Looking for Dividend Stars

Funds that focus on dividend-paying stocks come in all stripes. Some specialize in sectors, such as real estate investment trusts or utilities, that are associated with high-yielding stocks. Some fill up on beaten-down value stocks with above-average yields. Others are concerned more with future dividend growth than with high current yields. One such fund is Vanguard Dividend Growth (symbol VDIGX), which seeks strong, steadily growing companies that boost their dividend payouts year after year. "The fund's main thrust is to grow dividend income over time," says Donald Kilbride, the fund's manager since February 2006. Over the past year through March 21, the fund returned 14.0%, beating Standard & Poor's 500-stock index by 1.3 percentage point, according to Morningstar.

When considering a company, Kilbride begins by estimating how big a dividend it might pay in five years. To do this, he assesses the company's dividend history, its free cash flow (the cash that's available to make acquisitions, buy back shares and pay dividends), and management's willingness to continue boosting the payouts. "I want to own companies in which I have a high conviction that there is a dividend growth story," he says.

The trickiest part is determining management's attitudes toward dividends, Kilbride says. To do so, he finds out if executives own shares (with the idea that insider ownership provides extra incentive to boost the dividend). And he interviews them to learn how they feel about future dividend boosts.

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Most of the 60 companies in Kilbride's $1.2 billion fund have a long history of paying and boosting dividends. But several holdings, such as Microsoft, have relatively short track records. The software giant declared its first dividend payout in 2003.

Kilbride likes to buy stocks on the cheap. He invested in Medtronic in August 2006, when the medical-device company's stock fell to nearly $42 after management lowered its earnings forecast for the year (the shares recently traded at $49). Kilbride also likes Medtronic because it has a history of paying out 20% of the prior year's earnings as dividends. He expects the company to boost the dividend at a rate of 13% a year over the next five years.

Kilbride's top-five holdings include energy giants ExxonMobil, Chevron, and French oil company Total SA. "I think energy companies are a terrific source of dividend income going forward over the next three to five years," says Kilbride, a former oil analyst. Lately, he's been finding the best opportunities in health care, consumer staples, and retail -- "especially maturing retailers like Gap and Home Depot," he says. "When opportunities to increase their store bases are reduced, the cash goes to shareholders." The fund, which charges 0.37% in annual fees, currently yields 1.8%.