Many people have heard the popular riddle of whether they would rather have $1 million today or a penny per day, doubled every day for a month. At first glance for some, it may seem like a no-brainer to take the $1 million. What is not so easily apparent is that by the last day of the month the payment stream from the penny has increased to over $5 million! This compounding effect of the penny fascinated me from a young age and has been one of the reasons I am a firm believer in the dividend growth investing approach. It may not result in instant riches, but over the long term is a very effective way to build sustainable wealth.
The interesting thing about the riddle above is that the right choice drastically changes if the penny is only doubled for 25 days instead of the full 30 days. Only about $167,000 is paid out on the 25th day, resulting in a total of less than $400,000. So by starting the process even just 5 days late, the returns have been drastically reduced. This shows just how powerful compounding can be, and what can be gained by beginning to invest at an early age. I believe that starting early in life is the most important key to success when investing for retirement. Although this advice may not be helpful for people who have already retired, it is something that I think should be stressed to younger generations, especially as statistics show that people nationwide are saving less now than ever before.
A person who bought $10,000 of Altria (NYSE:MO) back in 1980 would now have accumulated a hefty $1.1 million, for an annualized return of 15.2%. Had that investor bought the shares 10 years earlier however, they would have a current value of over $4.2 million. This translates to a 15% annual return, about the same annualized rate as the previous example, but with 10 extra years. We must consider the effects of survivorship bias when observing this however, as these consistently high returns are not common with most companies. However, it shows what a little patience and a lot of time can do to help build wealth.
Let's take a look at what $10,000 invested in the SPDR S&P 500 ETF (NYSEARCA:SPY) today would look like in the future, assuming an investment age of 25 years old and a growth rate of 7%, which is below the average rate since the early 1900s. It is important to note that recent returns in the past decade have been lower. We can compare this to the value of the portfolio started at age 40 and see how starting the compounding process earlier results in huge differences down the road.
When the investor waits until age 40 to begin investing:
As you can see, the investor who waits until 40 to begin investing starts off at a significant disadvantage, and will find it difficult to catch up. It would take about triple the initial investment at age 40, compared to age 25, in order to accumulate the same amount at age 65.
Now let's see how an investor can use the power of compounding over large periods of time through dividend growth stocks to achieve increasing income. I will use the following two portfolios as examples, with the average trailing dividend growth rates listed. I will assume a constant dividend growth rate of 10% for A and 6% for B going forward, although the actual rates will vary over time. The point of this is to show how higher growth rates impact long-term wealth
|Low Yield, High Growth - A|
|Company||Yield||3 Yr DGR||5 Yr DGR|
|Deere and Company (NYSE:DE)||2.11%||16.90%||14.50%|
|Lowe's Companies (NYSE:LOW)||1.70%||19.70%||18.20%|
|Target Corp. (NYSE:TGT)||2.28%||24.70%||20.50%|
|Walgreen Co. (WAG)||2.64%||26.00%||23.70%|
The companies listed above have similar characteristics - huge companies with steady, growing cash flows and low payout ratios. I feel that is why they have the potential to keep increasing dividends by double digit percentages in the near future. The increase in DGR from the 5 year past DGR to the 3 year past rate shows that these companies are accelerating their payouts. The payout ratios for the four companies in the portfolio are 23%, 38%, 32%, and 50%, respectively. This means that they have lots of flexibility with growth going forward. For example, since DE pays out only a quarter of earnings, it is able to reinvest lots of capital into growing the business and increasing sales going forward. It also helps to ensure the safety of the dividend in the future. The second portfolio has a higher current yield, but with lower trailing DGRs.
|High Yield, Low Growth - B|
|Company||Yield||3 Yr DGR||5 Yr DGR|
|Johnson & Johnson (NYSE:JNJ)||3.20%||7.50%||8.20%%|
|Verizon Communications (NYSE:VZ)||4.54%||2.80%||4.10%|
|Waste Management (NYSE:WM)||3.88%||7.00%||8.10%|
These companies are more mature than the companies in Portfolio A, and their dividend growth rates reflect it. These DGRs have decreased over the past 3 years as payout ratios have increased and revenues grow at a slower rate. While they offer an impressive average of 4% yield, these stocks have lower potential for large dividend increases in the future. The way for investors to create their own growth in this portfolio would be to reinvest the dividends. This double compounding would compensate for the lower DGRs.
Shown below is the income stream from Portfolio A, with dividends reinvested versus not reinvested.
Here is the annual dividend flow from Portfolio B, showing both with and without reinvestment.
What can we take away from these graphs? An investor that starts young and accumulates companies that grow their dividends at a high rate has the potential to become very wealthy over the course of his or her career. By starting even just a few years earlier and getting the compound machine running early, an investor can significantly increase capital appreciation. The cash flows shown above increase from $218 to $9,866 and $416 to $4,280, respectively, without reinvestment. With reinvestment, they reach $23,400 and $21,900 by age 65. This combination of lots of time and dividend reinvestment can maximize total returns for an investor.
The graphs also show what preferences should be for each type of dividend growth investor. Younger investors should really focus on the stocks with highest potential dividend growth, as these returns are superior long-term. Someone closer to retirement would most likely be better off concentrating on higher yielding stocks. I believe the 4 stocks in portfolio A would be a great addition to any young investor's portfolio, and portfolio B would be great for retirees.
As an investor of dividend stocks, my eventual goal is build a portfolio of stocks that provide me with sufficient income to cover my living expenses without the withdrawal of capital. Being a young investor, I have lots of time to weather recessions and other market downturns. I am therefore not as influenced by current market prices, unless I am provided with an opportunity to add a quality company at a discount. I hope that compounding my returns over such a long time period will leave me with enough to retire at a young and healthy enough age to enjoy a steady stream of dividend income.
Disclosure: I am long JNJ, MO, TGT, VZ, WAG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.