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Dividend growth investing
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I have noticed that every time I write about dividend growth stocks whose yield is less than 3%, some novice investors wonder whether this return is even worth it. Some even go on to question whether this stock will be even able to provide protection against inflation. Such comments solidify my beliefs that dividend growth investing is the most misunderstood strategy in the investing world.

First, dividend investors should not forget about capital gains. Investing in a stock, simply because it yields a certain percentage should be avoided. In fact, many investors who chase high yielding stocks are playing with fire, using money they need badly. Investors should focus on selecting the best stocks, and then try to purchase them at the right prices. Companies with growing earnings that pay a dividend yield of 2%- 3% will likely deliver solid capital gains in the process. As a result, the total returns for these dividend investors who were smart enough to capitalize on that opportunity, will exceed the dividend yield alone. Capital gains are not guaranteed of course, and are not as reliable a source of income in retirement as dividend checks. A long term investor who plans to hold on to the stock of a dividend paying stock with growing earnings stands a great chance of enjoying stock price increases in the process of holding this security.

Second, naysayers that claim that a stock whose yield is lower than inflation should be avoided, are using faulty logic. As mentioned in the preceding paragraph, stocks deliver dividends and the potential for capital gains. As a result, an increase in stock prices will maintain purchasing power of the principal. In addition, what these naysayers tend to ignore is that while the yield could be lower than inflation, investors will generate a rising stream of dividend income by investing in companies which regularly increase distributions to shareholders. Income investors should focus on whether the income stream can increase faster than inflation, rather than whether the current yield is higher or lower than inflation. A portfolio of quality dividend stocks with rising earnings and dividends will deliver sufficient income growth to provide an inflation adjusted stream of dividend income while also delivering capital gains in the process.

For example back at the end of 2007, shares of McDonald’s (NYSE:MCD) traded at $58.91/share. The company paid an annual dividend of $1.50/share, for a yield of 2.50%. Investors who avoided McDonald’s stock in 2007 because its yield was less than the rate of inflation made a huge mistake however. Fast forward to September 2011, the stock is trading at $87.37/share. However, the company is now paying a quarterly dividend of $0.70/share or a cool $2.80 in annual dividends. This amounted for a 86.70% increase in dividend income for the enterprising dividend investors who spotted this opportunity in 2007. This is much higher than the inflation since the end of 2007. The capital gain of 48.30% also helped to preserve the purchasing power of the principal as well. Check my analysis of the stock.

Between 1920 and 2008 US stocks have managed to increase dividends by 4.70% per year on average, which is 1.70% higher than the average inflation per year. I expect dividend growth to be similar over the next 90 years, as global companies sell products and services to the existing middle class of the developed world as well as the emerging middle class in new economic powers such as China, India and Brazil. Besides McDonald’s, other companies that will profit from these trends include:

  • The Coca-Cola Company (NYSE:KO) manufactures, distributes, and markets nonalcoholic beverages worldwide. The company's global operations account for 70% of its revenues. Coca-Colahas a ten year dividend growth rate of 10% per year and a sustainable dividend payment. The company has increased dividends for 49 consecutive years and yields 2.80%. (analysis)
  • Procter & Gamble (NYSE:PG) provides consumer packaged goods in the United States and internationally. The company derives 58% of its revenues from its international operations. Procter & Gamble has a ten year dividend growth rate of 10.90% per year and a sustainable dividend payment. The company has increased dividends for 55 consecutive years and yields 3.40%. (analysis)
  • Johnson & Johnson (NYSE:JNJ) engages in the research and development, manufacture, and sale of various products in the health care field worldwide. International operations account for 52% of the company's revenues. Johnson & Johnson has a ten year dividend growth rate of 13% per year and a sustainable dividend payment. The company has increased dividends for 49 consecutive years and Yields 3.70%. (analysis)
Disclosure: Long all stocks mentioned above