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Dividend Increases: An Indicator for Stock Strength?

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January 28, 2016
Are dividends like free candy? Here's what steady dividends indicate about a given stock's potential strength.

If it’s true that investing is preparing for what comes after the paycheck stops, dividend investing could offer a way to capitalize on time and return on investment. That should be a signal to growth-oriented and momentum investors, who may want to pay attention to dividend-yield payouts as part of their overall stock analysis. Indeed, there are indications that a long-term pattern of dividend increases is a reliable predictor of stock price appreciation.

Follow the Money

The goal of most investors—let's be honest here—is all about making money. Two paths to potential profits through stock investing are dividend payouts and stock price appreciation. Get a win on both simultaneously, and an investor could be in stock market trading heaven. "Stocks with a long-term history of consistent dividend increases tend to have a corresponding long-term history of consistent price increases," says Kelley Wright, managing editor at Investment Quality Trends newsletter.

Scoring on those stocks can be particularly important during this low-rate environment for savings and money-market accounts as well as CDs. Even with a Federal Reserve bent on raising interest rates throughout 2016, the average payout from dividend-paying stocks in the S&P 500 is 2.2%, still ahead of traditional bank products.

Moreover, there are blue chip companies with long histories of steady dividend increases over time that have preceded long-term price appreciation. Consider Wright’s hypothetical example:

Suppose you pay $10 for a stock with a $0.50 dividend to represent a 5% yield. If the dividend is increased to $0.60 for a yield of 6%, has the return on investment increased? Yes. Has the value of the investment to the investor increased? Yes. “In a rational world, then, how must that increased value be recognized by the market?” Wright asks. “The price of the shares must increase."

Put Time on Your Side

"In early 2003, you could have bought 66 shares of McDonald’s for $1,000. Today those shares would be worth about $7,600. The dividend in 2003 was around $0.19 per share. Today it is $3.56 per share. If you had reinvested those dividends into additional shares, your growth of capital, and income, would be significantly higher," Wright says.

Are Dividends Standard Operating Procedure?

That’s an important question, because to many companies, dividends are a time-honored practice that won’t be sacrificed during rough patches. How do you find those companies? Start in the boardroom.

"The only reason a board of directors will vote to pay or increase a dividend is if they believe their revenues will support the dividend,” Wright says.

No one knows the company better than the board, which can look out to the horizon to determine if the revenues will not only cover the current dividend, but are “reasonably assured” they can support a higher dividend on an ongoing basis, he says. “In short, it is a vote of confidence by the board about the company’s state of health and future prospects," Wright says.

Keep Following the Money

When it comes to winning the dividend race, it is the slow-and-steady turtle that comes out ahead, versus the hare that might sprint for a short period of time. Wright looks for a minimum of five historical dividend increases over a 12-year period. Why 12? Because a typical business cycle will run about four years, which means that over that period you should see some notable economic expansion and correction—“some bull and bear,” as Wright says. “A company that is competently managed should be able to increase its dividend at least five times in 12 years," he says.

Is it dependable? Another sign of long-term strength is the length of uninterrupted dividend payouts. Wright, for example, only considers companies with 25 years of uninterrupted dividend payouts.

Timing is Everything

He’s also found over decades that high-quality, dividend-paying stocks tend to move between high-yield and low-yield price areas. That can offer potential buying and selling opportunities. “Stocks that meet our criteria follow a pattern of trading between repetitive areas of high- and low-dividend yield,” Wright explains. “When the yield is at the repetitive high-yield area, price is low and, therefore, offers value. When the yield is at the repetitive low-yield area price, it’s high and there is little to no value. This allows us to purchase stocks when they have the greatest upside and then sell them when that upside has been realized."

Follow the Fed

Investors could see dividend-yield ranges expand in the months ahead as these stocks react to the rising interest rate environment. "From 1929 until 1995 the Dow Industrials were as predictable as a Swiss watch, trading between dividend-yield extremes of 6% and 3%,” Wright says. By the dot-com bust, those extremes had morphed to 3% and 1.5% before rising today to 4% and 2%. “As the Fed normalizes and yields return closer to historical norms, the historical high/low dividend yield spread of the Dow Industrials will return to the 6% and 3% extremes," Wright theorizes.

No matter the business cycle, and no matter the Fed Reserve bias, long-term investors may consider dividend increases as potential indicators of long-term price appreciation and overall return on investment. But be picky. Look for companies that have maintained a consistent dividend policy over a significant time period.

“In our experience, these companies are committed to the dividend as a policy rather than a fad,” Wright says. That means they take the steps necessary to keep their products and services attractive to the consumer. That, in turn, “generates the earnings that make the dividends and dividend increases possible," Wright says. Just keep in mind that dividends, and much in investing, are not guaranteed.

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Use Stock Screener to narrow selections based on dividends and more. Log in at tdameritrade.com > Research & Ideas > Screeners > Stocks