Thursday, February 25, 2016

Time is an ally of the dividend investor

The power of compounding is seen as of the eight wonders of the world.

Time is an ally to the quality business. Most of the companies we discuss on this site are some of the best business brands in the world. Those are the types of companies which have many things going for them, such as instant customer recognition, growth prospects, pricing power and other solid competitive advantages, which ultimately lead to more profits, more dividends and higher intrinsic values. When you have a compounding machine that grows shareholder wealth by 7 – 10%/year on average, your only input after investing in that company is to let power of compounding do the heavy lifting for you.

I will repeat that again: If you are able to invest money each month in a diversified portfolio consisting quality dividend paying companies available at attractive valuations, your next job is to sit tight and hold on to your investments. Over time, assuming you had done your proper homework, those companies should be able to earn more and pay more in dividends. Those dividends could then be used to buy more shares of the same company that produced them in the first place, or buy shares in other companies, which pay more dividends on their own.

When I say that you have done your proper homework this includes not overpaying for each company, and building a diversified portfolio consisting of at least 30 - 40 companies that are representative of as many sectors that make sense. It also means understanding how every company's fortunes have been affected by the economic cycle in the past, and making an educated guess as to how sustainable the dividend would be during the next recession. This evaluation is part art, part science, due to the fact that no matter how much analysis you do, the future is somewhat unpredictable to a certain extent. On the other hand, certain traits such as fear and greed are expected. In addition, certain products/services are inherently more recession resistant and more stable than others.

It is quite evident from this simple exercise that someone who regularly manages to put money to work, and manages to regularly reinvest their already growing dividends into more dividend paying stocks, cannot help it but be richer in 5, 10, 20 or 30 years into the future. The important thing is to get started, and focus on quality compounding machines. You do not need to do any complex math, or sit in front of a computer all day to try and outguess where the stock market is going in order to be successful. All you have to do is slowly build a diversified portfolio of dividend growth stocks over your accumulation period, patiently reinvest dividends, and allow some time for the power of compounding to kick in.

Many investors get discouraged at the initial stages of investing, because they are lacking the vision that small amounts of money can turn into very nice nest eggs over a few decades, provided that the right investments are chosen. For those who are consistent in their approach to investing, they will succeed and live off dividends in their retirement. Many others lack the patience to sit quietly, without doing anything for extended periods of time. Actually, inactivity is a competitive advantage in the investing arena, where everyone else buys and sells stocks online rapidly and loses a fortune in taxes, commissions and slippage.

Big fortunes are made slowly over time, as the accumulator slowly buys one income producing asset after another, and uses the income to build out their collection even further. For example, Buffett started out with Berkshire Hathaway in the 1960s as he was transitioning out of his role of a hedge fund manager for the Buffett Partnerships. He then kept using its cashflows to purchase companies or stakes in companies. He then used these additional cashflows to buy interests in more businesses, and let the dividend snowball roll to propel him onto the ranks of the world’s billionaires. A dividend investor can use a similar approach and start out with one dividend paying stock, and then use cash dividends and fresh contributions to acquire stakes in other dividend paying companies. This process of building a sustainable dividend machine will take years however, and would not be complete in a day or two. Therefore, the investor needs to have patience to let the investment work out for them, and stick to their strategy through thick and thin.

Those who have bet on a diversified portfolio of American blue chips, they have the odds in their favor. Over time, productivity gains, efficiencies in the cost structure and overall growth in US and Global economic activities are power propellers for future earnings growth of quality enterprises. This tailwind can pay dividends for years to come.

With dividend growth investing, you get rich slowly, one dividend check at a time. If you bought $100 worth of stock that yields 3%, that first year you will earn $3/share in dividend income.  If you are a dividend investor, you focus on the stability and reliability of the dividend income stream. Your goal is to live off the stable dividend stream, which is more reliable than capital gains. A business can be perfectly fine, and just chugging along nicely, and still be quoted by Mr Market anywhere from $50 to $200.

If you manage to reinvest that dividend, while earnings and dividends grow, that investment can produce $6/year in a decade, $12/year in two decades, $24/year in three decades and $48/year in four decades. This of course assumes that compounding ( growth and reinvestment of dividends) is going on at 7%/year, which is very conservative estimate.  This estimate includes ability to reinvest those dividends at a 3% yield. This estimate also includes the ability to grow that dividend at 4%/year. This shows you that the slow and steady compounding of capital and income, while pretty difficult to notice at the onset of setting up your dividend income stream, can turn into a very noticeable income stream that produces gobs of dividend income.

Let's look at it through the lens of an investor who bought $1,000 worth of shares of Johnson & Johnson (JNJ) at the end of 2007. This was one of the first companies I analyzed on this site in February 2008. An investment of $1,000 would have purchased you 14.9925 shares of the company at the year-end price of $66.70/share. Each share was paying a dividend of 41.50 cents/quarter. The company earned $3.63/share in 2007. This was a P/E of 18.40, and an yield of 2.50%

Initially, you were not making that much in dividends at around $24.88/year, and others were laughing at you for the low “yield” or the fact that you were betting on stocks when the economy was not good or unemployment was high. If you patiently reinvested those growing dividends however, you would be sitting at close to 19.50 shares today. Your initial position would be generating close to $58.40 in annual dividend income. Of course, if history is any guide, Johnson & Johnson would likely raise dividends from the current rate of 75 cents/quarter. Using the closing prices from February 23, 2016, at $104.08/share, the value of those shares was approximately $2,027.

The company earned $5.48/share in 2015, and sold at a P/E of 19 and a current yield of 2.90%. The returns were driven partly by the growth in earnings per share, and part by the ability of the investor to reinvest money through regular dividend reinvestment. I would encourage you to read this article on what drives future investment returns here.

So to summarize:

1) The long-term investor received more dividend income every single year
2) They also managed to double their money in the process
3) This was all possible because this stable business was able to earn more and pay more over time

Full Disclosure: Long JNJ

Relevant Articles:

What drives future investment returns?
Reinvesting Dividends Pays Off
How to value dividend stocks
The most important metric for dividend investing
Johnson & Johnson (JNJ): A Quality Dividend King At An Attractive Valuation

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