The Secret Ingredient of Dividend Growth Stocks

When people learn that I am an income investor it is not uncommon for them to ask why I invest in stocks instead of  other "safer" alternatives such as bonds, high yield money market accounts [MMA] or certificates of deposits [CD]. I generally start with my short answer of, "Dividend stocks have a secret ingredient that makes them a much more desirable investment."

Needless to say this usually piques their interest and normally the response is something like, "Secret ingredient? What secret ingredient?" Then I explain.

Dividend Stocks Hidden Power

Let's assume you can find a CD that earns a similar rate as the dividend stock (a stretch now days, but stay with me) and it is federally insured, thus protecting the purchaser from loss. So it must be better, right?

What separates good dividend stocks from bonds, MMAs and CDs is a hidden power not readily recognizable to the uninitiated - dividend growth. While a CD will pay a market interest rate for its term, its only growth is movement in the market rate at renewal, which can go either up or down. Contrast that with a good dividend stock with decades of consecutive annual dividend increases.

Dividend Stocks Yield On Cost

One way to compare the earning power of two investments or an investment and a CD is to look at their Yield On Cost [YOC] over time. YOC is a simple concept where you divide annual earnings over the investment's original cost. Consider this simple example of a stock with a 2.75% yield and a dividend growth rate of 7%, compared a 5-year CD paying 3.00%, where earnings in both are withdrawn when paid:

	Div. Stock	CD
Investment $	10,000	10,000
Initial Yield	2.75%	3.00%
Div. Growth	7.0%	0.0%
Earnings Yr. 1	275	300
YOC Yr. 1	2.8%	3.0%
Earnings Yr. 2	294	300
YOC Yr. 2	2.9%	3.0%
Earnings Yr. 3	315	300
YOC Yr. 3	3.1%	3.0%
Earnings Yr. 4	337	300
YOC Yr. 4	3.4%	3.0%
Earnings Yr. 5	360	300
YOC Yr. 5	3.6%	3.0%
Earnings Total	1,581	1,500
YOC Final	3.6%	3.0%

Though the dividend stock started with a lower yield of 2.75%, its final YOC after 5 years was 3.6% compared to the constant 3.0% of the CD. The key here is to find dividend stocks that are growing their dividends and will continue to do so. Since these numbers are contrived, the obvious question is how does this translate to the real world?

Dividend Stocks The Last 10 Years

Below are some bellwether dividend growth stocks and their performance over the last 10 years, assuming the stock was bought at the stock's 2002 high price:

Coca-Cola Company (KO)
- 2002 Dividend per Share: $0.40
- 2002 High Share Price: $28.96
- 2002 Yield on High Price: 1.4%
- 2012 Dividend per Share: $1.02
- 2012 Yield On Cost: 3.5%
- Current Yield: 2.7%

Johnson & Johnson (JNJ)
- 2002 Dividend per Share: $0.795
- 2002 High Share Price: $65.89
- 2002 Yield on High Price: 1.2%
- 2012 Dividend per Share: $2.40
- 2012 Yield On Cost: 3.6%
- Current Yield: 3.5%

3M Co. (MMM)
- 2002 Dividend per Share: $1.24
- 2002 High Share Price: $65.78
- 2002 Yield on High Price: 1.9%
- 2012 Dividend per Share: $2.36
- 2012 Yield On Cost: 3.6%
- Current Yield: 2.6%


McDonald's Corp. (MCD)
- 2002 Dividend per Share: $0.24
- 2002 High Share Price: $30.72
- 2002 Yield on High Price: 0.8%
- 2012 Dividend per Share: $2.87
- 2012 Yield On Cost: 9.3%
- Current Yield: 3.5%

Abbott Laboratories (ABT) 
- 2002 Dividend per Share: $0.915
- 2002 High Share Price: $58.00
- 2002 Yield on High Price: 1.6%
- 2012 Dividend per Share: $2.01
- 2012 Yield On Cost: 3.5%
- Current Yield: 3.2%

The above data demonstrates another important concept - your starting point is very important. Ten years ago the stock market was higher in relative terms than now, thus the yields for most companies were lower than now. After 10 years of growth, the YOC is not much higher than the stocks current yield for several of the companies. However, similar growth over the next 10 years will produce a dramatically higher YOC. Just look at MCD to get an idea of what superior growth will do to YOC.

Full Disclosure: Long KO, JNJ MMM, MCD ABT. See a list of all my dividend growth holdings here.

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(Photo Credit)

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