By Jonathan Burton, MarketWatch
"Management shares the growth of the business directly with shareholders through dividend increases," Peters added. "I would not consider buying any common stock that didn't have the capacity to grow its dividend, because it's a vital sign of financial health."
One ready supply of top-drawer dividend payers is S&P's "Dividend Aristocrats" -- a diverse group of larger companies that have increased dividends at least 25 years in a row. If a company misses one year, it's off the list.
This year's 43 Aristocrats include many household names such as McDonald's Corp. /zigman2/quotes/203508018/composite MCD -1.57% , Coca-Cola Co. /zigman2/quotes/209159848/composite KO -1.37% , PepsiCo /zigman2/quotes/208744353/composite PEP -1.59% , Procter & Gamble, Kimberly-Clark Corp. /zigman2/quotes/201766540/composite KMB -2.05% , Exxon Mobil, Johnson & Johnson, Target Corp. /zigman2/quotes/207799045/composite TGT -2.84% , Wal-Mart Stores Inc. /zigman2/quotes/207374728/composite WMT -1.98% and Walgreen Co.
Lesser-known Aristocrats include VF Corp. /zigman2/quotes/206706147/composite VFC -3.03% , Consolidated Edison /zigman2/quotes/207137172/composite ED -0.37% Inc., C.R. Bard Inc. , Automatic Data Processing Inc. /zigman2/quotes/207661132/composite ADP -1.55% , Pitney Bowes Inc. /zigman2/quotes/200721363/composite PBI -3.76% , Emerson Electric Co. /zigman2/quotes/200181610/composite EMR -2.89% , Abbott Laboratories /zigman2/quotes/203724446/composite ABT -0.65% and Eli Lilly & Co. /zigman2/quotes/200106384/composite LLY -0.99% . Emerson, for example, has increased its dividend for 53 straight years.
Some firms not on the Aristocrats list but still garnering the high ratings from S&P include consumer-staples giants Colgate-Palmolive Co. /zigman2/quotes/200774077/composite CL -2.19% , Kellogg Co. /zigman2/quotes/209631250/composite K -0.69% and J.M. Smucker Co. /zigman2/quotes/203835894/composite SJM -0.99%
Predictability is important for dividend investors, who tend to be a patient lot and often buy more shares through company-sponsored dividend reinvestment plans, commonly known as DRIPs.
"Dividend investors typically invest for years or decades," wrote Howard Silverblatt, senior index analyst at S&P, in a recent research note. "Investors need to be comfortable with the company's long-term business model."
If researching individual U.S. stocks is too daunting, dozens of mutual funds and exchange-traded funds offer dividend-centric portfolios. Yet finding the right dividend investment isn't solely about yield and return; you also have to incorporate two key factors that are in your control -- risk and cost.
Using a screen developed by Christine Benz, Morningstar's director of personal finance, Morningstar searched for diversified U.S. stock funds that sport 12-month trailing yields of 2% or better, with below category-average risk and expenses.
The results produced 18 retail funds with five-year returns. The top five on that score: Vanguard Equity-Income /zigman2/quotes/204144399/realtime VEIPX +0.05% ; Vanguard Dividend Growth /zigman2/quotes/204877826/realtime VDIGX +0.05% ; American Funds American Mutual /zigman2/quotes/200625334/realtime AMRMX +0.04% ; ING Corporate Leaders Trust Series B /zigman2/quotes/203946829/realtime LEXCX -0.23% and State Farm Growth /zigman2/quotes/203991507/realtime STFGX -0.08% .
A companion search produced exchange-traded funds for dividend-oriented investors to consider. The highest-ranked on a yield basis include: iShares Dow Jones Select Dividend Index /zigman2/quotes/204321812/composite DVY -0.65% ; WisdomTree SmallCap Dividend /zigman2/quotes/205763385/composite DES -1.67% ; SPDR S&P Dividend /zigman2/quotes/206871683/composite SDY -1.37% (a portfolio based on the Dividend Aristocrats); Vanguard High Dividend Yield Index ETF /zigman2/quotes/205740569/composite VYM -0.77% , and WisdomTree MidCap Dividend /zigman2/quotes/208396493/composite DON -1.51% .
Other ETFs worth noting: First Trust Value Line Dividend Index /zigman2/quotes/206971334/composite FVD -1.13% ; PowerShares Dynamic Large Cap Value /zigman2/quotes/206944888/composite PWV -0.72% ; Vanguard Value ETF /zigman2/quotes/209486178/composite VTV -1.00% , and SPDR Dow Jones Industrial Average /zigman2/quotes/208954582/composite DIA -1.13% , dubbed the Dow "Diamonds" in reference to its ticker symbol, which tracks the 30-stock benchmark /zigman2/quotes/210598065/realtime DJIA -1.07% .
The Dow, in fact, is a wellspring for dividend-based investment strategies. One of the most popular, the so-called "Dogs of the Dow," invests in the 10 highest-yielding components in a given year, such as current leaders Verizon Communications Inc. /zigman2/quotes/204980236/composite VZ -0.56% , AT&T Inc. /zigman2/quotes/203165245/composite T -0.47% , and Merck & Co. /zigman2/quotes/209956077/composite MRK 0.00%
No discussion of dividends can ignore the possibility that the favorable tax treatment of dividends will end this year. The Obama administration has proposed a 20% tax rate on stock dividends, versus the 15% rate most taxpayers pay now. But without congressional action qualified dividends will be taxed at full individual income-tax rates starting in 2011.
If Congress does not act, many companies might decide to prepay fourth-quarter dividends in 2010 rather than early next year, or even to use surplus cash for a special dividend.
In anticipation of such an outcome, equity strategists at Bank of America Merrill Lynch recently screened for nonfinancial companies they believe stand a good chance of providing such a one-time payout -- particularly where managers and other insiders have significant shareholdings and so would be adversely affected by a tax-law change.
Candidates include Microsoft, Gap Inc. /zigman2/quotes/206554267/composite GPS +0.76% , Estee Lauder Cos. /zigman2/quotes/200740220/composite EL -2.56% , Polo Ralph Lauren Corp. /zigman2/quotes/207257694/composite RL -3.83% , and CA Inc. . The list even includes companies that have never paid a dividend, such as eBay Inc. /zigman2/quotes/204653455/composite EBAY -3.91% and Dell Inc. /zigman2/quotes/203822527/composite DELL -0.81%
Still, as with other aspects of investing, taxes shouldn't be your most important concern.
"Prior to the 2003 Tax Act, dividends had always been taxed at ordinary tax rates and dividend-paying stocks still outperformed non-dividend-paying stocks," Morningstar's Peters said. "Dividends aren't about having some tax dodge; it's about earning a more reliable return from stocks than from capital gains alone."