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Where to Look for Dividend Growth

Josh Peters, CFA

Josh Peters: Hello. This is Josh Peters, editor of Morningstar DividendInvestor.

It certainly has been an interesting year on the dividend front, but perhaps it's getting a little bit less interesting. And I think that's probably a good thing. Over the last couple of months, we haven't seen the kind of dividend cuts and dividend omissions that were taking place late last year and earlier this year, which was frankly the worst stretch for dividends going all the way back to the Great Depression.

In the last couple of months, what we've seen is more normal type of patterns. The kind of companies that raise their dividends every year have managed to put out those increases, even if they're not normally as big of increases as you'd like to see.

So let's start looking forward. If the tone has turned back toward dividends' normal pattern of going up, then what can we expect from different companies and different sectors in the years ahead?

First let's take a look at the biggest source of dividend income that has disappointed investors in the last couple of years, and that's banks. It was very interesting to see, over the last couple of weeks, managers of both US Bancorp and JPMorgan Chase sounding ideas that their dividends could be heading toward increases in the near term. This is really good news, for a number of different reasons, not least of which is the idea that it's going to put more money into shareholders' pockets. It's also sending a signal that loan losses may be peaking and earnings may be starting to improve.

For the whole sector, though, watch out. There will be a lot of different companies in these financial industries, banks in particular, that are going to have to continue to pay for loan losses, going to have to continue to build capital levels in order to strengthen their balance sheets, before any kind of dividend increase will come onto the agenda. To look for dividend growth, best stick with some of the strongest players, especially a stock like US Bancorp that's committed to returning a lot of cash to shareholders.

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Now, what about cyclicals, another area of the market that has handed a lot of dividend cuts out to shareholders? I wouldn't be looking for quick rebounds here, either. Chances are, you're going to want to see companies not just improve earnings but also reduce debt levels.

Never forget that bondholders and other creditors have to be paid before dividends are. When you have a company that's seen itself get into trouble because of strained liquidity, because of too much debt, not enough cash flow, they've learned a lesson. They're going to want to bring those debt levels down. To do that, they need to generate more cash than they pay out. That could put dividend increases on hold for a while.

If there is some redeeming quality to the poor outlook here, it's that companies like Dow Chemical probably aren't that good for dividend investors in the first place. Even when Dow was doing relatively well, it still wasn't able to provide good dividend growth. The fact that its cyclicality triggered a dividend cut just tells you, pretty much, to stay away from that kind of a business if you're looking for income.

Now, for all kinds of companies that are affected to one degree or another by the economy, even where dividends haven't been cut, they may be relatively slow to rise for the next year or two. But that doesn't mean that we can't still find some good dividend increases.

For example, just recently, McDonald's Corporation, whose stock now yields close to 4 percent, gave its shareholders a 10 percent pay rise, reflecting continued earnings growth and management's determination to return lots of cash to shareholders. This is a business that once was run, really, for growth at any price, and now is all about return on capital and return for shareholders. This is the kind of name that I would expect to be able to continue raising its dividend at a good clip.

Another stock that's raised its dividend recently that I think might be a good pick for a lot of investors if it comes down a little bit: Philip Morris International, which was spun out of the old Altria Group and has all of the Marlboro cigarette businesses outside of the United States. Their dividend increase continues to show that, even while smoking is hardly good for your health, it can be relatively good for a shareholder's wealth.

Now, both McDonald's and Philip Morris International are the kind of companies you'd expect to do fairly well during a recession. But that's part of the point. Which brings me to my last observation.

When you're looking for a consistent dividend to provide you with income and income growth to help keep your purchasing power in line with inflation, you're going to want to see relatively resilient business results, the kind of companies that are not going to rise and fall as dramatically as the economy, companies that haven't had to pile on the debt, companies that can even grow their earnings in tough years or provide shareholders with pay increases when the rest of the economy is suffering.

These may not be the kind of stocks to lead a big market rally. And that's certainly not what we've seen this year. Dividend-paying stocks, especially some of the highest-quality ones, have really been held back. But they provide the best results when you start looking out over longer periods of time, which is about the time frame you want to be thinking about when you're going to want to invest for dividends.

Now, if you're looking for more ideas for dividend income, dividend growth, and what kind of companies can help your portfolio produce good results, whether the economy is doing well or not, be sure to check out Morningstar DividendInvestor. You can find more information at mdi.morningstar.com.

Again, this has been Josh Peters, editor of Morningstar DividendInvestor, and thanks for watching.