Over the past five-plus years of a near-zero interest rate environment, dividend-paying stocks – especially high dividend stocks – have been an attractive option for investors. But rising rates on the horizon necessarily change dividend stocks' favor in investors' portfolios.
Earlier this month, the Federal Open Market Committee (FOMC) met and decided to alter language on when the Fed would start to consider an increase in interest rates. The new language provides the central bank with greater discretion to implement a rate increase, i.e. regardless of the national unemployment rate, which sits today at 6.5%.
Contrary to what the prevailing "wisdom" is, the Fed's taper and eventual interest rate hike "will not unfairly punish dividend stocks," according to Money Morning Chief Investment Strategist Keith Fitz-Gerald.
"In fact, I believe that the opposite is true," Fitz-Gerald said. "Dividend-paying stocks have always been markedly more stable than their non-dividend-paying brethren. More importantly, they've shown that they really are worth the valuation assigned to them."
All dividends are not the same, however. The key is not the payout rate or even the percent yield.
The key for investors, Fitz-Gerald points out, is to choose dividend growth potential over high dividend stocks.
He recommends focusing on companies that continuously raise payouts over time – they historically outperform companies that don't pay dividends in the wake of Fed rate hikes.
Not only do investors reap benefits from the cold hard cash paid out by such companies on a quarterly basis (most of the time), but they also benefit from the growth in their cash flow, according to Fitz-Gerald.
Hold the stock long enough and the dividends received can actually end up being more than the cash initially invested.
Moreover, companies with a long history of dividend growth display higher returns on equity (ROE). Companies in the Nasdaq US Dividend Achievers Index (DAA) have logged a 22% annual ROE over the last decade. Compare that with a 13% annual ROE for all companies in the S&P 500 Index, according to exchange-traded fund sponsor and asset manager Wisdom Tree.
"In some cases, the dividends are so steady and increase so much that over time you can actually make more in dividends than you originally paid to buy the stocks that produced them," Fitz-Gerald said.
A portfolio that includes dividend growers is one that tends to beat the market – and with market returns this year expected to be modest compared to the 32% return (including dividends) logged in 2013, investing in dividend growers is a smart move.