(MONEY Magazine) – The way most investors pick stocks today, you'd think that dividends were worthless. The yield on the S&P 500 is currently running a pitiful 1.2%, its lowest level in more than 75 years. Yet recent research shows that dividends offer one of the best ways to spot great growth stocks--sometimes at bargain prices.

There's a twist, of course. It isn't especially important how much a stock pays. What really matters is how fast the company is raising those payouts. For instance, a stock with a 1% yield but a 20% annual dividend growth rate is a far better bet than one with a fat 5% yield but only a 5% growth rate. Moreover, the importance of dividend growth appears to be increasing. "In the past three years, the excess returns associated with dividend increases have been well above prior norms," concludes a recent study by Bernstein Research.

To see how well Bernstein's findings hold up in practice, I asked MONEY researcher Brian Murphy to help me put together some dividend growth data. We started by screening the Baseline database for stocks with a market capitalization of more than $1 billion that have shown positive dividend growth over the past five years. Almost 500 stocks made that cut. On average, the price appreciation of those shares reflected their dividend growth rates (see the chart at right). Increases of more than 12% a year fueled price appreciation that topped the S&P 500's average annual gains of 23.5% over the past five years.

If you think about it, the relationship between dividend growth and stock-price gains makes a lot of sense. Even if investors don't care much about yields, most companies will be able to raise their dividends fast only if they have rapidly rising earnings. In addition, the very fact that a company pays and regularly increases a dividend is a sign that the top managers lean toward traditional ideas of sound financial management--they believe in returning a growing stream of cash to shareholders and aren't betting every cent they can borrow on future expansion. Those two factors will steer you toward exactly the sort of blue-chip growth stocks that tend to lead the market most of the time.

In our group, the stocks with the fastest dividend growth tended to have the biggest gains. So I decided to look at stocks with dividend increases that had averaged more than 20% annually over the past five years. That elite group included 46 companies. Then I eliminated all those that hadn't shown equally good earnings growth over the same period. I rejected a few more because they didn't have Value Line Financial Strength ratings of at least B++.

That left me with a short list of 14 stocks that included plenty of investor favorites, such as Citigroup, Dollar General, Tiffany, Medtronic, Intel, Schwab and Home Depot. The only trouble is, none of these top performers are exactly unrecognized--they all carry price/earnings ratios ranging from 26 to more than 100. I was more interested in those that seemed undervalued.

Two midcap stocks looked interesting. Raychem, a maker of products such as specialty fuses for electronics and telecommunications, was trading at a P/E of only 13. Gross margins are down, though, because of soft sales in five of Raychem's seven divisions.

Ross Stores, a $2.4 billion chain of discount retailers, looked more compelling. The stock is up sixfold since 1995 and yet trades at a P/E of only 14. My only reservation is that discounters are always vulnerable to price wars that eat away at margins.

Two big-caps intrigued me more. Morgan Stanley Dean Witter offered compound dividend growth of 32%, earnings increases averaging 25% and an A financial rating from Value Line. Best of all, it was reasonably priced. With annual earnings and dividend growth projected in the 15%-plus range over the next five years, MSDW's 19 P/E seems fair. The only catch is that this broker and underwriter depends on the bull market continuing full blast.

My kind of numbers

I tend to be a value-oriented, contrarian buyer. In other words, I'd rather own a stock that's already been through bad times rather than one that's riding high and looking like it's due for a pullback. As a result, the stock that appealed to me most was Caterpillar, the world's largest producer of earth-moving equipment, with annual sales of more than $20 billion, five-year dividend growth of 35% annually and 21% compound earnings growth. Since 1992, the stock is up fourfold, which is impressive, considering that business is soft at the moment. At a recent price of $47 a share, the stock is trading at a 12 P/E with a 2.5% yield.

Those are my kind of numbers. All value investing requires patience, but you might not have to wait that long for Caterpillar to start outpacing the market indexes. Profit growth could well improve by the second half of the year if the rebound in Asia and other developing markets strengthens. Moreover, last year's $203 billion U.S. highway improvement bill should bolster domestic sales. Several analysts have upgraded Caterpillar in recent weeks. I'd be tempted to buy it myself--especially if I can get the company to send me one of its baseball caps.