Why Dividend Growth Stocks Beat High-Yielding Stocks

The U.S. stock market, as measured by Standard & Poor's 500-stock index, currently sports a yield of 2.0%. That sure beats the microscopic yields on money-market funds, but it's still not enough for many investors, who have been scurrying after higher-yielding fare. But chasing stocks -- or any other investment -- based upon yield alone is a recipe for disaster. Many bank stocks, for instance, yielded 5% and up before they were crushed during the 2007-09 bear market.

There is a better way to invest in dividend-paying stocks. Consider Vanguard Dividend Growth fund (symbol VDIGX) or some of the stocks it owns. If you prefer exchange-traded funds, check out Vanguard Dividend Appreciation ETF (VIG). It tracks the Dividend Achievers Select index, which holds stocks of companies that have raised their dividends at least ten years running and that are likely to continue hiking their payouts.

You can’t go wrong with either one, but in my opinion, the fund is the better choice. Both are dirt-cheap -- the ETF’s annual expense ratio is 0.18%, and the mutual fund’s is 0.34%. But over the past five years through July 1, the fund beat the ETF by an average of 1.2 percentage points per year. Plus, the fund is slightly less volatile than the ETF, and the fund owns fewer economically sensitive stocks. (Vanguard Dividend Growth is a member of the Kiplinger 25.)

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The fund also gives you the services of Donald Kilbride, 47, a patient and canny manager at Boston-based Wellington Management, which subadvises the Vanguard fund. An investment pro since 1986, Kilbride has been with Wellington since 2002 and has piloted the fund since 2006. He has four full-time analysts, and he draws on the work of about 50 other stock analysts employed by Wellington.

Kilbride has a strong interest in seeing his fund perform well. His pay depends, in part, on whether he beats an index similar to the ETF’s. Plus, he has north of $1 million of his own money invested in the fund.

Kilbride tries to identify companies that are both able and willing to raise their dividends by at least 10% annually for the coming five years. That gives him a long-term focus -- on average, stocks stay in the fund about five years. “Trading is expensive,” he says.

It also leads him to stocks that display a host of other attractive characteristics. A company that hikes its dividend regularly and substantially probably isn’t saddled with a lot of debt. Odds are that the company boasts high profit margins. On average, the return on equity (a measure of profitability) of the fund’s holdings is a sky-high 25.

The high-quality companies Kilbride invests in generally require relatively small capital expenditures to keep their businesses humming. “They’re not spending a lot of money every year to generate returns,” he says.

Kilbride picks stocks one at a time, without focusing on sector weightings. But he winds up with a slew of health care and consumer-related stocks. Health care companies are growing because of demographic trends and improving technology. “Consumer-staples companies don’t grow that fast, but they have powerful brands that endure over time,” Kilbride says. His fund also owns a fistful of mature technology companies, such as International Business Machines (IBM) and Microsoft (MSFT).

Indeed, Kilbride owns a lot of old companies. On average, the 47 companies in the fund have been in business 92 years. “I love old companies because they’ve shown they have the ability to adapt,” he says.

Almost all of the stocks in his portfolio are household names. Top holdings include ExxonMobil (XOM), Pfizer (PFE), Johnson & Johnson (JNJ), Western Union (WU) and Target (TGT). These are blue chips almost anyone can feel comfortable owning.

I’ve saved the best for last. The fund’s record is first-rate. Over the past five years through July 1, it returned an annualized 6.2%. That’s an average of 3.1 percentage points per year better than the S&P 500 and puts it in the top 5% among large-company blend funds (funds whose holdings share a blend of growth and value attributes). Longer-term results are equally superb. Kilbride has only been at the helm five years, but Wellington has run the fund since its inception in 1992.

The fund holds up better than most in down markets. It lost 42.3% in the brutal 2007-09 bear market, compared with a loss of 55.3% for the S&P 500. Over the past three years, the fund exhibited 19% less volatility than the S&P.

Many of the high-quality stocks that Kilbride owns have lagged during the bull market that began in March 2009. Many are surprisingly cheap -- and they’re due for a comeback, especially if the U.S. economy continues to grow only slowly.

Steven T. Goldberg (bio) is an investment adviser in the Washington, D.C. area.