Friday, February 28, 2014

How to Generate an 11% Yield on Cost in 6 Years

A few years ago I shared the story of one small investment of a beginner income investor I met at the beginning of my own dividend journey. This story shows that anyone can start learning investing, no matter what age, level of money they can set aside. All that truly matters is having the right attitude that you can achieve anything you set your mind to, through hard work, persistence, patience and determination. Of course, the most important thing about dividend investing is to get started.

You do not need a lot of money to get started with dividend investing. One should never despise the days of small beginnings, and think that they need a large pike of cash before starting dividend investing. If you start slowly, even with a $10 investment, you are years ahead of most other individuals. Unless you are drowning in debt, you do not have any excuse to avoid investing in some of the strongest dividend paying blue chips today. With brokerages like Loyal3, it is possible to purchase shares in companies like Coca-Cola (KO), McDonald’s (MCD) or Wal-Mart (WMT) with as little as $10, commission free. Of course, you should increase the amounts you put to work for you as your level of income increases over time. Otherwise, you would need to spend a higher amount of time working prior to accumulating a sufficient nest egg.

So back in May 2008, my young friend opened an account with Sharebuilder with $40 that he had to his name. He paid a steep $4 commission, but managed to purchase 1.4196 shares of Realty Income (O) at 25.36/share. Being a poor college student, he was low on cash so he took advantage of a brokerage deal at Sharebuilder. As part of the deal, he received a $50 cash bonus for opening an account and making one investment. So after he made the investment, he essentially started playing with the house’s money, as he had no funds at risk after the rebate.

The next smartest thing this investor accomplished was selecting the "reinvest dividends" button at Sharebuilder. This meant that the first distribution of 20 cents that he received was immediately reinvested at a fractional share of Realty Income (O). That was 0.0084 shares to be exact. His latest distribution was 36 cents, which purchased 0.0093 shares. All in all, the investor’s number of shares has risen to 1.968 shares by January 2014.

He selected Realty Income because he liked the fact that it was a dividend achiever, which had raised distributions for 14 years in a row. The payout ratio was adequate, and there was possibility of further dividends growth down the road fueled by acquisitions and rent increases over time.

The beauty of dividend reinvestment is that it forces the investor to allocate cash back into the same security that paid it, through thick and thin. This eliminates emotion out of investing, and enables the investor to buy when prices are low, without second guessing themselves.

The power of compounding is further magnified, when distributions are received monthly, rather than quarterly or annually. That way, distributions are put to work for you much faster, and you end up taking of advantage of time in the market to a fuller extent.

The other advantage was that dividend payments were increased regularly between 2008 and 2014, which further turbocharged the compounding process. This was a rarity among REITs, many of which had to cut or eliminate distributions to shareholders during the Financial Crisis. The monthly dividend was increased from $0.137375/share in May 2008 to $0.1821667/share by December 2013 for Realty Income.

The high dividend yield from Realty Income of 6.50% in 2008 was also helpful in reaching to 11% yield on cost in 6 years. If you start with a high dividend initially, which is sustainable, and you reinvest this growing distribution monthly, you are turbocharging your dividend income growth exponentially. If you earn $65 on a $1000 investment, and you reinvest dividends at 6% without any growth, your dividend income is destined to double in 12 years, using the rule of 72.

However, the important thing is to not just focus on yield alone, but on the growth of the dividend payments. This is because during retirement, you will need to spend all of that dividend income on daily expenditures. Therefore, having your dividends increase above the rate of inflation is absolutely essential for you to maintain your standard of living. As a result, in my portfolio I have some high yielding stocks with lower growth, and some low yielding stocks with high dividend growth rates. However, the majority of my portfolio is in companies in the sweet spot, which have average yields ( around 3%) and average dividend growth rates ( around 7%).  Long-term investing is a marathon, not a sprint, so you need to search for assets that will provide high inflation adjusted growth for 2 - 3 decades in the future at the minimum.

The other lesson to learn is that this investment was not diversified at all. If our investor had put their money in American Capital Strategies (ACAS) in 2008, rather than Realty Income, they would not have benefited from the power of compounding. This is because American Capital Strategies eliminated distributions in 2008. Therefore, it is important to spread risk between at least 30 – 40 quality securities that have dividend growth potential. That way, if one or two of them cut or eliminate dividends, your overall portfolio income will not decline, but might even increase due to the dividend growth from the remaining components.

The lessons that this young investor learned, after watching a small amount of money compound for years, were worth every single penny. Based on the experience, the investor has been ultimately able to apply lessons learned in his investing for his future goals. As he got jobs after college, and earned promotions, he was able to put increasing amounts of funds to work. It would likely take him at least 2 decades before his dividend income becomes substantial enough for his level of spending, but luckily he is on the right plan to success.

Investing $40 is not much different than investing $40,000 or $400,000, if you have the right attitude and you focus on learning the correct process for achieving your goals. The difference is that you can easily replace $40, but $40,000 or $400,000 would take a long period of time to replace. Therefore, you need to spend the time and learn the right lessons early on, and then use this knowledge as your means increase over time. If you learn how to avoid doing dumb things to your portfolio, you would have dramatically increased your chances of achieving your goals one day.

Full Disclosure: Long O, MCD, WMT, KO

Relevant Articles:

Reinvesting Dividends Pays Off
Do not despise the days of small beginnings
How to buy dividend stocks with as little as $10
Margin of Safety in Dividends
Six lessons I learned from the financial crisis

8 comments:

  1. Dear DGI

    Great post. You are absolutely right about compound interest and time for it to work its magic.
    The only slight problem with re-investing in the same company is that you may be purchasing at a too high valuation as opposed to re-investing the dividends in the most attractive valued company.

    Regards
    Louis

    ReplyDelete
  2. Hi Louis,

    Your comment is right on the money - investing distributions regardless of valuation might not be the most optimal method of allocating those distributions. That's why I accumulate dividends in cash, and allocate the money in what I believe to be the best values at the moment.

    Best Regards,

    DGI

    ReplyDelete
  3. I prefer to use the automatic dividend reinvestments, as I feel that it gets the money "working" for me much more quickly than waiting for it to accumulate to the point where I can buy another investment. The value of time compounding the investment seems more important to me than being absolutely sure I'm paying the best price for a given investment. It ends up much like dollar cost averaging we do in our 401Ks.

    ReplyDelete
  4. Another benefit to having dividends reinvested is that many brokers will do this without charging a commission. DGI's friend in Realty Income will take a long time of dividend accumulation to cover the Sharebuilder trading commission - and will not benefit from the compounding that he sees at the moment.

    Having said that, choosing to have the divs reinvested or not will benefit people differently at different phases of life - retirees might be counting on the income, whereas pre-retirees might benefit from the compounding (while still mindful of the potential for over-high valuations).

    ReplyDelete
  5. I do the same as Jon for now. When my monthly dividends get high enough, I think I'll switch to buying the best value at the time, senario. Right now it doesn't cost anything to reinvest, while there would be anywhere from $5-9 to buy the current best value stock.

    Can't wait till I hit $1k a month!

    ReplyDelete
  6. As Nick mentions, my plan is to turn off the DRIP when I retire, at least to the extent that I need the cash flow to pay expenses. Can't come soon enough for me.

    ReplyDelete
  7. The story reminds me of my first investment. My Grampa gave me 275 to invest in WMT back in the late 90s. After 17 years of reinvestment my yield is now about 18% on the 275. This is a great lesson because in order to get yields like that you have to pick up quality and be patient.

    Two regrets, I didn't practice DGI sooner and I didn't invest any of my paperboy money in WMT!

    Thanks for the posts, I enjoy your blog!

    ReplyDelete
  8. After adjusting my budget in July I am going to be investing like the beginner in this DGI story. With little capital I will have to look for they cheapest (free) way to trade. Better to invest a little capital over time than to wait until it is cost effective. This kinda plays into the conversation about reinvesting dividends vs. applying the cash elsewhere. For us beginners it is better to DRIP it vs. those that earn enough dividends that the broker fee is negligible.

    ReplyDelete

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