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Dividend income is an important element of total return. But nicely yielding stocks are perceived as being at risk in a rising rate environment. What should the income-dependent investor do in this current climate of rising interest rates?

Argus recommends focusing on dividend growth over dividend yield. Specifically, we would focus on persistent dividend growers - companies that have boosted their dividend for many years consecutively - and companies that have an above average rate of dividend growth. We would scour for dividend growth in sectors outside the traditional equity-income areas of utilities, REITs, and MLPs. And for all names, we would track some measure of dividend safety; our favorite is cash flow coverage or free cash flow coverage of dividends.

The Current Interest Rate Environment

Even a rudimentary observer would say that interest rates are rising. But when you plot the path of rising highs and higher lows in the 10-year Treasury yield, the trend becomes more tangible. After hitting 1.63% in early May, the 10-year yield had an unbroken climb higher to 2.97% on 9/5/13. After the Fed deferred a first tapering, the 10-year made its low at 2.49% on 10/23/13 - 80 basis points above the May low. After edging above 3.0% at year-end, the 10-year yield has retraced again in the new year. But the recent basing low of 2.85% is well above that late-October low close to 2.5%.

We are more interested in lows than highs within this trend because 10-year yield lows represent the new floor in long yields. The official Argus rate forecast for the first half of 2014 is for a 10-year Treasury yield in the 2.75%-3.50% range. For the second half of the year, we think the long-yield could potentially rise further, ranging from 3.5% to 4.0%.

Stock-Market Behavior Amid Rising Interest Rates

A 50-year chart of the 10-year yield shows two great tendencies. Long rates broadly rise from 3% in 1953 to 15% in 1980; and rates broadly decline from the 1980 high to the low of 1.6% reached in spring 2013.

Within those broad trends are multi-year periods in which rates clearly rise or fall. Our research has demonstrated that the stock market can maintain its long-term uptrend during extended periods of rising rates. Interest rates rose across 1995-96 and again from 1998 to early 2000 without disrupting the great 1990s bull market. The long yield was also in a clearly rising trend from 2003 through 2006, or for most of the 2003-07 bull market. Reaching further back in time, the stock market rose 14% during 1986 in a rising rate environment. And the S&P 500 rose 25% in 1980 even as rates were approaching their double-digit peak. In 2013, the stock market delivered its best total return of the post-2008 bull market even though the long yield nearly doubled across the course of the year.

Not every sector in the market rallies in a rising-rate environment, however. In 2012, a year in which the S&P 500 appreciated 13.4%, the Utilities SPDR (NYSEARCA:XLU) declined 2.2%; a pronounced decline from July 2012 through year-end reversed 1H12 strength. And in 2013, a year in which the S&P 500 appreciated 29.6%, the XLU SPDR delivered a lagging 11% gain. All of gain was realized in 1H13; the SPDR lost about 2% in 3Q13 and gained about 2% in 4Q13.

Negative Linkage: The 10-year yield and income stocks

Senior Analyst and Argus Director of Utility Research Gary Hovis has long studied the linkage between high-yielding equities and long yields. The differential between long yields and dividend yields tends to be stable over time. At the same time, those differentials may not be the same for companies with varying levels of economic exposure.

A company like a utility whose dividend is funded by rate-payers is lower risk, and its yield differential to Treasury yields is low. A company such as an auto-maker whose dividend is funded by the level of economic activity is higher risk, and thus may have a higher differential. But for both companies, those differentials tend to be stable.

Historically, when Treasury yields change trend by either rising or falling, those yield differentials are maintained. If Treasury rates are rising and differentials are stable, and assuming no change in dividend policy at a company, the only way for that company's dividend yield to adjust upward is for the stock price to decline.

Utility Research Director Hovis noted that as the era of deregulation flowered in the 1990s and early 2000s, utilities engaged in more and more non-regulated activity. Consequently, the correlation between 10-year yields and dividend yields (and thus utility stock prices) frayed and in some cases was severed altogether.

But after the Enron disaster and a few other non-regulated fiascoes, many utilities exited or scaled back non-regulated activities. As more utilities "stick to their knitting" and focus exclusively on regulated operations, Gary believes the traditional relationship is reasserting itself.

Dividend Growth Supports Superior Total Return

We have already explained the risks of high-yield investing in a dynamic rate environment. Why then go anywhere near income stocks at such a time? Investors need income. Moreover, we have found that dividend-growth stocks tend to hold their value better in periods of rising rates and deliver solid total returns in all markets.

First Sort: Fast Dividend Growers

To perform our analysis, we loaded the Argus coverage universe in our data base and sorted for all companies with a least a 5-year dividend history. This eliminated lots of smaller growth names and even some giants (Cisco, Apple) with generous current dividends but no five-year history. We then sorted the remaining 300 or so names by 5-year annualized dividend growth, while also recording five-year annualized total return.

Over the past five years, the S&P 500 has averaged 19.4% total return while growing its cumulative dividend at a 4.5% annualized rate. We sorted for "fast" dividend growers: companies that have a five-year annualized dividend growth rate exceeding 20%. These 40 superior dividend growers in Argus coverage have average annualized 5-year total return of 27.96%, or 857 basis points better than the S&P 500 over the past five years.

Second Sort: Consistent Dividend Growers

We performed a second sort for companies that have grown their dividends every year for at least 10 years consecutively. Over the past five years, this elite list has averaged 8.26% annualized dividend growth. And over the past five years, total return for this group has averaged 17.25% on an annualized basis. While that is about a 220 bps lag vs. five-year annualized total return for S&P 500, keep in mind this list has a significant representation of Dow 30 and S&P 100 names.

We learned in 2008 that there are no more "buy 'em and forget 'em" investments. But if you own this group of 10-year dividend growers, you can be confident you own companies whose boards are committed to shareholder return. we find that when it comes to shareholder return, share repurchases may resonate with institutional investors, but private and retail investors want tangible return in the form of dividend.

Sector Diversity & Cash Flow Support

While we regard our two lists - fastest five-year dividend growth, and consistent 10-year dividend growth - to be composed of best-of-breed names, investors should still keep an eye out for signs of financial deterioration. One our favorite means of measuring financial strength is to compare annual cash flow from operations with the annual cost of dividends paid. These data points can be found in the annual Cash Flow Statement, required to be filed by all public companies.

For example, one of the 10-year dividend growers, Emerson Inc. (NYSE:EMR), reported cash flows from operations for the September 2013 year of $3.65 billion. Dividends paid in fiscal 2013 were $1.1 billion. Thus, operating cash flows covered dividends by more than three-times. We are comfortable with this level of cash flow coverage for non-utility names.

Utility companies are a different story. They typically have much lower cash flow coverage. However, their cash flows are not economy-sensitive; instead, they are generated by rate-payers. As such, we are comfortable with lower cash flow coverage for utilities.

Finally, we note that our list of 10-year dividend growers, which has 52 companies in all, contains eight utilities. But it also contains one telecom stock, two technology names, five materials stocks, seven industrial stocks, five healthcare stocks, three financial stocks, four energy stocks, seven consumer staple stocks, and 10 consumer discretionary stocks. The point is that, in compiling a dividend growth portfolio as in any other part of investing, it pays to be diversified.

Conclusion

Dividend growth is not an ironclad defense against a down market. But for investors requiring income, dividend growth outperforms in a rising rate environment. Dividend growth stocks, when purchased and held, also provide a rising yield on your original cost basis. Even though stated yield on a high-total-return stock may be 3%, your effective yield based on your original cost basis can be much higher.

In our view, dividend growth is a superior strategy in relation to chasing high yield for long term returns across the entire market cycle.

FAST DIVIDEND GROWTH
5-yr Total Return5-yr Dvnd Grwth
TkrCompanyAnnualized (%)Annualized (%)
UNHUnitedhealth Group Inc25.26103.71
AETAetna Inc22.4983.18
HFCHollyFrontier Corp43.4260.55
RLRalph Lauren Corp33.3752.51
LUVSouthwest Airlines Co20.3948.50
HPHelmerich & Payne Inc28.6046.91
VVisa Inc33.6945.93
THOThor Industries Inc36.9345.41
CACA Inc14.6844.27
ABCAmerisourceBergen Corp33.1239.71
MAMasterCard Inc40.4237.04
SNIScripps Networks Interactive I27.7131.95
CVSCVS Caremark Corp22.3228.39
ACNAccenture PLC21.3928.33
STXSeagate Technology PLC70.5127.83
WMBWilliams Companies Inc29.8027.30
CBRLCracker Barrel Old Country Sto47.2026.89
FCXFreeport Mcmoran Copper & Gold26.5826.76
CMCSAComcast Corp30.1925.55
DFSDiscover Financial Services45.5625.26
NEMNewmont Mining Corp(6.03)25.09
UNPUnion Pacific Corp33.2024.74
SISiemens AG20.5224.61
HLFHerbalife Ltd52.6724.57
LAZLazard Ltd13.9924.57
PRUPrudential Financial Inc28.0124.43
CCECoca-Cola Enterprises Inc42.6323.36
WAGWalgreen Co20.8323.24
CMSCMS Energy Corp24.9023.16
TUPTupperware Brands Corporation35.2723.03
DRIDarden Restaurants Inc18.6422.48
SYKStryker Corp15.3022.42
WECWisconsin Energy Corp17.9121.76
OMCOmnicom Group Inc24.5121.67
TGTTarget Corp14.2321.37
ALTRAltera Corp16.4721.35
TJXTJX Cos Inc45.8021.24
LMTLockheed Martin Corp18.0221.17
TXNTexas Instruments Inc26.0421.15
TEVATeva Phar Inds Lt1.7020.99
AVERAGE27.9632.81
Companies: Argus Universe of Analyst Coverage
Source: Bloomberg data
CONSISTENT DIVIDEND GROWTH
5-yr Total Return5-yr Dvnd Grwth
TkrCompanySectorAnnualized (%)Annualized (%)
TJXTJX Cos IncConsumer Discretionary45.8021.24
SWKStanley Black & Decker IncConsumer Discretionary22.069.46
GPCGenuine Parts CoConsumer Discretionary21.806.63
LOWLowe's Companies IncConsumer Discretionary21.3515.21
WAGWalgreen CoConsumer Discretionary20.8323.24
TGTTarget CorpConsumer Discretionary14.2321.37
MCDMcDonald's CorpConsumer Discretionary13.4213.94
SYYSysco CorpConsumer Discretionary12.874.66
MDUMDU Resources Group IncConsumer Discretionary12.112.98
WMTWal-Mart Stores IncConsumer Discretionary10.8814.63
IFFInternational Flavors & FragraConsumer Staples26.788.75
MOAltria Group IncConsumer Staples25.311.84
KMBKimberly-Clark CorpConsumer Staples19.556.91
KOCoca-Cola CoConsumer Staples15.828.06
CLXClorox CoConsumer Staples14.919.44
PEPPepsiCo IncConsumer Staples12.906.30
PGProcter & Gamble CoConsumer Staples9.508.83
OKEOneok Inc (New)Energy38.8013.67
COPConocoPhillips CoEnergy16.337.51
CVXChevron CorporationEnergy14.529.04
XOMExxon Mobil CorpEnergy7.489.68
TROWT Rowe Price Group IncFinancial24.609.63
CBChubb CorpFinancial18.035.92
HCPHCP IncFinancial17.312.90
CAHCardinal Health IncHealthcare22.7316.97
MDTMedtronic IncHealthcare15.489.86
JNJJohnson & JohnsonHealthcare13.727.61
ABTAbbott LaboratoriesHealthcare13.64(14.97)
BDXBecton Dickinson & Co.Healthcare11.3811.37
PHParker-Hannifin CorpIndustrial27.6614.11
ITWIllinois Tool Works IncIndustrial21.416.28
UTXUnited Technologies CorpIndustrial20.2310.29
CATCaterpillar IncIndustrial19.937.50
EMREmerson Electric CoIndustrial18.176.18
LMTLockheed Martin CorpIndustrial18.0221.17
GDGeneral Dynamics CorpIndustrial14.619.36
PPGPPG Industries IncMaterials38.982.98
SONSonoco Products CoMaterials16.962.83
ADMArcher Daniels Midland CompanyMaterials10.657.89
MONMonsanto CoMaterials9.0212.46
NUENucor CorpMaterials7.67(5.07)
IBMInternational Business MachineTechnology18.7714.26
ADPAutomatic Data Processing IncTechnology18.738.27
TAT&T IncTelecom11.272.37
EGNEnergen CorpUtilities18.903.86
NEENextEra Energy IncUtilities16.208.20
GASAGL Resources IncUtilities13.452.28
EDConsolidated Edison IncUtilities11.581.01
WTRAqua America IncUtilities10.537.44
SOSouthern CoUtilities8.533.90
NJRNew Jersey Resources CorpUtilities7.687.36
PPLPPL CorpUtilities3.851.87
AVERAGE17.258.26
Companies: Argus Universe of Analyst Coverage
Source: Bloomberg data

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.