Vanguard Dividend Growth: In Search of New Income Sources

Vanguard Dividend Growth (symbol VDIGX), a member of the Kiplinger 25, was originally designed for aging baby-boomers who wanted a growing stream of income and the opportunity for capital appreciation. But manager Donald Kilbride says the stock market's 2007-09 implosion "scared the bejesus out of everybody" and so his fund, which invests in the stocks of high-quality companies that regularly boost their payouts, began attracting younger customers as well.

Complicating matters for managers like Kilbride is that the definition of “high quality” has changed. Financial companies used to be lumped in with producers of drugs, energy and consumer necessities as dependable dividend payers. But since the collapse of the financial sector in 2008, dividend-oriented investors have come to view that group as iffy, in part because it’s unclear how much capital regulators will require banks to retain.

Clearly, financials have lost their cachet as steady dividend stocks, so Kilbride has lightened up on them and had to look elsewhere to fill the dividend gap. Dividend Growth’s biggest sector overweighting is in industrial stocks, according to Morningstar, with nearly one-fourth of the fund’s assets in that broadly defined category. Among those holdings are Automatic Data Processing (ADP), the big payroll-processing firm and the fund’s largest position; General Dynamics (GD), the military contractor; and Lockheed Martin (LMT), another weaponry maker.

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Dividend Growth also has a big bet on health care stocks, with 16% of its assets in that group, compared with 11% in Standard & Poor’s 500-stock index. The fund’s 11 biggest positions as of March 31 included Pfizer (PFE), Medtronic (MDT), Cardinal Health (CAH) and Johnson & Johnson (JNJ).

Big recent additions to the portfolio include retailer Target (TGT) and CVS Caremark (CVS), the drugstore and pharmacy benefits management company.

In general, Kilbride looks for companies with steady profit growth and executives who show that they’re committed to sharing their growing wealth with investors. Kilbride, who took over the fund in 2006, crunches the numbers to determine how much he thinks companies will pay out in five years, but he also tries to get inside the heads of executives to get a sense of their philosophy about dividends.

Given that Dividend Growth mainly holds stocks of big, U.S. companies, you’d expect it to closely track the S&P 500 index. However, over the past five years through May 19, a period that coincides with Kilbride’s tenure, the fund has thumped the S&P 500, returning 6.3% annualized, compared with 3.4% for the index. That performance was helped considerably by Dividend Growth’s performance in 2008, when it lost 25.6%, compared with the S&P 500’s plunge of 37.0%.

Although the fund focuses on dividends, don’t buy it thinking it will deliver high income. Its current yield is 2.1%, a shade above the overall market’s yield.