It's not hard to understand the appeal of investing in companies that are sturdy enough to pay dividends. As Dan Lefkovitz, content strategist for Morningstar Indexes, explains, corporate management must be confident of future cash flows in order to commit to a dividend payment. That's because once a dividend commitment is made, it’s not withdrawn lightly: The market usually punishes dividend cuts or eliminations severely because they indicate financial distress. So it follows that dividend-paying companies tend to be competitively well-positioned, cash-generating businesses.
Dividend growth investment strategies home in on companies whose cash flows have translated into a rising payout. To find companies with a history of dividend growth--and the ability to sustain it--the Morningstar US Dividend Growth Index uses several screens, Lefkovitz explains. First, we cull the U.S. equity market for securities that pay qualified dividends. (This excludes real estate investment trusts.) Index constituents must exhibit a five-year history of increasing their dividend payments. To gauge the sustainability of dividend growth, eligible constituents must display positive consensus earnings forecasts from the analyst community. As a safeguard against dividend cuts and financial distress, stocks with indicated dividend yield in the top 10% of the universe are excluded. Finally, existing constituents are allowed to remain if they have recently bought back shares and have not decreased their dividend payment.
Karen Wallace does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.