The best dividend stocks are not just the ones paying big dividend yields; companies with strong and sustainable dividend growth can be even more profitable investments over the long term. Names such as Nike (NYSE:NKE), TJX Companies (NYSE:TJX), and Starbucks (NASDAQ:SBUX) offer modest dividend yields, but they have enormous potential for dividend growth over the years ahead.
Why you should invest in dividend growth stocks
Dividend growth investing is one of the most powerful and time-proven strategies to obtain superior returns over the long term. According to data from Ned Davis Research, companies with consistent dividend growth tend to deliver both higher returns and lower volatility.
Based on this research, dividend growth companies produced an average annual return of 10% from January 1972 to July 2014, while annual volatility was around 16%. During that period, companies that did not pay a dividend delivered annual returns around 2.5%, while volatility was a much higher 25.2%. Companies with stable dividends produced an annual return of 7.7%, while volatility was around 18.1%. In a nutshell, dividend growth stocks substantially outperformed both companies with no dividend and those with stable dividend payments.
When thinking about the best dividend stocks, names like Procter & Gamble (NYSE:PG) typically come to mind. The consumer staples giant has an amazing track record of dividend distributions: Procter & Gamble has paid uninterrupted dividends since its incorporation in 1890, accumulating 126 years of consistent payments under its belt. In addition, the company has raised dividends over the last 60 consecutive years. With a dividend yield of 3.25%, it's quite easy to understand why Procter & Gamble is one of the most trusted and reputable dividend stocks in the market.
On the other hand, the company is facing slowing performance, and the dividend payout ratio is quite high, at nearly 75% versus earnings forecasts for the fiscal year ending in June of 2016. This is putting downward pressure on dividend growth, and Procter & Gamble announced a disappointing dividend increase of only 1% for 2016.
Companies like Nike, TJX, and Starbucks don't have such a long trajectory of dividend payments, and they come way behind Procter & Gamble in terms of dividend yield. On the other hand, they are well positioned to deliver substantial dividend growth over the coming years, so dividend investors should not underestimate these younger and more dynamic dividend growth stocks.
The best dividend growth stocks
To begin with, it's of utmost importance to look at the fundamentals behind a company's dividend. If management is going to reward shareholders with growing payments over the years, then the business needs to generate solid financial performance and growing cash flows in a sustainable way.
Both Starbucks and Nike are among the most powerful brands in the consumer sector. The two companies sell their products for premium prices, and this generates superior profitability for investors. TJX follows a different strategy -- the company is all about cost advantages, selling home and apparel fashions for conveniently low prices and generating impressive financial performance in the challenging retail business.
The three companies have produced consistent revenue growth over the long term, and they also have solid balance sheets and strong cash flow generation capabilities. Even better, they have rewarded investors with growing dividends over the last several years. Nike has raised dividends in the last 14 consecutive years, TJX has increased dividends for 20 years in a row, and Starbucks raised dividends in the last 6 years.
In addition to a stock split and a new share buyback plan, Nike announced a 14% dividend increase in November of 2015, TJX raised dividends by a generous 24% in February of 2016, and Starbucks increased dividend payments by 23.4% in November of last year. The three companies are clearly raising dividends at an impressive speed.
Dividend yields are not particularly high: Nike pays 1.2% at current prices, TJX has a dividend yield of 1.5%, and Starbucks yields 1.5% in dividends. However, payout ratios are comfortably low, in the area of 28% of earnings for Nike, 25% for TJX, and 42% for Starbucks. Healthy earnings growth, in combination with conservatively low payout ratios, should allow the three companies to deliver strongly growing dividends in the future.
Companies such as Nike, TJX, and Starbucks are no match to an established dividend powerhouse such as Procter & Gamble in terms of dividend yield or dividend history. However, they are poised to deliver vigorous dividend growth in the coming years, and this could be a powerful return driver for investors in these companies over the long term.
Andres Cardenal has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Nike and Starbucks. The Motley Fool recommends Procter & Gamble. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.