Recently I wrote about six little-known dividend growth stocks that could hold the key to your ability to retire in comfort and security.

This was based on two studies, one from 2008 by Jack Gardner, who found that the highest 100 yielding companies in the S&P 500 outperformed the entire index by 28.4% annually between 1968 and 2007. A 2004 study by Ned Davis likewise found that, between 1972 and 2004, dividend growth stocks were the best-performing class of stock.

Dividend Policy Annual Return 1972-2004
S&P 500 8.5%
Nondividend payers 4.3%
Dividend cutters and eliminators 5.2%
Dividend growers 7.2%
All dividend payers 10.1%
Dividend growers and initiators 10.6%

Source: "DIVIDENDS, METALS, AND 1960 REPLAYS," Ned Davis Research.

During my research I came across four investing principles that studies show lead to superior long-term investing returns, and which none other than Warren Buffett, whom many consider history's greatest investor, continues to use to this day. 

To better illustrate these principles, let's examine Berkshire Hathaway's (NYSE:BRK-B) 10 largest dividend growth stock holdings: Wells Fargo (NYSE:WFC)Coca-Cola (NYSE:KO)American Express (NYSE:AXP)IBM (NYSE:IBM)Wal-Mart (NYSE:WMT)Procter & Gamble (NYSE:PG)ExxonMobil (NYSE:XOM)US Bancorp (NYSE:USB), and Moody's (NYSE:MCO), to see how they can teach you to invest better. 

Buffett's favorite dividend stocks

Company Value in Berkshire's Portfolio (in billions) Yield Long-Term Dividend Growth Record 21-Year Performance
Wells Fargo  $23.35 2.70% 9.47% over 42 years 14.70%
Coca-Cola  $16.07 3.10% 12.01% 52 years 8.40%
American Express  $13.23 1.20% 7.22% over 37 years 13.30%
IBM  $13.18 2.30% 14.26% over 52 years 13.90%
Wal-Mart  $4.37 2.60% 23.33% over 40 years 11.90%
Procter & Gamble $4.33 3.20% 9.77% over 44 years 11.50%
ExxonMobil  $4.08 2.80% 7.09% over 44 years 12.40%
US Bancorp  $3.33 2.40% 3.44% over last 27 years 16%
Moody's $2.26 1.30% 20.11% over last 14 years 12.70%
Average Top 10 Holdings   2.40% 10.67% over 35.2 years 12.76%
S&P 500   1.96% 5.05% over 24 years 9.60%

Sources: Multpl.com, Yahoo Finance, Buyupside.com.

The above table exemplifies two of the four investing principles that research has found to be the key to investing success: high yield and consistent dividend growth. As you can see, Buffett's favorite dividend stocks have an average yield significantly higher than the S&P 500 and an average dividend growth rate that is more than double. Given those facts, along with the research I cited above, its not surprising that these dividend growth stocks have outperformed the market by 32.9% annually over the last 21 years. 

The power of high-yielding, dividend-growth investing is well known to many investors. However, two investing principles personified in Buffett's dividend growth portfolio are less famous, yet equally important to achieving long-term investing success. 

Lower risk, higher reward

Company Beta 5-year Projected Earnings Growth Rate 5-year Projected Dividend Growth Rate Age of Company (years)
Wells Fargo 0.79 9.69% 8.50% 162
Coca-Cola 0.51 4.60% 7.48% 128
American Express 1.25 9.60% 8.94% 164
IBM 0.86 8.27% 9% 114
Wal-Mart 0.37 6.77% 5.95% 69
Procter & Gamble 0.53 8.60% 5.16% 177
ExxonMobil 1 3.18% 7.47% 144
US Bancorp 0.72 6.90% 8.22% 85
Moody's 1.590 13.80% 12.61% 114
Average Top 10 Holdings 0.85 7.93% 8.15% 128.6
S&P 500 1.00 12.54% 5.05% 15

Sources: Yahoo Finance, Fast Graphs, Yahoo Finance, Professor Richard Foster, Yale University.

As seen in the above table, Buffett's top 10 dividend growth stocks have an average beta (a measure of volatility) that is 15% lower than the market. It turns out that lower volatility is key to the outperformance of this portfolio.

In a 2011 study, Harvard University finance professor Malcolm Baker analyzed 40 years of stock market data and discovered something astonishing: "Low-volatility and low-beta portfolios offered an enviable combination of high average returns and small drawdowns. This outcome runs counter to the fundamental principle that risk is compensated with higher expected return."

A 2010 New York University study found that low-volatility portfolios outperformed in "18 of 19 global equity markets, in treasury markets, for corporate bonds sorted by maturity and rating, and in futures markets."

How is it possible that low-volatility investing can be so powerful? Well as explained by my Motley Fool colleague Matthew Frankel, the key is the smaller losses suffered during a bear market.

For example, let's say you invested $1,000 into an S&P 500 index fund (beta 1) and $1,000 into a low-volatility portfolio (beta .5). If the market declines by 30%, the low -volatility portfolio drops by 15%. The next year the market rallies 40% while the low volatility portfolio climbs 20%. At the end, the S&P 500 index fund is worth $980, a 2% loss, but the low-volatility portfolio is is worth $1,020, up 2%.

Is age an asset?
The last investing principle I want to highlight is the fact that older companies often make exceptional, if "dull," investments. Specifically, note that the average company in Buffett's top 10 dividend stocks is 128.6 years old, 8.6 times older than the average company in the S&P 500 and 53% older than Mr. Buffett's own age of 84.

Why is age such an asset? Well, age by itself isn't, but what it represents can be. For example, the reason that the average age of company in the S&P 500 is only 15 years is mostly because of business failures, mergers, and acquisitions. As Richard Foster, emeritus director at McKinsey and a Yale management lecturer, explained:

When a company has run its course it gets bought ... this is a good thing, because if the economy stops changing then productivity would go away ... all companies would like to think that they're going to be the Methuselah, but they're not.

However, Buffett's favorite dividend stocks aren't "all companies": They represent some of the most successful brands and corporations in U,S, history -- the ones with exceptional management, long-term innovative spirit, and the ability to grow, adapt, prosper, and pay growing dividends through the most turbulent periods of history. These companies' longevity and superior dividend growth histories is proof of their enduring competitive advantages and what Buffett calls "a wide moat."

For example, Procter & Gamble was founded in 1837 and has survived 10 financial panics, two depressions, both World Wars, two oil shocks, and the Great Recession of 2008-2009. Not only has the company grown and adapted through all that, but P&G has increased its dividend annually for the last 58 years, and made countless investors wealthy along the way. 

The key to long-term wealth creation
In Warren Buffett's 10 largest dividend holdings we see four important investing principles that history has proven are the key to long-term wealth creation: a higher than average yield, consistent dividend growth, low volatility, and an enduring competitive advantage and adaptability that allows a company to prosper (and enrich shareholders) for decades or centuries. Perhaps you've never thought about these principles or considered adapting them to your own investments. However, history and numerous studies indicate that you'd be better off in the long run if you at least considered adding a low volatility, high-yield dividend growth component to your portfolio. 

 

Adam Galas has no position in any stocks mentioned. The Motley Fool recommends Amazon.com, American Express, Berkshire Hathaway, Coca-Cola, Moody's, Procter & Gamble, SolarCity, Tesla Motors, and Wells Fargo. The Motley Fool owns shares of Amazon.com, Berkshire Hathaway, International Business Machines, SolarCity, Tesla Motors, and Wells Fargo and has the following options: long January 2016 $37 calls on Coca-Cola and short January 2016 $37 puts on Coca-Cola. 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.