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Increasing-dividend stocks are timely

With growth slowing, interest rates persistently low, inflation on the rise, many companies flush with cash, the economic recovery cycle in its later stages and the tax treatment of dividends still favorable, a strategy focusing on stocks with the potential of increasing dividends may be particularly timely for investors

With growth slowing, interest rates persistently low, inflation on the rise, many companies flush with cash, the economic recovery cycle in its later stages and the tax treatment of dividends still favorable, a strategy focusing on stocks with the potential of increasing dividends may be particularly timely for investors.

Investors too often overlook the importance of dividends, particularly the contribution to total return from reinvested dividends. These also can provide significant inflation protection in the form of a growing stream of income.

Dividends contributed more than 44% of the total return of the S&P 500 from the start of 1986 to the end of 2010, according to research from T. Rowe Price Group Inc.

Total S&P 500 dividends paid have fallen from an all-time high in 2008 but have started to climb again. Moreover, there is plenty of room for more growth in payouts.

Ned Davis Research Inc. recently reported that S&P 500 companies had $3.6 trillion in cash on their books, or a record 13% of assets. And their dividend payout ratio (dividends as a percent of earnings) is at a record low of 28%.

Throw in a 10-year-Treasury yield of less than 3% and a 15% tax rate on dividends at least until the end of 2012, and it’s not surprising that pressure is mounting on corporations to increase their dividends.

T. Rowe Price has found that among stocks in the Russell 1000 Index, dividend growers showed an annualized total return of 11.26% from the start of 1986 through 2010, versus 10.78% for dividend payers and 10.06% for those who don’t pay dividends. (Growers, a subset of payers, were defined as stocks that increased their dividends in the preceding 24 months.)

A critical distinction here is that the highest-yielding stocks, as a group, have tended not to deliver the best returns over time, as compared with the performance of relatively high-yielding stocks that are increasing their dividends.

This makes intuitive sense: Companies with growing dividends are signaling confidence about their future earnings. They tend to be stable businesses well positioned in their markets and able to perform throughout market cycles, making them good candidates for long-term growth.

Our approach to dividend growth investing involves seeking growth at a discount. We use fundamental research to identify companies that offer an attractive valuation, a sustainable competitive advantage, better-than-average returns on invested capital, and excess free cash flow.

We prefer firms at an inflection point, where policies on returning capital to shareholders are changing.

One of the biggest risks in investments is poor capital allocation by managers. Their capital commitments often dictate the future of their stocks. A commitment to dividend growth raises the bar for the balance of capital allocation decisions and helps avoid acquisitions and capital expenditures that do not provide adequate returns for shareholders.

A share repurchase is another form of returning money to shareholders. When done thoughtfully — and at attractive prices — it can be effective. Too often, however, managers time their share repurchases poorly, paying too much for them. In addition, share repurchases are more episodic than increasing dividends.

In certain cases, we also like to lean into near-term head winds with stocks that have an issue which we can foresee the firms transcending in a certain time frame.

Accenture Ltd. Ticker:(ACN), the business consulting and outsourcing firm, is a good example: We acquired the stock in the recession of 2008-09. The company’s growth and stock price have rebounded strongly. Paying almost no dividend several years ago, it now is returning almost 9% of its capital each year in the form of dividends and aggressive share buybacks.

Steep economic recoveries — such as from the market low of the spring of 2009 — are not markets in which a dividend growth strategy generally tends to shine, as compared with the later stages of the economic cycle, which we are experiencing this year.

As growth becomes scarcer in the later part of the cycle, investors tend to flock to companies that are able to continue growing in a slowing environment. This consistency is the hallmark of many dividend growers, and we believe that it makes this strategy particularly appealing in today’s uncertain markets.

Thomas J. Huber is a vice president of T. Rowe Price Group Inc. and portfolio manager of its Dividend Growth and Growth & Income funds. As of June 30, Accenture made up 1.7% of Dividend Growth and 1.4% of Growth & Income.