A Crazy-Simple Dividend Strategy You Should Seriously Consider

Below, I'm going to share a very, very simple-to-use formula that can help you create a discerning portfolio of dividend stocks. Not just any dividend stocks, but dividend growth stocks (more on why that's important later). But first, I want to share one of my favorite quotes about dividends.

In a lecture to students (available thanks to YouTube), NYU Stern School's Aswath Damodaran compares dividends, an old-school practice of rewarding shareholders, with stock buybacks, a relatively recent phenomenon of corporate boardrooms:

"Dividends are like getting married; stock buybacks are like hooking up."

Brilliant!
Dividend payments are a long-term commitment, requiring consistency and discipline from management.

And that's exactly how they're treated. According to Fidelity Viewpoints, "Companies are loath to cut dividends, even during hard times, out of fear that reducing or eliminating the payment will cause investors to flee their stock." Neither party, it seems, wants the marriage to end.

But end it does, which is why prospective suitors need to be diligent in their research. In 2010, 145 companies reduced or eliminated their dividend payments. That's actually great news, suggesting a recovering economy; in percentage terms, it's 82% lower than the 804 cuts in 2009. It's also well below the 606 dividend reductions in 2008.

But back to that formula. I said it would be crazy-simple, and I hope you'll agree.

The 10-10 Formula
The 10-10 Formula goes as follows: Seek out stocks that have …

• Raised dividends for a minimum of 10 consecutive years, and
• Increased those dividends by an average of 10% or more per year for a decade

This 10-10 test was developed by Tom Cameron, the chairman of Dividend Growth Advisors, who currently uses it to run a mutual fund called Rising Dividend Growth Fund (ICRDX) to great effect. Over the past five years, the fund has returned more than 4 percentage points per year beyond the returns of the S&P 500, putting it in the top two percent overall in its category.

Why are growing dividends important? In November, I wrote about a Ned Davis Research study showing the impressive outperformance of S&P 500 "dividend growers and initiators." If invested in this segment, $100 grew to $3,214 from January 1972 through the end of September 2010. By comparison, dividend stocks with no change in their dividend policy turned $100 into $1,422.

Also, "growth in dividend payments often tends to be more reliable than earnings growth," says Fidelity Viewpoints. "Since 1946, dividend growth rates have had a standard deviation of just 6%, compared with 16% for earnings growth rates."

What this means for you
Exposure to fast-growing dividend payers should excite even the most conservative investors. After all, one side benefit of 10-10 is that if a company chooses to maintain its dividend payout, rather than increase it, the strategy kicks it aside. Status quo even for one year removes a stock from consideration for the next decade. (One caveat to this crazy-simple strategy: I find it compelling as a starting point for screening and researching, but not as a binding mechanical strategy.)

By focusing only on the consistent growers, you score bigger checks every year (or more shares bought when reinvesting). More importantly, steady dividend increases bode well for a stock's future. My colleague Todd Wenning wrote about a 2003 study showing a link between higher payouts and higher earnings growth, for the simple fact that managers had to carefully allocate capital to value-creating projects.

Putting it into practice
I'd like to share a few specific dividend stocks with you -- and provide a link where you can get one Fool dividend favorite in particular. But let me first make clear that I'm not here to proselytize on behalf of Rising Dividend Growth.

Although a spokesman for the fund told me that fees would drop as economies of scale are realized with things like back-office costs, the fund's fees are higher than the Morningstar category average, and A shares have a front-end load. (Read up on why I hate load funds.)

Nonetheless, I'm impressed by the fund's performance figures, and I love its 10-10 Formula. Its strategy deserves serious consideration among dividend investors.

So let's get a sense for the companies that pass the 10-10 test. Below are five stocks that have been paying dividends every year for 10 consecutive years, and which have raised those dividends by a minimum of 10% per year over that time frame. They are also favored by the management team of the Rising Dividend Growth fund, ranking among the fund's top 10 holdings.

Source: Dividend Growth Advisors. Top holdings as of Dec. 31, 2010.

I'm no expert on all these stocks, and thus I'm not making a buy or sell call right now. But those dividend track records are things of beauty.

There's another top-10 fund holding that Fool retail editor Jim Royal called his dividend stock "for a lifetime." If you're looking for a thoroughly vetted stock idea, click here, enter your email address, and we'll send you the full write-up free of charge.

Stocks that pass the 10-10 test show a marriage-like commitment and consistency to raising their dividends, making this a simple yet powerful strategy to consider.