A Wealth-Building Strategy for the Next 10 Years

The past 10 years made up an absolutely horrendous decade for stocks -- the worst calendar decade in recorded history, in fact. However, one strategy handily beat the broad market, enabling investors to build real wealth, instead of experiencing losses even before factoring in the cost of inflation. Before I get to that, let's consider the extent of the damage suffered by broadly diversified stock investors:

Source: Standard & Poor's.

The two sets of numbers show that dividends cushioned the blow of lower prices, but that's cold comfort when one's total return over an entire decade remains negative. Still, the table below shows that a dividend-focused strategy could have made a material difference on outcomes at the end of the same 10-year period:

*Assumes zero costs.

**At Nov. 30, 2009.

Sources: Standard & Poor's, Morningstar, and author's calculations.

Although the difference in annualized returns may appear small, they start to add up with compounding. In terms of the end value of your initial stake, the Morningstar Dividend Composite is up on the S&P 500 by nearly 60%, while the Morningstar Dividend Leaders is ahead by more than 100%!

No academic debate
You might object that this discussion is largely academic, because you can't go out and buy these indexes. However, with the development of exchange-traded funds, you can almost do just that. While there are no ETFs based on the Morningstar indexes I refer to, the iShares Dow Jones Select Dividend Index Fund (NYSE: DVY), tracks the (what else?) Dow Jones U.S. Select Dividend index. With a 6.3% annualized return over the past decade, its performance is close to that of the Morningstar Dividend Leaders index. Moreover, the expense ratio of the ETF is an acceptable 0.40%.

The above table also illustrates that as your dividends rise, so too do your returns. As we noted earlier, Morningstar's Dividend Leaders, which contains the 100 highest-yielding stocks in the Dividend Composite index, significantly outperformed the S&P 500 and its parent index. That's not as self-evident as it may seem.

Higher dividends = higher earnings growth
On the one hand, high dividend yields contribute directly to total returns; however, in theory, earnings that are paid out as dividends can't be reinvested in the business, thereby reducing future earnings growth. The real world works differently, however; Rob Arnott and Cliff Asness used market and fundamental data from 1946 through 2001 to show that the higher the current dividend payout ratio, the higher the subsequent earnings growth. They suggest that a higher payout may prevent corporate management from engaging in "empire-building" and other value-destroying stunts.

There are more than 700 companies listed on major U.S. exchanges with a market capitalization in excess of $500 million and a dividend yield greater than that of the S&P 500. A significant number of these companies are expected to grow their earnings faster than the benchmark index, too. They include:

Source: Capital IQ, a division of Standard & Poor's.

(Let me be quite clear: These stocks are not recommendations, though they may be worth looking at in more depth.)

So there you have it: You can build real wealth over extended periods by investing in stocks that pay a sustainable, high dividend. Of course, not all dividends are created equal -- the trick is being able to identify which dividends are sustainable and which aren't. During last year's turmoil, even stalwart General Electric (NYSE: GE) was forced to cut its dividend by two-thirds.

Do you want to be wealthier 10 years from now?
Sustainable or not? That's a question the folks at Motley Fool Income Investor spend a lot of time on; they can show you how to build -- and more importantly, how to manage -- a portfolio of sustainable dividend payers that will be working relentlessly to compound your wealth. Income Investor's approach is built around six "Buy First" stocks -- "stable, best-of-breed companies that should be paying rich dividends in 10, 20, or 30 years." You can find out which Buy First stocks the team is recommending by taking a 30-day free trial of the service today -- it's a simple first step toward being wealthier in 10 years' time.

You can follow Fool contributor Alex Dumortier on Twitter. He has no beneficial interest in any of the companies mentioned in this article. 3M and Wal-Mart Stores are Motley Fool Inside Value picks. The Fool has a disclosure policy.