One of the worst misconceptions about dividend investing is that it's boring. Heck, some even think dividends are dumb. But I would argue (and I have) that for those of us who love it when someone deposits money into our brokerage accounts, dividend investing is the most powerful and low-risk form of investing around.
In fact, dividend investing is so powerful that the world's greatest investor, Warren Buffett, has made it a staple of his strategy. And that's a good reason dividend investing should be a component of your investment portfolio.
Buffett, a dividend investor?!
Sure, Buffett is known primarily as a value investor, but the Oracle of Omaha has made a career of finding businesses that pump out cash like oil from a well, a trait that makes them primed to be outstanding income stocks. These cash-flow companies include high-quality insurers such as GEICO and other well-run financials such as Wells Fargo and American Express.
One of Buffett's finest picks has been a dividend monster: Coca-Cola
In 1988, Coca-Cola wasn't the clear slam-dunk choice it appears to be today. Buffett was one of the first investors to see the enviable Coke brand as a serious competitive advantage. He's now held shares in the company for more than 20 years and has repeatedly praised the efficiency of its capital-light business model, which spits out tons of free cash.
That free cash has allowed the company to consistently raise its dividend and, in the process, create a small fortune for a long-term holder like Buffett.
Because Coca-Cola has raised its dividend by 12% on average over the past 21 years, Buffett now manages to get back about one-third of his original investment every year. If the company continues to increase its dividend at this historical rate, in about nine years Buffett will manage to get back his original investment in dividends every year!
Given Coca-Cola's steady economic performance and solid record of increasing dividends, there's every indication that it will continue those growing payouts. That's the power and excitement of income investing with a rock-solid company: increasing payouts for life. Adding that dividend dynamo to a well-diversified portfolio can round out your returns.
And that's not all ...
When screening for dividend stocks, follow Buffett's example with Coca-Cola and look for strong fundamentals, such as steady profitability and increasing growth over time.
Generally, you should avoid cyclical companies, since their potential for inconsistent profitability could endanger their dividends. Instead, focus on businesses whose products will be in demand regardless of the financial climate and are thus much more likely to ensure a steady payout.
Here are a few that fit my criteria.
5-Year Dividend-Growth Rate
5-Year Earnings Growth
Procter & Gamble
Johnson & Johnson
Source: Capital IQ, a division of Standard & Poor's, as of Oct. 14, 2010.
Each of these companies has a remarkably strong franchise for consumer products that we use day in and day out, as their solid earnings over five years bear out. Procter & Gamble offers the detergents and shaving products we use on a daily basis, and McDonald's offers the best-known fast-food brand. Johnson & Johnson's health products cover a wide swath, from mundane goods such as Band-Aids and Tylenol to ultra-high-tech medical devices, and AT&T provides the telecom that we take for granted.
Meanwhile, everyone knows it's hard to operate a computer without using some kind of Microsoft software. That type of ubiquity has led the company to post consistent earnings gains. Its Windows and Office products surpass a 90% share in their respective markets, and that type of dominant position is has allowed it to consistently boost its payout over the past few years. In fact, Microsoft just announced a 23% boost recently, and the company has shown that it's willing to return billions back to shareholders. Over the past decade, it's paid out nearly $170 billion in the form of dividends and buybacks. Better still, the stock looks cheap: It trades at just 10 times earnings after you back out its sizeable cash hoard.
The indispensability of these companies' products ensures that payouts from such blue chips can grow for decades and turn even a small initial investment into a dividend dynamo -- just as Buffett did with Coke.
Follow these stock stars
Like Buffett, the experts at Million Dollar Portfolio are focused on "boring" companies that mint money, including Coca-Cola and Microsoft -- both of which the service holds in its real-money portfolio. Million Dollar Portfolio buys the best of the best stocks from among Motley Fool newsletter recommendations, and advisor Ron Gross and his team manage a portfolio of more than $1 million of the Fool's own money. They make dividend dynamos a key element in their overall strategy, and they let you know when to invest and give you a chance to buy or sell before they do.
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This article was originally published on May 27, 2010. It has been updated.
Jim Royal, Ph.D. , owns shares in Procter & Gamble and Microsoft. American Express, Coca-Cola, and Microsoft are Inside Value picks. Chevron, Johnson & Johnson, Coca-Cola, and Procter & Gamble are Income Investor recommendations. The Fool owns shares of and has written covered calls on Procter & Gamble. Motley Fool Options has recommended a diagonal call position on Johnson & Johnson and Microsoft. The Fool owns shares of Coca-Cola, Johnson & Johnson, and Microsoft. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.