They buy stocks that boost payouts year in and year out. By Nellie S. Huang, Senior Associate Editor August 3, 2012 Dividend stocks were once viewed as so boring. My, how things have changed! Today, companies that pay dividends—and the funds that invest in them—are the things to own. Over the past year, investors have shoveled $19 billion more into funds that invest in dividend-paying U.S. stocks, while money flowing out of other kinds of stock funds exceeded money flowing in.SEE ALSO: Kiplinger's Guide to Income Investing Firms that pay dividends are the “workhorses” of the stock market, says Morningstar strategist Josh Peters. Looking back over 100 years, Peters found that after inflation, more than 70% of the broad market’s returns originated with the income that stocks generated each year. But it’s one thing to pay dividends; it’s another to raise them like clockwork. The beauty of a well-executed dividend-growth strategy is that not only does it provide a rising stream of income, it is often accompanied by a rising share price. Advertisement Consider Abbott Laboratories, a diversified health care company. Ten years ago, Abbott paid an annual dividend of 92 cents a share and yielded about 3%. The current yearly payout rate is $2.04 a share. If you had bought the stock at $30 back then, your yield today on that price would be 6.8%. Meanwhile, the stock now trades at $64. (For a closer look at another dividend champ, see Supersize Your Dividends.) We sifted through dozens of portfolios, looking for the best mutual funds and exchange-traded funds that practice dividend-growth strategies. We found that no two dividend-growth funds are the same. Some work under strict guidelines that define rising growth—for instance, annual dividend boosts of at least 10% a year for at least a decade—while others will invest in companies that merely have the potential to start paying dividends. In the end, we found three mutual funds and three exchange-traded funds that we like and that stay true to the same basic strategy. Top Dividend Mutual Funds At Vanguard Dividend Growth (symbol VDIGX), manager Donald Kilbride doesn’t spend much time checking on how the fund has done from day to day or even week to week. “I rarely look at performance until I have to talk to a client,” says Kilbride, who became Dividend Growth’s manager in February 2006. Once a month is as often as he’ll check on the fund’s returns. Advertisement Kilbride has guided his fund to market-beating results during a turbulent period for stocks. Over the past five years through June 29, Dividend Growth, a member of the Kiplinger 25, gained 3.3% annualized. That beat Standard & Poor’s 500-stock index by an average of three percentage points per year. Kilbride employs a straightforward dividend-growth strategy. The 48 large companies in his portfolio, including ExxonMobil, Johnson & Johnson, Microsoft and PepsiCo, epitomize the term high quality. Each is a leader in its industry, has a lot of cash and little debt, is run by smart managers and has a long history of hiking payouts. Kilbride prefers companies that boost dividends at least 10% annually; over the past ten years, his fund’s holdings have lifted their dividends by an average of 14% a year. Some raise their dividends at a slower rate, and others may boost their dividends at a rate of 40% over the next five years. Kilbride tries to balance the higher risk of the faster-growing companies with the lower risk of the steadier, slower-growing payers. As a result, Dividend Growth tends to outpace the stock market in rocky years and lag when stocks are on a tear. In 2009 and 2010, for instance, the S&P 500 posted gains of 26.5% and 15.1%, respectively; Dividend Growth returned 21.7% and 11.4%. In 2008, the fund slid 25%, but that still beat the market by 12 percentage points. “People were saying, ‘You had a great year,’ ” Kilbride recalls. “And I thought, But I’ve lost 25%. I have an absolute-return mentality. I do the best I can relative to zero.” Tom Huber calls himself a “big believer” in dividend-growth investing. But that doesn’t mean that every company in T. Rowe Price Dividend Growth (PRDGX), which Huber has managed since 2000, pays out cash (Crown Castle International is one such slacker). All of Huber’s fund’s holdings generate a lot of cash, however, and Huber will forgo current payments if a company uses its cash to buy back shares. Truth be told, nearly all of the 119 companies in the fund both pay a dividend and repurchase shares. Advertisement Huber doesn’t pay much heed to payout ratios (the percentage of earnings paid as dividends) or yield per se. Rather, he hunts for undervalued companies that are well managed and sport higher profit margins and returns on capital and equity than others in their industries—in other words, companies that are healthy enough to boost dividends. That said, Huber tries to better the yield of the S&P 500 by at least 0.15 percentage point before expenses; at 2.4%, the portfolio’s prefee yield beats that of its benchmark by 0.4 point. Like most dividend-growth funds, the Price product holds up well in shaky markets and lags in strong markets. Under Huber, the fund has returned 5.6% annualized over the past ten years. That sneaks past the S&P 500 by an average of 0.3 point per year. You may have heard of the Vanguard and Price dividend funds, but you’re probably not so familiar with Ave Maria Rising Dividend Fund (AVEDX). Its managers, Rick Platte and George Schwartz, are drawn to dividend raisers in part because they think companies that share more wealth are managed better than the average firm. “Knowing that you have to raise dividends next year tends to impose an additional element of discipline” on company managers, says Platte. The fund has a trim portfolio of 40 companies that yields 1.7% after expenses. But, Platte says, many of the stocks yield more than 4%, including ConocoPhillips, Federated Investors and Microchip Technology. Advertisement Not all of Ave Maria’s stocks raise dividends every year. For instance, the fund owns some bank stocks, among them U.S. Bancorp, which cut its dividend by 88% in 2009 (it raised it by 56% in March 2012). “Our interest is looking forward,” says Platte. “Our dividends have to go up in the future.” A twist to Ave Maria’s investing process is that the managers can buy only those stocks that pass muster with the fund’s Catholic advisory board (former football coach Lou Holtz is a member). Companies involved in abortion, embryonic stem cell research and pornography, for instance, are off-limits. The restrictions aside, Ave Maria has performed well. Over the past five years, it topped the broad market by an average of 2.8 points per year. Cream of the Dividend ETFs A handful of ETFs track indexes of consistent dividend raisers. The biggest such ETF, Vanguard Dividend Appreciation (VIG), focuses on companies that have lifted payouts for at least ten years in a row. With a 0.13% expense ratio, it ranks among the country’s lowest-cost ETFs. Over the past five years, VIG gained an annualized 2.3%. That beat the S&P 500 by an average of 2.1 points per year. SPDR S&P Dividend (SDY) stretches the time horizon for consistently raising dividends to 25 years. The fund holds 60 stocks, including Cincinnati Financial and Kimberly-Clark. The ETF’s five-year annualized return of 1.9% beats that of its rivals by 2.6 points per year on average. Yearly fees: 0.35%. The payout-growth mandate is more relaxed at iShares Dow Jones Select Dividend Index (DVY). This ETF invests in the stocks of the highest-yielding companies that have maintained or increased dividends over the past five years. The underlying index excludes companies that have paid out more than 60% of their profits as dividends, as well as any company that eliminated its distribution. Unfortunately, these measures didn’t help in 2007 through 2009, when the ETF cratered because of a hefty weighting in financial stocks. In response, Dow Jones now reviews its holdings every quarter, instead of just once a year. The changes seem to have helped. Although DVY’s five-year annualized loss of 0.9% trails the market’s return, it has performed better recently, beating the S&P 500 in both 2010 and 2011. And the fund, which charges 0.40% a year, sports a hefty current yield of 3.6%. Kiplinger's Investing for Income will help you maximize your cash yield under any economic conditions. Download the premier issue for free.