Beware of Rapidly Growing Dividends

Dividends are generally a boon for investors. But are they always a good thing?

First, the good news
The overall stock market, as measured by the S&P 500, has grown by an annual average of less than 3% over the past decade ... and that includes dividends. Yet without those payouts, the return would have been much more paltry. Over the past three years, the average has been just 1%. During those three years, Wal-Mart (NYSE:WMT) has paid out between $0.60 and $0.88 per share to shareholders, for a yield of 1.6% -- on top of gains the stock has seen lately.

GE's yield, meanwhile, has recently been around 4.7%, and it has grown at an average annual rate of 12% over the past decade. That's a healthy clip.

As long as a dividend-paying company is healthy and growing, it's likely to keep paying out its obligation to you no matter what the economy is doing. It's a good idea not only to seek out healthy dividend-paying companies for your portfolio, but to also look for ones with a record of increasing their dividends regularly and significantly.

So what's the problem?
I just want you to be careful when you screen for stocks with sizable dividend growth rates. Let me explain. Below is a table of several stocks that have displayed hefty dividend growth over the past decade. (My colleague Andrew Sullivan has noted that the Dividend Aristocrats are a strong group of performers for times like these.)

Data from Yahoo! Finance and SeekingAlpha.com.

Keep in mind that the annual averages in our table don't mean that companies always make regular increases of that size. In 2003, Becton Dickinson boosted its dividend by a whopping 50%, from $0.10 to $0.15 per share. Intel (NASDAQ:INTC), likewise, doubled its dividend between 2003 and 2004, from $0.02 per share to $0.04, and then doubled it again, between 2004 and 2005, to $0.08.

Increases like that are great, but we shouldn't count on having them occur too regularly. In many cases, the companies are ramping up from offering little or no dividend to offering a competitive one. Or they're distributing a rare extra sum to shareholders. Nucor, for example, has occasionally issued "supplemental dividends," which tend to be quite significant but irregular. During parts of 2006 and 2007, for instance, it paid a $0.50-per-share quarterly supplement on top of its regular $0.10-per-share dividend.

So what should you do?
Continue looking for dividend-paying stocks! As you evaluate dividend payers, check out how quickly they have been increasing their payouts. It can be smarter to buy a company with a lower dividend, if you expect that dividend to be increased substantially over time, as opposed to a company with a fatter dividend that isn't likely to give its payout much of a boost.

It's true that dividends can be great for retirees -- and better than annuities -- but all of us can benefit from their power. We needn't cash out the dividends, as many retirees might do; instead, we can invest them. If you have $100,000 invested in companies that pay an average of 2.5% in dividend yield, you'll be collecting $2,500 in dividends each year -- not too shabby, eh?

For recommendations of promising dividend payers, test-drive, for free, our Motley Fool Income Investor newsletter service, which includes recommendations on many stocks yielding more than 6%. Its picks are beating the market handily.