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. Buffett started acquiring Coca-Cola shares in 1988 and had 200 million shares as of March 2010, meaning he owns nearly 9% of the soda king. Coca-Cola forms 21% of Berkshire's investment portfolio, followed by Wells Fargo at 18%.
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 has 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
Source: Capital IQ, a division of Standard & Poor's, as of Nov. 12, 2010.
Each of these companies has a strong franchise for consumer products that we use day in and day out, as their solid earnings over five years bear out. Colgate-Palmolive has some of the most resilient brands out there, and its exposure to the personal care sector helps make its products extra "sticky," meaning consumers come back year in and out. PepsiCo offers its namesake cola, of course, but also its dynamic Frito-Lay snack division. PepsiCo spun off the next company, Yum!, which is going gangbusters in China right now, but its major restaurant concepts in the U.S. -- Taco Bell, KFC, and Pizza Hut -- are dining-out staples.
CenturyLink provides the essential telecom infrastructure that many of us use every day without thinking about it. Wal-Mart provides cheap access to our daily goods, while Republic Services -- a waste collector -- hauls off our refuse.
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
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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. Coca-Cola, American Express, and Wal-Mart are Inside Value picks. Wal-Mart is a Global Gains recommendation. Coca-Cola, PepsiCo, and Republic Services are Income Investor recommendations. Motley Fool Options has recommended a diagonal call position on PepsiCo. The Fool owns shares of Coca-Cola, Wal-Mart, and Yum! Brands. 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.