The Lure of Rising Dividends

Think of dividends and you may conjure up visions of carefree retirees using checks from utility stocks to pay for greens fees and trips to Hawaii. But dividend-paying stocks don't have to be stodgy. Whether you're 25 or 75, you can use dividend trends to flag solid growth companies run by managers who truly care about their shareholders. And how do you do that? Easy -- by finding companies that shower investors with more cash, year after year.

U.S. companies have plenty of money to share. Last year, they earned $1.8 trillion and "returned" $660 billion to stockholders. Two-thirds of that money flowed indirectly to investors when companies bought back their own stocks, a move designed to raise prices by spreading profits across fewer shares. However, companies often recycle many of the shares they buy back, giving them to employees and other holders of stock options. That practice can dilute the effect of the buyback.

But cash! Now there's a sure thing. And there's rarely been a better time to collect it. That's because the federal tax rate on most dividends is just 15%. Since 2003, when Congress cut taxes on dividends, more than 300 U.S. companies have initiated cash disbursements, and hundreds of others have raised once-token payments to meaningful levels. Last year, some 2,000 companies boosted their dividends.

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Don't confuse dividend excellence with stocks that yield the most (yield is the annual cash dividend divided by the stock price). In fact, a high yield can be a warning that something is amiss with the company and that it is likely to cut the distribution. That was the case with both Ford Motor and General Motors. Because of big share-price declines, their yields climbed as high as 10% before both automakers whacked their payouts. In addition, some dividends may not be as valuable as they seem to be, because of the impact of taxes. For example, most dividends from real estate investment trusts are taxed at regular rates, up to 35%. REITs are perfectly fine for your IRA, but look for stocks that pay dividends that qualify for the 15% rate to stash in a non-tax-sheltered account.

It's not hard to find dividend-growth champs. Standard & Poor's, for instance, lists dividend "aristocrats," companies in S&P's 500-stock index that have boosted their dividends for at least 25 years in a row. Mergent, another supplier of financial information, names dividend "achievers," companies that have boosted payouts for at least ten years and have met other criteria. If you prefer to let a pro pick the stocks, we identify three solid funds on page 36 that focus on payout boosters. Below, we use four different dividend-growth strategies to identify eight promising stocks.

All-around champs

These are the companies that boost dividends year after year after year. S&P says that over the past 15 years, its 59 current aristocrats have produced an average total return of 13% annually. That exceeds the return of the S&P 500 by an average of two percentage points per year. Moreover, S&P's dividend royals have provided those superior returns with below-average risk.

Who are these overachievers? Many are banks and insurers, both of which usually pay high dividends. Financial companies rarely carry high long-term debt loads and don't need to invest heavily in research and development or in expensive manufacturing facilities. Therefore, they accumulate and retain a lot of cash. But some investors lump financial companies together with other plodders, such as electric utilities. That's a mistake.

A bank can be both a dividend champ and a growth company. M&T Bank Corp. (MTB) is a case in point. It has raised its dividend 18% a year since 1983. M&T's stock has been fabulous as well, with an annualized return of 24% since 1980. M&T's performance is all the more amazing considering that the company operates mostly in long-declining sections of upstate New York in and near Buffalo, where it's based, and Rochester. M&T's opportune acquisition of a scandal-tainted Maryland bank in 2002 gives it a foothold in a more-thriving area.

The aristocrats also include prosaic industrial firms. W.W. Grainger (GWW) sells 138,000 products, including motors, tools, building-maintenance equipment and worker-safety gear. With customers that range from small heating contractors to the U.S. government, Grainger is well insulated from troubles in any segment of the economy. The company raised its dividend 21% last year, marking the 35th straight year of payout increases.

Or look at Johnson Controls (JCI), a 122-year-old company that is changing radically. Once dependent on sales of car interiors to Ford and GM, Johnson has added industrial air conditioners, environmental building-control systems and lithium-ion batteries. The new lines, aided by healthy sales of car seats and dashboards to foreign automakers, are leading to record profits. Analyst Ronald Tadross, of Bank of America Securities, says Johnson is capable of boosting its dividend 15% a year for the foreseeable future. The strong earnings gains that will fuel the growing dividend should help Johnson shares achieve a higher price-earnings ratio -- one that is more in line with those of the best diversified manufacturers.

If you're concerned that a company that steadily raises it dividends will undermine future earnings growth, you can relax. "High-dividend companies tend to experience strong, not weak, future earnings growth," says Baruch College professor Ping Zhou, who, with a colleague, has studied market data going back 50 years. They also found that the relationship between dividend growth and subsequent earnings gains is much closer than the connection between share buybacks and future profit growth.

Huge boosters

Not until 1993 did Harley-Davidson (HOG) pay its first dividend. But once the legendary motorcycle maker got religion, it went, er, hog wild. Harley has boosted dividends 30% annualized over the past ten years and 47% annualized over the past five. The annual payout rate is now 84 cents per share. Harley's total payouts went from $41 million in 2002 to $220 million last year. The short-term outlook for Harley shares may be clouded by the aftereffects of a strike and current high inventories, but motorcycle sales usually vroom in the spring and summer, and so often does the stock.

Praxair (PX), a supplier of oxygen, hydrogen, helium and other gases to industry, is as obscure as Harley is celebrated. But it's another convert to the notion that bigger is better when it comes to boosting the dividend. In January, upon release of its 2006 results, Praxair increased its dividend by 20%, to an annual rate of $1.20 per share. Chief financial officer Jim Sawyer told Wall Street that "we expect something similar in size or a little larger" when the company releases 2007 results next January.

Praxair is a perfect example of how rising dividends and a fine earnings outlook feed on one another. The company has issued bullish profit projections for 2007 based on expected high returns on its investments in Asia and Latin America. Normally, a company might set aside the extra earnings to pay down debt, build more facilities or make acquisitions. But Praxair already has numerous expansion projects in progress and decided that deals would be too costly now. Praxair's solution to this pleasant problem: Remember the shareholders. A doubling of the dividend since 2004 is proof that Praxair hasn't forgotten them.

Great expectations

How do you find companies that may boost dividends sharply in the future? You can screen for ideas using the online version of the Value Line Investment Survey. The service, for example, lets you compare stocks with the highest "projected dividend growth rates" over the next three to five years with companies that have boosted their payouts steadily over the past ten years. The exercise produces a short list of compelling candidates, including Harley and M&T.

Two sleepers among potential dividend boosters are Fastenal (FAST) and Expeditors International (EXPD). Value Line expects each to boost its distributions 24% a year over the next few years.

Fastenal, a distributor and retailer of industrial and construction supplies, sometimes competes with W.W. Grainger. Expeditors manages air and ocean freight for shippers, which pay the company to find space on cargo ships and planes. Neither stock yields much, but some consider serial dividend increases to be an indicator of financial health and profitability, and both stocks have performed well. Over the past decade of rapid dividend growth, Expeditors shares returned a sizzling 32% annualized and Fastenal returned 15%. Both companies say they plan to persist with regular increases. "There's nothing magical about this, no great epiphany in the boardroom," says Jordan Gates, Expeditors' chief financial officer. "We just say that as we increase earnings, we'll be sure to raise dividends."

Expeditors and Fastenal are members of an exclusive club. They are among only 22 stocks caught by a Value Line filter for high past and future dividend growth, high ten-year returns on total capital (a measure of profitability), and high ten-year cash-flow growth. Among others in this august group are insurance broker Brown & Brown, Harley, medical-device maker Stryker and mutual fund giant T. Rowe Price. Historically, all have been fabulous stocks for investors to own at any stage of life and in almost any kind of market.

New believers

The reduction in dividend tax rates enacted in 2003 helped reverse a 20-year decline in the percentage of publicly traded companies that pay dividends. It also seems to have changed entire industries.

Take freight shipping, for example. Fleets of tankers and containerships have been converted into entities that promise both smooth sailing and steadily increasing dividends. For example, Seaspan (SSW), a fleet of 41 containerships, went public in 2005 at $19 and set its first full-year dividend at $1.70 a year. In January, it raised the yearly payout rate to $1.79 a share. Chief executive Gerry Wang says he's aiming to deliver a "very, very steady pattern of dividend increases," which he hopes will lead to steady share-price performance.

Thirty-eight of Seaspan's ships are leased for 10 to 12 years, which improves the chances that the company will be able to steadily boost dividends. As Seaspan acquires more ships, the company will make more money and earmark some of the increased profits for higher dividends, says Wang. Investors seem to be happy with the strategy, as Seaspan shares have risen to $26 in less than two years.

Seaspan is one of hundreds of new dividend payers. Not all of the newcomers will be able to boost their payouts year after year or win inclusion in a list of dividend aristocrats. But those that do will be sending a powerful message to their shareholders. As David Pearl, chief of U.S. stocks at Epoch Investment Partners, a New York City money-management firm, puts it: "There's no question that if a company grows its dividends and raises them every year, it's making a public statement and a commitment."

By the numbers: 8 companies that enjoy sharing the wealth

As the table indicates, growing dividends are not synonymous with high yields. But as long as their profits keep growing, expect the companies listed below to boost payouts. And that should bode well for share prices.

Data to February 12. N/A not applicable; company went public in 2005. Sources: The companies, Value Line, Yahoo.