Wednesday, January 27, 2016

The advantages of being a long-term dividend investor

Most readers know me as a person that buys a stock in a company I like, and then I keep building a position as long as valuation and allocation to security makes sense. Once I purchase a security, my intent is to hold it forever. I rarely sell, and have only done so when dividends have been cut or valuations have been hard to justify. There are many reasons why I keep holding on to a stock for as long as dividends are at least maintained.

If dividends keep increasing, and earnings keep going up, this means that the intrinsic value is increasing. If dividends are at least maintained, I take the approach of wait and see if fundamentals can improve again. I have seen it time and again with established companies like Hershey (HSY), Kellogg (K) and General Mills (GIS), where dividends are increased for many years, and then frozen for a few more years. After that, the streak of dividend increases continues, and the patient investor keeps reaping the rewards. The advantages of being a long-term dividend investor include:

1) Not paying a lot of taxes

The US tax code is set up in a way that every investment activity you do is heavily taxed. The highest tax rate on long-term capital gains and qualified dividends for married individuals earnings over $250K/year combined is 23.60%. The short-term capital gain is equivalent to the marginal tax rate for ordinary income, which could be as high as 42.60% for high earners. If I frequently sell investments, in order to put the money to work in other investments, I would end up paying a lot in capital gains taxes in the process. I would also not have any guarantees that the new investment would make me better off than the original one that I had in the first place. If you have to pay a tax of 23.60% on the capital gains you earned, you would not be able to compound your capital in the long-term very effectively.

2) Not paying a lot of investment costs

Every time I buy and sell a security, I end up incurring investment costs. These used to be much higher prior to the advent of online discount brokerages in the 1990s, when costs for trades fell from $30 - $40 to $5 - $10. This could still be a large cost however, depending on position sizes. If you frequently churn positions, and your size is say $1000, this could result in an annual cost that is as high as 1.50% - 2%. I assume your commission is $5/trade, and you buy and sell and replace a company in this calculation annually with a $1000 stock position size. If the dividend ideas you are following yield 3%, you might end up costing yourself as much as 50% of what you earn in dividend income alone, merely because you paid too much in commissions due to your frequent trading.

3) Not making stupid mistakes

In reality, the more you tinker with your portfolio, the greater your chances of doing something silly. We often deal with imperfect information, which is why selling a company in order to buy another one could look smart at the time, but really dumb in subsequent years. After analyzing some of my earlier sales, I have become convinced that selling merely because stock price went a little ahead of itself for a slightly cheaper company is not a valid reason to sell. That is because the new company usually ends up performing much worse than the original company, both in terms of dividend income and capital gains.

The large chunk of wealth is made by patiently holding on to the holding of your diversified portfolio for the next 20 – 30 years. It is not going to be made by trying to outmaneuver or outwit other investors in a short-term game of outguessing the next point in this or that stock. It is over long periods of time that the true power of dividend growth investing is so evident. If you think about it, there is not much to get excited about a 3% yield that a Coca-Cola (KO) or Johnson & Johnson (JNJ) pay today. However, if those companies manage to raise distributions by 6% - 7% per year for the next 30 years, the lucky investor could end up with a future yield on cost of 12% - 24% between 2025 and 2035. If you reinvest those dividends each year in securities that yield 3% and grow dividends at 6%/year one could easily earn over $370 in annual dividends after 30 years for every $1000 invested. If that growth is 7%, this could translate in over $480 in annual dividend income after 30 years on every $1000.

Of course this sort of behavior works for companies that have sustainable advantages over time ( wide moats), which can help those companies earn high rates of return on new and existing capital, and earn more money so that they can pay more in dividends. Things can change, but in aggregate, a diversified portfolio of those best in breed companies should do very well for a passive dividend investor, allowing them to sleep better at night. If you are investing in companies with promising future like Tesla, Facebook, 3D Systems, or Twitter, the principles in the article outlined here would probably not work that well for you, due to the nature of business and lack of sustainable moats.

Full Disclosure: Long KO, JNJ, GIS, K, HSY

Relevant Articles:

Successful Dividend Investing Requires Patience
Dividend investing timeframes- what's your holding period?
How to Make Money in Your Sleep with Forever Dividend Investing
Should you sell after a dividend freeze?
The most important metric for dividend investing

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