Maximizing Long-Term Returns With Dividend Investing

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 |  Includes: KO, MCD, PG
by: Integrator

There are many aspects of dividend growth investing that I value. These include the focus on companies with sustainable competitive positions, the ability to earn tax advantaged income and most importantly for me, the ability to achieve financial independence.

Not losing any of my investment capital is my Rule No 1. If I have my money in a business that is paying increasing dividends, it is also likely that the business is growing earnings and increasing cash flow. In order to consistently increase earnings and dividends over a long period time, it is highly likely that the business has some sustainable competitive advantage and unique value proposition. In my opinion, I'll have the best chance of preserving my capital if I have it sitting in a business with strong barriers to entry and good cash generation. Businesses like McDonald's Corp. (NYSE:MCD), Coca-Cola Company (NYSE:KO) and Procter & Gamble Co. (NYSE:PG) have solid brand and business advantages that I expect to continue indefinitely.

However there is also one additional aspect of dividend growth investing that I have to this point under appreciated which is that dividend growth investing helps you maximize long term return. I'm not just referring here to the contribution of dividends to total return, which is significant. Rather, with dividend stocks, the ongoing income stream that you receive from a stock actually provides you with a strong incentive not to sell, in no small part because you are holding a stock which is providing you with a progressively rising dividend stream.

Why is this significant? For investors in companies that pay increasing dividends there is an inbuilt mechanism to implicitly drive the price of a stock higher over time. With increases in profitability, dividend paying companies are able to increase the amount of the dividend that they pay out to investors. What this then means is that to the extent the risk profile of the company is unchanged, investors will "bid up" the stock price to the extent of the increase in the dividend to keep the effective risk / return of the company the same.

There is this virtuous cycle that is in-built for dividend paying companies with wide moats and sustainable competitive advantages giving rise to increasing profitability, cash flows and rising dividends all of which work collectively to increase not only dividend income to an investor but also maximize wealth over the long term if an investor can remain invested in a stock.

During this process of progressively increasing stock prices and wealth accumulation, there can be an increasing temptation for investors to look to take some profits and cash out on the ride up. This used to be an attitude that I have often had at many times in the past myself. However the mistake in doing so is that an investor can actually be short changing themselves and missing out on continued and sustained ongoing stock appreciation that continues well after profits have been taken.

Consider the example of McDonald's stock. An investor who invested $10k in McDonald's stock in 2003 would have almost $80k worth of stock today. Along the way, with the spikes in Mcdonald's stock, an investor would have had numerous opportunities to cash out and reinvest those proceeds into the S&P 500. However, looking back an investor who did so would probably be kicking themselves for the loss in potential returns that they would have experienced from following such a strategy. While a $10k investment in McDonald's 10 years ago would have turned into almost $80k today, a similar $10k investment into the broader S&P 500 basket would be worth approximately $22k today.

The opportunity cost of selling too early is best illustrated for much longer holding periods. An investor who invested $10,000 in the S&P 500 basket of stocks in 1970 would have almost $190,000 today. Certainly not a bad return. However consider that same investor who invested $10,000 in Coca Cola stock. They would have an investment worth almost $1.67M today. That's almost 9 times what a comparable investment in the S&P would have delivered.

What may have been less obvious is the significant dividend income that investors in both McDonald's and Coca Cola would have received. This would likely have been a strong motivator to hold onto both stocks. The almost $50k in dividends that an investment in Coca Cola would pay today as well as all those dividends which would have been received over the years should have provided strong motivation for an investor to continue to hold Coca Cola stock, and resist the urge to sell out.

In both cases, investors who enjoyed the ride up in McDonald's and Coca Cola may have looked to have cashed out along the way. However it's clear that those investors who sold out too soon to take profits and reinvested in an index such as the S&P may have actually short changed themselves.

Had investors in McDonald's and Coca Cola actually held onto their stocks over the time periods referenced then they would have not only been rewarded with a rising dividend income stream but additionally with significant total return over a long period of time.

My goal of investing for an accelerated financial independence has meant that I am focused on a growing income return from high quality businesses. Implicitly, that has given me the focus of a long-term owner in a business and a willingness to hold a stock for long periods of time to maximize the growth of that dividend income. The interesting thing for me with such an approach is that I also minimize my risk of selling what could be a good long-term investment too early. In having a focus on maximizing my growing dividend income, I actually also give myself the best opportunity of maximizing my total long-term return.

Disclosure: I am long MCD. 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.