Wednesday, March 9, 2016

Give your investments time to compound

The most important ingredients for success in investment is initial capital outlay at a favorable valuation, annual return and time. Many times investors are able to identify a good company, which has the potential to grow earnings and dividends over time, and reward them handsomely in the process. For example, a business like Diageo (DEO) is a quality one, which is attractively valued today. I believe that it would still be selling premium alcoholic beverages throughout the world twenty years from now. I also believe that this business will be able to earn more over time, and pay a higher dividend twenty years from now. It is quite possible that the higher earnings per share will make the business itself more valuable as well.

The problem is that the investor bails out because either the stock price goes down, it stays flat, or they sell because of the fallacy that nobody goes broke taking a profit. The other silly reason why people sell is because they get scared by rumors and speculation, that makes them get irrational and emotional, and thus they bail out. If you believe that people will be willing to exchange their hard earned money for a good beverage in 2036, then chances are that Diageo (DEO) might be of interest for further analysis.


Even if the initial analysis was correct, the investor might not earn much dividend income and profit, because they were impatient and didn’t give time for the investment to work out. Unfortunately, good things take time to happen in life. If you bought a company like Johnson & Johnson (JNJ) with $1000 today, chances are that you won’t earn a dividend of $100 in the next year. However, over time, if you let the power of compounding do its magic, it will be able to pay a $100 in annual dividend.

The power of compounding is truly miraculous. The problem is that it takes patience for the fruits of compounding to materialize in a matter that makes them material for your wealth. After a certain critical mass is reached however, the compounding process becomes truly astounding. For example, it took Warren Buffett approximately 56 years to become a billionaire. However, by age of 85 he has a net worth of 60.80 billion. If he wasn’t patient at age of 56, he would not have been worth $60.80 billion 29 years later. The $1.40 billion net worth from 1986 pales in comparison to the $60.80 billion he is worth now.

In the case of a company like Johnson & Johnson (JNJ), a 2.80% yield might not look like much today. In fact, the company’s stock price could move up or down by 3% in any single day. However, if you purchase the stock, patiently reinvest dividends, and let it earn more for you and pay you more dividends each year to hold it, the results would be more than satisfactory. This is because it takes time for things to have a noticeable impact. But once they do, the impact is enormous.

Let’s see what will happen if $1000 are invested, that dividend grows by 7%/year and dividends are reinvested into companies paying 3% and growing dividends by 7%/year. The dividends earned in the first year will be close to $30. This is nothing to write home about (though in my case, I am making my retirement projections using an yield of 3% and dividend growth of 5% - 6%/year). If you wait to year 5, your dividend income would have increased to $45.50 per year. By year 10, the investor will be earning something like $74 per year in annual dividend income. After 20 years, this dividend machine will be earning $196 in annual dividend income. This means that every 5 years, the investment will be sending your enough in cold hard cash that you initially put altogether after that point. After 30 years, the investment will be earning something like $520 in annual dividend income.

Just like a small seed turns into a mighty oak, a small investment in a handful of quality dividend growth stocks could turn into a reliable cash machine after you set it up and patiently let it accumulate for the next 20 – 30 years. Thus, in order to be truly successful with dividend growth investing, you need to not only know how to read annual reports, search for and identify great companies, but you also need to have the patience to sit on those investments for long periods of time.

Full Disclosure: Long DEO and JNJ

Relevant Articles:

Let dividends do the heavy lifting for your retirement
Key Ingredients for Successful Dividend Investing
How to become a successful dividend investor
Five Dividend Growth Investing Lessons I Have Learned Over the Years
Dividend Growth Stocks are Compounding Machines

24 comments:

  1. My only quibble is your dividend growth scenario lacks inflation adjusted context. If you had instead used a real dividend growth rate of say 3%, the future value of the dividend could be compared to the cost of today's expenses. No doubt you know this but people reading your blog may not.

    But yeah, there is a reason Einstein said compounding is the eight wonder of the world.

    ReplyDelete
    Replies
    1. I have a quibble with your quibble.

      My readers are not dumb. Your comments assumes they don’t have any common sense – and you are wrong.

      They know that dividend growth has a built in inflation adjustment – historical dividend growth in the US has exceeded inflation by 2.50% - 3% since the 1920s. Perhaps you don’t understand the fact that dividends grow above the rate of inflation over time, therefore providing you with an income stream that exceeds cost of living increases?

      This article illustrates a simple concept about compounding. We can talk about inflation, and taxes, etc – but this would not add much to the discussion.

      I mean we can quibble about anything – I have a quibble with the 3% historical figures- my personal rate of inflation could be zero or lower because I moved to a lower cost of living area, or because I have fixed a large portion of certain expenses etc. I paid $8.95/trade with Schwab, and now pay 35 cents with Interactive Brokers. Investors paid $60/trade 20 years ago just for reference. I used to pay over $700 for rent, and now I pay $500. I used to pay $100 for cable, but now I watch my shows on Hulu and Netflix. If you started dividend investing in 1980s or 1990s, you had to purchase expensive stock manuals with tables - now you can get this information for free.

      Others might quibble that the 3% is too low, perhaps because they spend a large portion of their pay on expensive healthcare.

      Delete
  2. My Road to Half a MillionMarch 9, 2016 at 5:27 AM

    Great article but I do have to comment as a side note that I would not consider Diageo as a quality company because a) is it younger than 20 years and b) Brown-Forman has better financial figures

    ReplyDelete
    Replies
    1. What financial figures are you looking at?

      DEO EPS went from 74P in 2011 to 95P in 2015. You have some stable, reliable growth over time.

      BF.B EPS went from $2.61 in 2011 to $3.23 in 2015.

      DEO has managed to increase dividends every year since it was formed in 1998. Before that, Guinness and Grand Met had been increasing dividends as well for at least 5 years.

      http://web.archive.org/web/19980614083725/http://www.diageo.com/Guinness96Review/index.htm

      http://web.archive.org/web/19980614083701/http://www.diageo.com/GrandMet96Review/index.htm

      I like both BF.B and DEO ( and own both), but BF.B is very overvalued relative to DEO. Given the family control there is an added risk there of the business being acquired. Forward returns on DEO could be better on those from BF.B over the next decade.

      Delete
    2. But Diageo was formed from the merge of Guinness (founded i 1759) and Grand Metropolitan (founded in 1934), it's got much longer history than the Diageo name itself.

      Delete
    3. Diageo PLC (DGE in the UK) has raised their dividends for 27 consecutive years.

      Delete
  3. DGI,

    Right you are. I feel like this can be said about almost every investment. It's how Buffett made his money and also how many others out of his same class (Graham's) made theirs as well. He urges that you should never buy into a company without the full expectation that you will at the very least hold it for a year. Great article- keep up the good work!

    -Dividend Monster

    ReplyDelete
    Replies
    1. The actual Warren Buffett quote is:

      “If you aren't willing to own a stock for ten years, don't even think about owning it for ten minutes”

      Ben Graham made as much profit from buying and holding onto GEICO as spending all the time looking for bargains.

      Delete
  4. Great article. You are right on about compounding. In addition to the yield and DGR, I also look at the annualized percent share repurchase, since that tends to be accretive to total return. On the other hand, if that number is negative, I am very wary, because it can dilute the effect of Yield + DGR.

    ReplyDelete
    Replies
    1. I don't like stock buybacks - I prefer dividends. Companies tend to buy stock when they are flush with cash and their stock prices are high. Companies tend to stop buybacks when things look at their bleakest - unfortunately this is when their shares are at their cheapest points.

      So in summary, companies that buy back shares end up buying high, and not buying low. This is not a smart way to allocate resources.

      Delete
    2. Hi, basic finance tells to buy back shares when cost of buying back is less than cost-opportunity of that money invested. That's why most of companies buy back when shares are low. See Berkshire hathaway as an example of this.
      Cheers
      Luca

      Delete
    3. Luca,

      Basic finance tells you that when you are flush with cash, your stock price is high. If you buy high, you may be wasting money.

      Berkshire buys stock only when it is cheap. Most corporations buy back stock for no good reason other than the fact they have too much cash on hand.

      Delete
  5. Forecasting where any company will be in 20 years from now is pure speculation. This is why I advocate holding dividend ETFs instead of dividend stocks.

    ReplyDelete
    Replies
    1. Saying that a dividend etf will be around in 20 years is pure speculation – there weren’t any dividend etf’s 20 years ago. But a company like Diageo has the characteristics and products of an enterprise that will likely be around in 20 years, that will be earning more and paying more to shareholders. People around the world will still be drinking its beverages 20 years from now – that I am certain of.

      In addition, I am talking about one company that is part of a portfolio that has more than one company. Why is it so hard to understand that I am talking about one company in the context of my overall portfolio? My portfolio includes a lot more than one company.

      A dividend etf is not the optimal way of holding a diversified portfolio of individual dividend paying stocks.

      You get to pay an annual fee in perpetuity with ETFs, for a list of stocks you can buy for free from a broker. The stocks are already known. The rules for this ETF could change at any time and they will make mistakes in weighting companies, adding/removing components. The ETF will have turnover over time, and you will pay for it. You also get a lot of overvalued companies with an ETF and a lot of companies that are not very good.

      Delete
    2. Dividend ETFs have lumpy and irregular distributions which don't necessarily reflect the dividends & dividend growth of the collective stocks they hold. I prefer to hold individual dividend growth stocks for their more reliable and consistent increasing income streams.

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    3. That's a good point about the lumpiness of distributions with ETFs Bernie. This is caused by frequent switching of ETF components.

      Indexing has also distorted peoples ability to apply sound logic. To many index zealots, anything indexing is good, and anything with collecting a portfolio of individual stocks is bad.

      To an indexer, if I bought directly to hold each of the companies in the Dow Jones Industrials Index and end up paying no commissions in the process, I am doing a dumb thing. But if I bought all those companies through an index/etf, I am getting the approval of index zealots. Yet, if I were to buy the ETF I will be subjecting myself to an annual fee in perpetuity - whereas I could simply avoid paying any commissions and just use a service like RobinHood.

      Delete
    4. The inability to see that Diageo was used as an example for a diversified portfolio, and the apples to oranges comparison of Diageo to a dividend etf shows that index person has no common sense

      Delete
  6. Hi DGI,

    I understand the power of reinvesting dividends received and compounding but I am not sure how to put it in practice. For e.g. I bought 10 shares of BHP for 25€ and received dividend of 3€ after a couple of months. How do I reinvest these 3€ ? This amount is too low and i'll have to pay high commission fees...

    Sorry if it sounds like a basic question but there is s start to everything!!

    Thanks in advance,

    BB

    ReplyDelete
    Replies
    1. Most brokers allow for automatic reinvestment of dividends free of charge. You need to reach out to your broker and ask them about it.

      Ideally, you want to make sure that you keep costs low - so you may want to shop around for a low cost broker. If you are a US resident, I would refer you to research RobinHood

      Delete
    2. I am from Belgium and we pay high taxes. My broker only allows me to automatic reinvest my dividends but only if the value of dividends received are worth 1 full share...If not I will still receive them in cash. As I am not investing a huge amount for the moment it is an issue.

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    3. Guys if you deposit 100€/month in buying shares you are already compounding dividends... Either you buy one shot and do not invest further or you deposit and invest little by little. In that case you will be able to buy an amount of shares equal to deposit+dividends/price.

      Delete
  7. So what you are saying is too deposit for e.g. 100€/month and when I have a respectable amount I buy more shares using that money + dividends already received? (it has to be a high enough amount so that I don't pay 10€ transaction fee every time I buy new shares!

    ReplyDelete
  8. Historically, I was a value investor looking for capital appreciation. Once I started looking for investment income, I had a few options: real estate, bonds, dividend stocks.

    I have stayed away from real estate due to the liquidity concerns and management requirements. If you understand the credit risks, high-yield bonds can be a great option, but again there are liquidity concerns.

    I've just started to embrace dividend stocks and find your site to be a useful reference.

    Thanks for the information.

    ReplyDelete

Questions or comments? You can reach out to me at my website address name at gmail dot com.

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