Why Stock Charts Are Misleading for Dividend Investors?

As a dividend investor, I do not really look at stock price charts. The things I look for are trends in earnings and dividends, catalysts for further earnings growth, and whether the security is cheap relative to the other investment opportunities within my opportunity set. In other words, if I expect PepsiCo (PEP) to deliver the same growth as Johnson & Johnson (JNJ), but Johnson & Johnson is available at a cheaper valuation, I would buy Johnson & Johnson (JNJ). It won’t matter whether Johnson & Johnson is selling at a 52 week high, or 52 week low.

However, I know that for a lot of investors, they look at stock price charts for whatever reason. I believe that focusing only on stock price history is misleading, because it doesn’t show you everything you need to know about a security.

The missing link of course are dividends. One of the biggest lies told to investors is that stocks , as measured by S&P 500 or Dow Jones Industrial Average, went nowhere between 1929 – 1954 and 1966 - 1982. It might be true that stock prices were volatile but mostly flat, however dividends provided for a handsome return to those patiently reinvesting them through thick or thin.

For example, if let's look at the annual price performance of the S&P 500 between 1929 and 1954. The price in 1929 was 24.86 points, which was not reached again until some time in 1953. Based on looking at price alone, someone could incorrectly assume that stocks did not provide any returns to shareholders for a quarter of a century.

However, if you add in dividends, and reinvest them, you can see that someone who put money in 1929 broke even by sometime in 1937. This is a very interesting finding, because it shows that even during a period where unemployment was at 25%, industrial and agricultural production fell, GDP fell stocks in the US did well for the long-term shareholder who was not afraid.  In fact, during that 25 year period, the whole return on US equities came from reinvested dividends. Over that period from 1929 to 1953, a $1000 investment quadrupled in value.

Let's also look at the 1966 - 1982 period for US stock prices. Again, I used historical annual data for the S&P 500. You can see that between 1966 and 1982, the S&P 500 increased from $93.32 to $117.28. If you look at reinvested dividends however, you can see that a $1000 investment at the end of 1966 pretty much doubled in value during that period.

Dividends usually accounted for 40% of average annual total returns. They are always positive, and more stable than capital gains, which makes them as a reliable source of income in retirement. Interestingly enough, prior to 1994, the yield on US Stocks was averaging around 4%. Incidentally, a researcher found that it is “safe” to "withdraw" 4% of your portfolio in retirement. I say incidentally, because it is clear that this researcher inadvertently makes the case that the safe 4% average annual spending comes entirely from dividends and the high interest income that was prevalent at the times. For those in the accumulation stage, the thing to remember is that reinvested dividends have accounted for 97% of stock market gains since 1871.

The shortcoming of stock charts is also evident when looking at individual companies returns over time.  Another thing stock price charts miss is spin-offs. Altria (MO) is a prime example of this, if you look at historical charts on Yahoo Finance. To anyone who only looks at the chart, and ignores everything else, it looks like Altria has done pretty badly since 2007. In reality, the chart fails to account for the fact that Altria (MO) spin-off Kraft in 2007 and Phillip Morris International in 2008.

Those two spin-offs actually have confused a lot of institutions. For example, despite the fact that Altria had a record of consistently increasing dividends for over a quarter of a century, it was booted off the S&P Dividend Aristocrats index in 2007. Anyone who blindly followed the index, likely also sold their shares. In reality, Altria (MO) never cut dividends. Anyone who purchased Altria in early 2007, has been receiving growing annual dividends ever since. The only issue is that those dividends were generated from shares of Altria (MO), Phillip Morris International (PM) and Kraft Foods (KRFT) ( and later Mondelez (MDLZ) as well). This is why I am very skeptical about blindly following indexes - there could be lapses of judgment that stem from mechanical application of rules, without really giving much thought to the reality and facts involved.  This is also why I think it is important to analyze every company I own, or expect to own in detail. Luckily, when Abbott split in two in 2013, the mighty S&P Dividend Aristocrats committee decided to keep both Abbott (ABT) and Abbvie (ABBV) in the index. Either way, I focus on the dividend champions index, which is the most complete list of US dividend growth stocks I know of.

The spin-off situation at Altria also confused a lot of "chartists" that appear on CNBC. You might want to check this article - it blatantly ignores the fact that the split from 2007 and 2008 ever happened.

To summarize, stock price charts only show one part of return that investors would have received. However, without taking into accounts dividends, and the power of dividend reinvestment, you cannot understand what the total returns on an investment really are. It pays to research every investment in detail, before putting hard earned money to work there. In addition, it pays to own investments that regularly shower their investors with cash, in order to reduce the risk of outliving money in retirement. As we was above, stock prices can remain flat for extended periods of time - anywhere from 16 to 25 years. If you only rely of capital gains to bail you out, you might be in for some nasty surprises if you happen to invest during one of those periods. An investor who expects to live off the dividend stream generated from their portfolio can afford to ignore stock price fluctuations, and enjoy the retirement that they have worked so hard to achieve. An investor who wants to sell of portions of their portfolio will be in real trouble if that portfolio doesn't pay dividends and share prices fail to increase.

Full Disclosure:

Relevant Articles:

- Altria Group (MO): A Smoking Hot Dividend Champion
- S&P Dividend Aristocrats Index – An Incomplete List for Dividend Investors
- S&P 8000 – The power of reinvested dividends in action
- Dow 370,000
- The case for dividend investing in retirement

How to turbocharge dividend growth

Once an investment is made, and assuming no new money is put to work, there are four levers to help an investor reach dividend income goals:

1) Attractive entry price

The importance of the entry price cannot be overstated. Even the best company in the world is not worth overpaying for. It matters a lot that you can acquire those shares at low valuations, which ensures better entry yields. For example, if you bought Coca-Cola (KO) in 1999 at $23.50/share, you would have paid over 30 times earnings and received an initial yield of about 1.30%. Despite the fact that earnings and dividends increased rapidly, your yield on cost did not go that much higher than 5.20% although you did earn some capital gains in the subsequent 15 years. You would have been better served putting that money in REITs, oil companies or tobacco shares, which were cheap at the time and had better starting yields. Therefore, when you buy shares, it pays to always pick the ones with the cheapest valuations. Quality should never be sacrificed, but if you make a purchase at a cheap enough price, you can earn a decent return even if growth projections turn out to be poor. For example, I bought ED in 2008 – 2009 at really low valuations and entry of 6%. In hindsight, this was a mistake since the dividend was growing slower that inflation. But I still earned a high return despite that, and once I realized the mistake I sold and redeployed capital elsewhere.

2) Dividend growth

Dividend growth is the second important component in turbocharging the dividend income. A company that is cheap, and manages to grow dividends is a must to invest. Even if you spend your dividend income each year, your dividend income still increases. For example in 2004 Coca-Cola sold for 20-21 times earnings and yielded close to 2.50%. Since then the dividend income would have more than doubled by now, rising from 50 cents/share in 2004 to $1.22/share by 2014. Historically, dividends per share on US stocks have grown by 5%- 6%/year. This has beaten inflation, and ensured that the purchasing power of your passive income is maintained.

3) Dividend reinvestment

Another important component to grow income is the power of dividend reinvestment. Let’s assume a scenario where you have a company that yields 3% today, which manages to grow dividends by 7%/year and you spend all your dividend income. In this case, using the rule of 72, you will end up with double the dividend income in a decade. However, if you decided to reinvest those dividends into more shares yielding 3% and growing dividends by 7%/year, your dividend income will double in approximately seven years. It is important to treat reinvestment carefully however, and be mindful of valuations when doing so. In some cases, it might only be cost effective to automatically reinvest dividends, particularly if the position is only a few hundred dollars for example. In other cases however, it might be preferable to accumulate cash dividends for a month, and then put that amount to work in your best ideas at the time. This would work if you generate $600 - $800/month in dividend income.

4) Tax advantaged growth

Two things in life are certain – death and taxes. Investors who receive dividend income and are in the 25% tax bracket have to pay 15% tax on qualified dividend income. This reduces the amount of money one can feed their dividend machine. In order to reduce the effects of this obstacle, many dividend investors place their stocks in tax-advantaged accounts like Roth IRA’s. As a result, their dividends grow tax free, and therefore they could reinvest the whole amount into more dividend paying shares. If you are in the 15% tax bracket however, this means your qualified dividend income is essentially tax free.

The four points discussed above could be best illustrated by a small investment I made in Kinder Morgan Energy Management LLC (KMR) in 2009. This was one of the smartest investments I ever did, and hit the four points perfectly. I was bullish on the Kinder Morgan Partnership (KMP), which was a dividend achiever that offered sustainable current yield, and high distributions growth. I liked the prospect for high distributions growth and high current yields. However, I noticed that KMR was selling at a discount to KMP. KMR was equivalent to KMP in every single economics way, with the only exception being that it paid distributions in additional shares, and not in cash. Some investors disliked this idea, which explained why KMR was always cheaper by 5%-10%. In addition, since the distributions were payable in additional shares of KMR, this meant that IRS saw them as stock splits and considered them tax-free as long as the investor held on to shares. I thought of buying up KMR since I am in the accumulation phase, and then if the gap narrowed to sell and buy the limited partnership units and live off those distributions. For each dollar invested in August 2009, with distributions being reinvested tax-free at KMR that was selling at a massive discount, I ended up with approximately $2.80. Thus, an investment of $1000 back then would have turned into approximately $2800 today. Once the acquisition by Kinder Morgan Inc (KMI) is performed, and each of my shares of KMR is exchanged for 2.4849 shares of Kinder Morgan Inc, this small investment will result in an yield on cost of over 13% at the current rate of $1.76/share. At the $2/share annual dividend that is expected by Kinder Morgan Inc in 2015, that $1,000 investment in 2009 will generate close to $150 or a 15% yield on the amount invested. Not too shabby if you ask me.

As we all know however, Kinder Morgan Management LLC (KMR) is about to stop trading, since its shares will be exchanged for shares in Kinder Morgan Inc (KMI).

A recent example was the purchase of shares in several companies in tax-advantaged accounts such as Roth IRA and Sep IRA. I plan on maxing out the Roth IRA in 2015, and the SEP IRA, along with the 401 (k) and a newly started Health Savings Account. When you get the powers of compounding withing a tax-deferred vehicle, the results are truly spectacular.

Full Disclosure: Long KMR, KMI, KO,

Relevant Articles:

- Kinder Morgan to Merge Partnerships into One Company
- Kinder Morgan Limited Partners Could Face Steep Tax Bills
- Kinder Morgan Partners – One Company three ways to invest in it
- How to buy Kinder Morgan at a discount
- Two and a half purchases I made this week