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Over the past couple of months, I have gradually shifted away from reinvesting dividends on autopilot into the same companies that pay them out. In some regards, this was an inevitable move. When I study the records of investors, I admire people such as Charlie Munger, John Neff, Donald Yacktman, and the old-guard gentlemen that ran Tweedy, Browne, the discussion of reinvesting dividends back into the same company is never seriously presented. Rather, they always speak in terms of value and creating systems that treat dividend income as something that can fuel additional searches for value. Often, when the people I respect in a field all do the same thing, it is usually worth giving the idea serious consideration.

Personally, I have come to the decision that I should stop reinvesting dividends into the same company for the following two reasons:

1. Taking the dividend in cash guarantees a quarterly accumulation of permanent utility from the investment. I have recently studied what happened to long-term shareholders of excellent companies that eventually wiped out (or nearly wiped out) shareholders, such as Wachovia, Kodak, General Motors (NYSE:GM), and Bank of America (NYSE:BAC) during the worst of the financial crisis. When I tallied up the dividends for each company over 20+ years, I found that the investment often paid for itself if you add up all the dividends that accumulated. Obviously, all of this wealth got destroyed if reinvested into the same company.

Instead, I choose to think of each dividend payment as an insurance policy that can limit the amount of my losses if the company goes bankrupt. I'll use Royal Dutch Shell (NYSE:RDS.B) as an example. Right now, the oil company currently pays out $0.86 per share, or $3.44 annually in dividends. If I own 1,000 shares (for a total investment of $67,000), then I would receive $3,440 in the first year as dividends. Even if the dividend remained constant (unlikely given Royal Dutch Shell's history of raising the annual distribution), I could receive over 15% of my investment back in just three years (in nominal dollars). Most likely, it will be more than this because Shell's dividend tends to rise with time.

By the way, this is probably one of the best secrets that can explain why dividend investors can quietly go about doing their thing while most investment commentary chooses to focus on whatever is going with Amazon (NASDAQ:AMZN) or Netflix (NASDAQ:NFLX) lately. Let's assume that Royal Dutch Shell's price barely moves over the next twelve months, and trades at $67 per share this time next year. While some investors might look at the stock chart and see a boring oil company barely budging, the dividend investor will have received a 5% return (read: nearly half the market's historical total return average) from the dividend alone. That is a very real form of under-the-radar wealth creation.

For me personally, I find a lot of appeal in taking that dividend income and applying it towards a different dividend security. That way, every year that the company "stays alive" and continues to pay the dividend, I can receive a rebate that, with each passing dividend payment, further isolates me from receiving a 100% loss on investment.

To continue with the Royal Dutch Shell example, let's assume two highly unfavorable inputs: (1) the dividend does not grow over the next ten years, and the company goes bankrupt ten years from now (and I do not sell). While it goes without saying that I would hate to experience such a terrible capital loss, seeing a $67,000 investment go up in smoke can be a lot easier to tolerate if I used that base to buy $3,440 worth of McDonalds (NYSE:MCD) stock in year one, $3,440 worth of Johnson & Johnson (NYSE:JNJ) stock in year two, $3,440 worth of Procter & Gamble (NYSE:PG) in year three, and so on. That is a great way to hedge against permanent capital loss. The bottom-line is this: by taking the dividends and employing them elsewhere, you have a much greater chance of "having something to show for it" in the event that something bad happens to your original investment.

2. The dividend income should be put towards finding an undervalued stock, particularly when there are fully valued or overvalued stocks sitting in the portfolio paying out dividends. While the first reason I listed above is subjective and is consistent with my own personal disposition, this is the textbook reason why value investors do not reinvest dividends.

To use an example, Colgate-Palmolive (NYSE:CL) is an excellent company. Even though it is slightly overvalued, there are a lot of reasons to hold on to the stock (particularly if the holding has been built up over many years and is in a taxable account). If I owned the stock, I wouldn't want to use my dividends to buy more shares at 22x earnings. There is no margin of safety at that kind of price. I'd rather take that Colgate-Palmolive dividend check and put it in a company like Shell that is trading at 7x earnings.

The key here is to think of each dividend arrival as a new purchase decision. There is a difference between holding a company that has appreciated in value and deciding to accumulate additional shares at the higher price. I have reached a point where I am content to hold an excellent company that has become overvalued, but I am not content to use my dividend income to fund further purchases of a company that has become overvalued. The dual desires to put dividend money into an undervalued company while simultaneously not putting money into an overvalued company have convinced me that it is worth pooling dividends together.

The appeal of not reinvesting dividends is that it creates a margin of safety on three fronts. First, taking the dividend income and putting it elsewhere hedges against the failure of the original dividend-paying company. Secondly, it can provide a margin of safety against plowing dividend income back into a company that is overvalued. And lastly, it allows me as an investor the opportunity to take the dividend checks and buy the stock that I believe is most undervalued at the present time. Although you should do fine if you reinvest your dividends back into the same company, I decided to shift my strategy for the three reasons listed above.

Source: The Wisdom Of Not Reinvesting Dividends