Better Buy: Big Dividends or Fast-Growing Dividends?

A couple of my fellow Fools seem to have a bit of a disagreement. In his article "The Most Outstanding Dividend Portfolio I Know," Jeremy Phillips said he believes "dividend growth, much more than current yield, is critical to a successful dividend portfolio."

Meanwhile, in his article "The Outstanding Dividend Stock I'm Buying Now," Jim Royal countered, "I think a high current and sustainable yield is every bit as important as growth."

So who's right? Should we be focusing more on a company's ability to grow the dividend or give preference to higher current yields?

To the numbers! (Jeremy's turn)
Jeremy was looking for stocks with above-average dividend growth, so I pulled up all of the stocks with a market cap above $500 million as of a decade ago that also had positive dividend growth over the three years ending in 2000. I then found the average dividend growth of the group (11.9%) and cut down the list to just the companies with dividend growth above that average.

The average dividend-adjusted return for that group was 88.4% -- far better than the 4.4% loss the S&P 500 delivered over the same period.

I then ran through the same exercise for the past five years. This time the average dividend growth rate was 20.8% and the average dividend-adjusted return for the stocks that had above-average dividend growth was 26.7%. Once again, investors focusing on dividend growth did well, easily besting the S&P's 1.7% return over the same period.

To the numbers again! (Jim's turn)
Jim wants higher current yields, but he also wants sustainable yields. Since the specific stock in question for Jim was National Grid (NYSE: NGG), with a whopping 7% yield, I took it to mean that he's looking for more than just above-average yields. As for the sustainable part, I figured that meant Jim would steer away from any stock with a payout ratio above 100%.

Once again, I focused on all of the companies with a $500 million market cap or higher 10 years ago. I excluded all companies with a payout ratio above 100%, then split the group into deciles and grabbed the top decile, which had a minimum 4.9% yield. The average dividend-adjusted return for the group that remained was a whopping 187.3%, not only better than the market's small loss, but also topping the dividend growers' 88% return.

As above, I ran the whole exercise again for the period over the past five years. This time the low-end dividend was a bit lower at 4.3%, but the average dividend-adjusted return of 26.9% once again beat the results from the dividend growers -- though by a razor-thin margin.

Grab those high yields!
The results don't come as a big shock to me, as I found similar results when looking at high-yield stocks and dividend growers last year. Granted, these results aren't exactly statistically robust, so don't take this as an immutable law of investing.

Of course, if you want to bag some of the stock market's high-yield magic, you can hop onboard National Grid with Jim -- it has a 7% yield and a 51% payout ratio -- or you could take a closer look at one of the following stocks. Each has a market cap above $500 million, is currently in the top decile in terms of dividend yield, and has a payout ratio below 100%.

Source: Capital IQ, a Standard & Poor's company.

Will all of these stocks outperform in the years ahead? Maybe not. However, if history is any guide, we're pulling from a good bucket when we focus on high-yielding stocks with sustainable payout ratios.

In considering which high-yielding stocks I might want to buy, I always examine the underlying business. What I'm looking for is first whether it's a business I can understand; if it's too complex, I skip it. Next, I'm looking for whether it's a business whose products or services will be in demand five and 10 years down the road. For me, all of the companies above fit the bill.

However, the same process has kept me away from some of the highest-yielding stocks -- the mortgage REITs like Hatteras Financial (NYSE: HTS), which yields more than 14%. Hatteras, like many of the other mortgage REITs, has only been around for a few years, so there's no history of how the company is able to operate in environments other than the current ultralow-rate one, which is not only ideal for the mortgage REITs but also unsustainable for the long term.

Go big or go home?
As I noted above, the numbers I've dug up are hardly conclusive in the dividend debate. What I think is important to bear in mind is that both groups – high yielders and high dividend growers -- handily beat the S&P over the past five and 10 years. I don't believe that's a coincidence. So while the debate about big dividends and fast-growing dividends may continue to rage, just make sure you're getting dividends.

If you're a dividend investor you're certainly in good company. After all, Warren Buffett is a dividend investor.