Reinvest Growing Dividends: Don't Fall For Big Yields

by: Bob Wilson

"More people get killed chasing after a higher yield than by looking down the barrel of a gun."

Jesse Livermore was saying it's a mistake to buy stocks with what look like dividend yields far above the norm for their industry group. There are at least two reasons for this. One, the higher the dividend, the harder it is to increase it annually. Two, stocks with high dividends commonly don't increase in price very fast because the money that might have gone for R&D, acquisitions, plant expansion or share buybacks is being paid to shareholders.

Another reason for J.L.'s statement is that the dividend might be high because the stock has dropped in price. This could be cyclical, so maybe the stock is a good recovery candidate. But companies are generally loathe to cut their dividend. Plenty of companies maintain their dividend through a rough patch, so if they don't, you know the business is in a tight spot. A drop in the stock price might suggest this, but if it's accompanied by a dividend cut, storm warnings are being posted.

I'm making an argument here for common stocks with dividend yields in the range of 2%-6% with good records of annual dividend increases. REITs, utilities or telecoms, for example, could be in the high end of that range. But annual dividend increases of 5%-8% are the secret sauce. The higher the dividend, as a rule, the less likely you'll see that rate of annual dividend growth.

Standard and Poor's published a white paper several years ago (May 2, 2005) in which they described their Dividend Aristocrats. These are 50-60 stocks that have paid a dividend a long time--Eli Lilly (NYSE:LLY) and Consolidated Edison (NYSE:ED) started paying dividends in 1885--and have raised their dividends at least for the past 25 years. This is a good place to look for dividend growers you'd want to own anyway, stocks like Automatic Data Processing (NASDAQ:ADP) or Abbott Labs (NYSE:ABT). From 1990 to 2005 the Dividend Aristocrats beat the S&P 500 by 2.5%/yr in CAGR while posting lower volatility of returns (i.e. a smaller standard deviation), producing a lower risk/return.

Why are annual dividend increases so important? The answer goes back to 1924 when E.L. Smith wrote "Common Stocks As Long Term Investments", based on a study he had done of stock prices from just after the Civil War up to 1922. None other than J.M. Keynes reviewed this book (1925), in which Smith wrote that well managed companies typically retained some earnings over and above what was paid out to shareholders as dividends. These retained earnings were then used to expand the business, which usually contributed to more earnings and higher dividends. Keynes wrote in his review (his italics): "Thus there is an element of compound interest operating in favor of (stocks of such industrial companies)."

Some, including Warren Buffett, have attributed the bull market in the 1920s in large part to Smith's book and Keynes' review ("Warren Buffett on the Stock Market", Davis Advisors Investor's Guide 2002).

If a stock is in an industry where big dividends are the norm, then fine. But let's look at a hypothetical that shows why annually increasing dividends, though they start modest, are the way to go if you don't need the cash.

Mary and Louise both start out with 100 shares of a $40 stock (not the same one). Mary's stock is an electric utility with the ticker UTLY, initially paying a dividend of $2.40/yr (6%). This stock grows at 4%/year and Mary takes her dividend in cash each year, glad to see it grow annually by 4% as well. She's happy with these low growth rates because she likes UTLY's low volatility.

Louise's stock is a consumer defensive issue with the ticker CONS, initially paying $1.20/yr (3%). This stock grows at 9%/year and the dividend grows at 6%/year. Louise reinvests her dividends in shares. She knows CONS can be volatile but she's willing to take on the added risk in exchange for higher potential growth rates on the stock price and its dividend.

Here's how Mary with UTLY and Louise with CONS start out:

initial

capital

initial

dividend

growth of

stock price

growth of

dividend

volatility
Mary $4,000 $240 4% 4% low
Louise $4,000 $120 9% 6% moderate
Click to enlarge

After 30 years here are the results:

Mary received $13,460 in dividends and her 100 shares grew to $12,974 ($129.74/shr), for a total of $26,434. This is a total return of 6.5%/yr.

Louise's 100 shares grew to 184.32 shares that appreciated to $530.71/shr, for a total of $97,821. Her total return was 11.25%/yr.

I intended this hypo to have at least vaguely realistic values relative to the stock types and comparative risk levels to illustrate the power of stock price growth combined with growing dividends reinvested. Even if Mary's utility had somewhat better growth rates, she is still going to come up well behind Louise's total return. If both women started with $40,000 in their stocks, in this scenario, Louise would have had $713,870 more than Mary.

Another benefit of reinvesting growing dividends is that they buy fewer shares when the stock price is higher, more shares when it's lower. This is similar to "dollar cost averaging" that mutual funds sometimes talk about.

One last point. Watch out for big dividend yields where a significant part of the dividend is actually just a return of (your) capital. If this is the main reason the dividend has a tax advantage, give it a very skeptical look. Such stocks are not known for their price appreciation, as a group.

If you see a dividend yield up around 10%, well, that might be just another form of junk bond because it's competing with junk. Buying that high of a yield could have downside risk to the stock price without much upside to compensate. That's what Mr. Livermore was talking about.

Here's the takeaway:

A) Don't fall for dividends greater than about 5% if you are shooting for good stock appreciation too. The higher the dividend, generally the slower your stock price will appreciate. Recovery candidates are sometimes exceptions. Take a dividend yield of 3%-4% and make sure there's a healthy past growth rate on those dividends on the order of 5%-10%.

B) If you don't need your dividend income, reinvest it in shares. You'll have to keep track of your basis in a taxable account, but it's worth it.

C) Try to avoid letting Mr. Market drive you into cash out of fear about a market decline. If your sell discipline kicks in, fine, but then be sure to re-establish those liquidated positions when the market has settled down again. In a bear market remind yourself that there have been a lot of them and the market has never failed to recover from every single one of them.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.