Wednesday, July 15, 2009

Dividend Reinvestment is important

Dividends represent a tangible return on investment, which investors can choose to reinvest, spend or just keep in the bank. Unlike capital gains, which can disappear quickly, dividends cannot be taken away from you once you have received. In addition to that, dividends tend to provide the only source of total returns during sideways and bear markets. When dividends are reinvested however, investors get the power of compounding on their side.

The power of reinvested dividends could be seen if we concentrate of the recent stock market activities of the past decade. Back in 1999 and 2000 the internet and technology stocks were all the rage; it was not uncommon for a dot com entrepreneur selling anything from pet supplies to books to become a multimillionaire overnight after a successful initial public offering. Then the tech bubble burst, and millions of investors lost a ton of money. For example, the tech but not dividend heavy Nasdaq Composite is still below its all time highs set in March 2000.
The housing bubble helped the economy turn around in the early 2000’s and we had a great run up until 2007, when once again all time highs were being hit daily. After the financial bubble burst, taking down companies like Fannie Mae, Bear Stearns, Lehman Brothers and others, stock markets took a dive to levels not seen in 13 years.

At the same time, dividends paid out by the companies in the S&P 500 increased from 16.69 points in 1999 to 28.39 points in 2008. Expectations for 2009 dividends in the S&P 500 is for a drop to 21.60 points, mainly due to dividend cuts in financial related stocks. Normally however, dividend payments are not as volatile as stock prices, based off this chart of the past 32 years of quarterly payments for the S&P 500.

I used data on the S&P 500 ETF (SPY) to backtest the returns of S&P 500 and S&P 500 with reinvested dividends from June 30, 1999 to June 30, 2009. If you had invested $100 in the S&P 500 in June 1999 your investment would be worth about $67.10 now. If you reinvested your dividends however, the value of your investment would have been $78.80 or 17% higher.

The difference of course would have been much higher had dividend yields been higher over the past decade. The 1990’s bull market brought in large capital gains for investors and high stock prices. This pushed down yields as companies spent money on buybacks and aggressive acquisitions, forgetting whom they are actually working for.

For example if we look at Con Edison (ED), a New York electric, gas and steam utility, we would notice that the stock price has mainly been flat over the past decade. The stock has been supported by its strong dividend yield of 5%-6% over the past decade.

Ten years is not really that long of a period. If we stretch it out to 30 years for the S&P 500, which is a period almost equal to the typical investing lifespan of an average investor in the accumulation stage, the results from reinvestment of dividends is much more pronounced.

True dividend investors however understand that the S&P 500 dividends should be taken with a grain of salt, since only 70% or 80% of companies in the index pay any dividends. In addition to that careful dividend investors would most likely screen out most dividend companies in the index benchmark since only a select few have a history of consistently raising dividends for more than a decade.

True dividend investors would slowly build a diversified portfolio of income producing investments in order to get the full force of dividend reinvestment on their side. That is something I have doing for some time now. Some stocks where I keep reinvesting my dividends include:

Johnson & Johnson (JNJ) (analysis)
Procter & Gamble (PG) (analysis)
McDonald's (MCD) (analysis)
Altria (MO) (analysis)
Chevron Corporation (CVX) (analysis)

Dividends are a sign of quality. They force management to look at cash flow and how it invests in its business. I am confident in the ability of those companies to generate enough cash flow in order to support a growing stream of dividends.

Full Disclosure: Long ED, CVX, JNJ, MCD, MO and PG

Relevant Articles:

-Should you re-invest your dividends?

Popular Posts