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:

Dec. 31, 1999 -- Dec. 31, 2009

S&P 500

S&P 500 (including dividends)

Annualized Average Return

(2.7%)

(0.9%)

Total Return

(24.1%)

(9.1%)

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:

 

S&P 500 (including dividends)

Morningstar Dividend Composite Index

Morningstar Dividend Leaders Index

Dividend Yield

1.9%

3.9%**

5.9%**

1999-2009 Annualized Average Return

(0.9%)

3.7%

6.7%

Theoretical value of $1,000 invested at the beginning of the period*

$909

$1,439

$1,925

*Assumes zero costs.
**At Jan. 31, 2010.
Sources: Standard & Poor's, Morningstar, State Street Global Advisors, 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 tracks the (what else?) Dow Jones U.S. Select Dividend index. With a 6.3% annualized return over the 2000-2009 calendar 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.

Almost 40% of the stocks in the S&P 500 have a dividend yield that is greater than that of the index. Approximately 1 in 4 of those companies is expected to grow their earnings faster than the index, too. They include:

Company

Dividend Yield

Long-Term Earnings Growth Estimate

Intel (Nasdaq: INTC  )

3.1%

11%

Home Depot (NYSE: HD  )

3%

10.7%

United Technologies (NYSE: UTX  )

2.5%

10.5%

NYSE Euronext (NYSE: NYX  )

4.5%

11.3%

Chevron (NYSE: CVX  )

3.8%

15.8%

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 stalwarts such as Dow Chemical (NYSE: DOW  ) and JPMorgan Chase (NYSE: JPM  ) were forced to cut their dividends -- the former by 64%, and the latter by 87%!

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.

This article was first published on Jan. 16, 2010. It has been updated.

Fool contributor Alex Dumortier, CFA, has no beneficial interest in any of the companies mentioned in this article. The Home Depot and Intel are Motley Fool Inside Value picks. NYSE Euronext is a Motley Fool Rule Breakers recommendation. Motley Fool Options has recommended a buy calls position on Intel. The Fool's disclosure policy's mama said there'd be days like this.


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