8 Ways to Profit From Dividend Stocks

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published 25 September 2013

Lately it's been hard to go wrong with dividend-paying stocks. Many companies are being generous with their payouts, and their stocks have generally performed well. But if your dividend holdings look a lot like your Grandma's—perhaps a smattering of utility and consumer-staples stocks—it's time to update your strategy.

One reason to revamp your approach: Some of the more traditional dividend-paying sectors, such as utilities and telecom services, may fare poorly when interest rates rise. What's more, income-starved investors have been snapping up higher-yielding stocks, leaving many of these shares looking pricey. And investors who limit their dividend hunt to the usual suspects are overlooking some companies with great dividend-growth potential. Some stocks that Grandma never dreamed of buying—including many technology companies—have become reliable dividend payers.

Here are eight ways income investors can profit from dividend stocks.

Don't Reach for the Highest Yields

Income-focused fund managers who have a lot of flexibility to invest in stocks, bonds and other asset classes have lately made some big moves toward dividend-paying stocks. But they're largely focused on finding future dividend growth, not the highest current yield.

Technology, energy and materials stocks, for example, don't always have the juiciest yields. But they offer better dividend-growth potential—and more reasonable valuations—than higher-yielding sectors such as utilities and real estate investment trusts, money managers say.

One mutual fund that's focused on high-quality companies committed to growing dividends over the long haul is Kip 25 member Vanguard Dividend Growth (symbol VDIGX). It may not have the highest yield in its category, but its total returns have outpaced about 95% of large-blend fund rivals over the past decade.

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Look for Steady Dividend Growers

The strategy is simple: Buy stocks that regularly boost their dividends and hold for the long haul. You can screen stocks for companies that have raised dividends consecutively for, say, five or ten years. These stocks don't necessarily pay superhigh dividends. But current income isn't the point. Rather, the idea is to target companies whose share prices rise steadily along with their dividend streams. If the strategy works as you expect, you could earn a handsome yield based on the price of your initial purchase.

You can see how dividend growth and share-price appreciation work together by looking at McDonald's (MCD). In 2001, Mickey D's paid out 23 cents a share in dividends on a stock that averaged about $30 a share, for a yield of 0.8%. In 2002, McDonald's raised its annual dividend to 24 cents. Then the company's fortunes improved, and McDonald's decided to give more generously to its shareholders. By 2006, the rate was $1 per share. After a 15% boost in November 2011, the Golden Arches paid dividends at a rate of $2.80 a year. The dividend rose 1,100% since 2001, or 28% annualized over that ten-year span. If you had bought McDonald's stock at $30 per share in 2001, the yield on that original purchase would have worked out to 9.3%. (McDonald's, recently selling for $98 a share, continues to hike its dividend: The company announced recently that the annual payout will be boosted to $3.24 per share.)

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Watch Out for Rising Rates

You already know that rising interest rates can hurt your bond holdings (as yields go up, prices go down). Rising rates can also be tough on dividend-paying stocks, which have to offer higher yields to stay competitive as bond yields climb. But some dividend sectors are more vulnerable than others.

Morningstar recently studied rising-rate cycles in which the monthly average ten-year Treasury yield rose one percentage point or more from its low point. In seven such cycles since 1992, the broader market trounced dividend payers, with Standard & Poor's 500-stock index posting an average total return of 11%, versus 3.7% for the Dow Jones US Select Dividend Index.

The market's most defensive sectors, such as utilities and telecommunications, have generally fared the worst, Morningstar found. One reason: Rising rates tend to coincide with stronger economic growth, which favors more cyclical, growth-oriented sectors such as technology and industrials.

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Think Outside the Box

The biggest contribution to the S&P 500's total dividends now comes from a sector that hasn't traditionally been known for big payouts: technology. Buoyed by plenty of free cash flow and strong balance sheets, tech giants such as IBM (IBM) and Microsoft (MSFT) can continue to raise their dividends, money managers say. Other tech names favored by analysts and fund managers include Intel (INTC) and Apple (AAPL).

For fast-growing dividends and relative resilience amid rising rates, investors should also look to financial stocks, managers and analysts say. After spending years working through financial-crisis hangovers, many banks are now getting back to the business of raising dividends.

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Get in on the Ground Floor With Dividend Rebuilders

Investing in companies that are restoring their payouts is a sound long-term strategy. If you buy shares that pay a small dividend, the yield on your original investment can soar if the company boosts the rate. And because rebuilders formerly paid high dividends, you can be confident the bosses are willing to share the wealth once the exchequer permits them to.

One sector in redevelopment: financials. Dividend investors still bitter about financial stocks' sharp dividend cuts during the financial crisis may find it's time to forgive and forget. Many banks are now boosting payouts. With a current quarterly payout of 30 cents per share, for example, Wells Fargo's (WFC) dividend has bounced back near pre-crisis levels.

Higher long-term interest rates can weigh down mortgage originations, a big source of fees for many banks. But as shorter-term rates start to rise, banks can profit by charging higher rates on many loans while still paying near-zero interest on a large base of customer deposits.

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Scout the Rookies

When a company offers a dividend for the first time, it generally means that business is going gangbusters and there's so much extra cash that it makes sense to toss some back to shareholders. Dividend rookies aren't necessarily small-fry companies. Recent dividend initiators include big names, such as Dunkin' Brands (DNKN) and Apple, which started paying a dividend in 2012 and raised it in 2013.

One word of caution: A dividend launch is not always good news. It could mean that a company's growth has slowed and that its prospects have dimmed so much that the bosses have no better idea for what to do with the money than give it back.

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Venture Overseas—Carefully

Foreign stocks in both developed and emerging markets tend to offer more enticing dividend yields than U.S. companies. In the energy sector, for example, some fund managers favor the richer yields of oil giants Royal Dutch Shell (RDS.A) and Total (TOT) over U.S. competitors, such as ExxonMobil (XOM).

The higher yields come with some potential pitfalls for U.S. investors. Many countries withhold taxes—often 10% to 20%—on dividends paid to U.S. shareholders. If you hold the shares in a taxable account, you can recover that money through the foreign tax credit. But if you hold the shares in an IRA or other tax-deferred account, you can't claim the credit.

Currency swings can also make for rough seas when dividends aren't paid in U.S. dollars. Many mutual funds hedge away at least some of this foreign-currency exposure, smoothing the ride for investors.

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Dissect Dividend Funds' Strategies

When sifting through dividend-focused mutual funds and exchange-traded funds, consider whether the fund is more focused on high-yielding stocks or on shares with more moderate yields and strong future dividend-growth potential. Funds in the two camps are likely to have very different portfolios.

The iShares Select Dividend ETF (DVY), for example, tracks an index that selects stocks based on dividend yield. That approach has lately led to a hefty concentration in the utilities sector. If you're looking for dividend growth and broader diversification, consider a fund such as Vanguard Dividend Appreciation ETF (VIG), which focuses on companies that have raised dividends for at least ten consecutive years.