Why are growing dividends magical?

Many investors fall back on dividend-paying stocks because they offer a kind of security against market downturns. The idea is intuitively sound, and even partly true. However, the first instinct when looking for such an investment is to go for the one that offers the best yield. The problem is that equities are not fixed-income securities like bonds. Choosing equities with yield as the sole criterion means exposing yourself to a fall in or outright cessation of dividend payments. Organizations' financial difficulties are driving down their share prices, which in turn is exploding their dividend yields for the current year. However, there's a good chance that these difficulties will be reflected in future dividend payments.

Dividend payers also have a reputation for beating the market (more on this below). One of the reasons given is that regular payouts force companies to control costs and constantly improve. This is all the more true for companies that increase their dividend year after year. The profits generated must be high enough to cover dividend payments to the greatest possible extent, otherwise dividends will stagnate at best, fall or, in the worst case, be eliminated. This is what happened to many financial companies during the sub-prime crisis.

It is therefore necessary to take into account not only yield, dividend growth and payout ratio (in relation to profits). The number of consecutive years of dividend increases also gives a good idea of the company's ability to generate sufficient cash on any given occasion.

By taking these different criteria into account, rather than focusing on yield alone, new perspectives open up. Ucompany that offers average returns, but has a track record of uninterrupted distribution growth, deserves more attention. A dividend of 3 $ can become 7.80 $ in 10 years, if it grows by 10% per year. An increasing yield of 3% may therefore be more attractive than a stable yield of 6%.

As for the payout ratio, it reflects the percentage of earnings that the company devotes to its dividend. A low payout ratio means there's plenty of room for a dividend increase. It also means that a significant proportion of the company's profits remain in its hands, enabling it to finance expansion, repay debt or buy back securities. On the contrary, uhigh payout ratio leaves less room for future dividend growth, and more risk that, in difficult times, it will have to reduce or even cease distributions.

As the baby-boom generation retires, income-based investment strategies will become increasingly important. In addition, the expected return of inflation will shift investors away from fixed (and mediocre) income securities such as bonds, towards dividends that grow over time. This is the best long-term strategy. Below, Ned Davis shows the performance of different investment strategies since 1972, with a a clear advantage for increasing dividends, followed by fixed dividends, and then, much further back, by non-dividend-paying securities. We also note that dividend "cutters" suffer a loss over this period, hence the importance of selecting companies with reasonable payout ratios and a strong dividend history.

Sources:
http://www.fool.com/investing/dividends-income/2011/03/25/the-most-promising-dividends-in-petroleum-refining.aspx
http://www.fool.com/investing/general/2010/10/18/3-reasons-dividend-stocks-are-a-must-own.aspx