ETFs to stock picking might look at the Vanguard Dividend Appreciation ETF (NYSEARCA:VIG). VIG’s total returns and dividend reliability have outperformed both the market and popular, higher yielding dividend-growth ETFs.

References and Links

Kiplinger Magazine, “Stocks That Pay Rising Dividends,” August 2009.

AllianceBernstein, “Why Dividends Matter,” November, 10, 2004.

Seeking Alpha, “Dividend Aristocrats: A Comprehensive View,” by David I. Templeton, January 22, 2010.

Additional acknowledgements: Thanks to all the Seeking Alpha authors and commenters who posted data and opinions that helped inform this article.

Disclosure: Long JNJ and PG.

Source: Why Stocks That Raise Dividends Trounce the Market