The Significance of Dividend Reinvesting

Dividends represent a tangible return on investment, which investors can choose to reinvest, spend or just keep in the bank. Unlike capital gains, which can disappear quickly, dividends cannot be taken away from you once you have received them. In addition to that, dividends tend to provide the only source of total returns during sideways and bear markets. When dividends are reinvested however, investors get the power of compounding on their side.

The power of reinvested dividends could be seen if we concentrate the recent stock market activities of the past decade. Back in 1999 and 2000 the internet and technology stocks were all the rage; it was not uncommon for a dot com entrepreneur selling anything from pet supplies to books to become a multimillionaire overnight after a successful initial public offering. Then the tech bubble burst, and millions of investors lost a ton of money. For example, the tech but not dividend heavy Nasdaq Composite is still below its all time highs set in March 2000.

The housing bubble helped the economy turn around in the early 2000’s and we had a great run up until 2007, when once again all time highs were being hit daily. After the financial bubble burst, taking down companies like Fannie Mae, Bear Stearns, Lehman Brothers and others, stock markets took a dive to levels not seen in 13 years.

At the same time, dividends paid out by the companies in the S&P 500 increased from 16.69 points in 1999 to 28.39 points in 2008. Expectations for 2009 dividends in the S&P 500 is for a drop to 21.60 points, mainly due to dividend cuts in financial related stocks. Normally however, dividend payments are not as volatile as stock prices, based off this chart of the past 32 years of quarterly payments for the S&P 500.

I used data on the S&P 500 ETF (SPY) to backtest the returns of S&P 500 and S&P 500 with reinvested dividends from June 30, 1999 to June 30, 2009. If you had invested $100 in the S&P 500 in June 1999 your investment would be worth about $67.10 now. If you reinvested your dividends however, the value of your investment would have been $78.80 or 17% higher.

The difference of course would have been much higher had dividend yields been higher over the past decade. The 1990’s bull market brought in large capital gains for investors and high stock prices. This pushed down yields as companies spent money on buybacks and aggressive acquisitions, forgetting whom they are actually working for.

For example if we look at Con Edison (ED), a New York electric, gas and steam utility, we would notice that the stock price has mainly been flat over the past decade. The stock has been supported by its strong dividend yield of 5%-6% over the past decade.

Ten years is not really that long of a period. If we stretch it out to 30 years for the S&P 500, which is a period almost equal to the typical investing lifespan of an average investor in the accumulation stage, the results from reinvestment of dividends is much more pronounced.

True dividend investors however understand that the S&P 500 dividends should be taken with a grain of salt, since only 70% or 80% of companies in the index pay any dividends. In addition to that, careful dividend investors would most likely screen out most dividend companies in the index benchmark since only a select few have a history of consistently raising dividends for more than a decade.

True dividend investors would slowly build a diversified portfolio of income producing investments in order to get the full force of dividend reinvestment on their side. That is something I have been doing for some time now. Some stocks where I keep reinvesting my dividends include:

Johnson & Johnson (JNJ) (analysis)

Procter & Gamble (PG) (analysis)

McDonald's (MCD) (analysis)

Altria (MO) (analysis)

Chevron Corporation (CVX) (analysis)

Dividends are a sign of quality. They force management to look at cash flow and how it invests in its business. I am confident in the ability of those companies to generate enough cash flow in order to support a growing stream of dividends.

Disclosure: Long ED, CVX, JNJ, MCD, MO and PG

Comments

[captainccs:]

This argument is one huge fallacy. Of course if you reinvest in a dividend paying stock you'll have more of that stock than if you didn't - no argument there, but that is NOT the issue. The test is to compare your total wealth after reinvesting in the "same" stock and using the money for something else, like buying another stock.

Let's suppose you have 100 shares of stalwart XYZ that shows zero growth but pays a 10% dividend. If you reinvest those dividends in stalwart XYZ your CAGR is going to be 10%.

Let's suppose that instead of reinvesting the dividend in stalwart XYZ you buy shares in stalwart ABC that pays 15% dividend and shows no growth, your CAGR would be higher than 10%

Or let's suppose that you invest the XYZ dividend in fast growing MNO that is growing by 20% annually, again your total CAGR would be higher than 10%

The conclusion is that at any time there is a best investment that is not necessarily reinvesting in the dividend paying stock which is just one of many options.

Jul 15 10:30 AM

[DanielMiller:]

I tend to reinvest my dividends in a company only if the stock price is closer to its 52 week low than its high when the dividend is paid put. If a stock is on a tear, I take the dividend as cash. I guess it all comes down to personal preference.

Jul 15 10:43 AM

[ppearson:]

I agree, all of these articles operate under the retarded hypothesis that the dividend money is just sitting there.

Jul 15 10:45 AM

[Dividend Gr...:]

That's a good comment. I do re-invest only a portion of my stocks directly; most other times however I let my dividends accumulate and I either re-invest in the same stock/s or in new stocks that have been on my watchlist.

One cannot argue with the fact however that reinvested dividends have contributed almost all of the stock markets total returns over large periods of time.

I don't typically look at dividend reinvestment on an issue by issue basis, but through the lense of a dividend portfolio.


On Jul 15 10:30 AM captainccs wrote:

> This argument is one huge fallacy. Of course if you reinvest in a
> dividend paying stock you'll have more of that stock than if you
> didn't - no argument there, but that is NOT the issue. The test is
> to compare your total wealth after reinvesting in the "same" stock
> and using the money for something else, like buying another stock.
>
>
> Let's suppose you have 100 shares of stalwart XYZ that shows zero
> growth but pays a 10% dividend. If you reinvest those dividends in
> stalwart XYZ your CAGR is going to be 10%.
>
> Let's suppose that instead of reinvesting the dividend in stalwart
> XYZ you buy shares in stalwart ABC that pays 15% dividend and shows
> no growth, your CAGR would be higher than 10%
>
> Or let's suppose that you invest the XYZ dividend in fast growing
> MNO that is growing by 20% annually, again your total CAGR would
> be higher than 10%
>
> The conclusion is that at any time there is a best investment that
> is not necessarily reinvesting in the dividend paying stock which
> is just one of many options.

Jul 15 01:47 PM

[Dividend Gr...:]

This is an interesting strategy. I do not re-invest dividends if the companies I own do not pass my entry criteria.


On Jul 15 10:43 AM DanielMiller wrote:

> I tend to reinvest my dividends in a company only if the stock price
> is closer to its 52 week low than its high when the dividend is paid
> put. If a stock is on a tear, I take the dividend as cash. I guess
> it all comes down to personal preference.

Jul 15 01:49 PM

[Dividend Gr...:]

Dividends could be either sitting there or get reinvested. The beauty of dividends is that it is under the discretion of the individual investor to purchase more stock, buy equity in a different company/investment or spend it another way.. That's what I call democratic capitalism at its best ;-)


On Jul 15 10:45 AM ppearson wrote:

> I agree, all of these articles operate under the retarded hypothesis
> that the dividend money is just sitting there.

Jul 15 01:52 PM

[Old Trader:]

captain,

I can't say for certain, but I'll take a guess and say that many, if not most, investors that pursue dividend stocks, do so in an effort to end up with a portfolio that throws off sufficient income to either support them in retirement (best case scenario), or at least contribute in a meaningful way to a retirement income stream, as an addition to SS, any sort of pension they may have, income producing real estate, etc..

Hopefully, dividend increases will provide at least a partial offset to any inflation-caused cost of living increases.


On Jul 15 10:30 AM captainccs wrote:

> This argument is one huge fallacy. Of course if you reinvest in a
> dividend paying stock you'll have more of that stock than if you
> didn't - no argument there, but that is NOT the issue. The test is
> to compare your total wealth after reinvesting in the "same" stock
> and using the money for something else, like buying another stock.
>
>
> Let's suppose you have 100 shares of stalwart XYZ that shows zero
> growth but pays a 10% dividend. If you reinvest those dividends in
> stalwart XYZ your CAGR is going to be 10%.
>
> Let's suppose that instead of reinvesting the dividend in stalwart
> XYZ you buy shares in stalwart ABC that pays 15% dividend and shows
> no growth, your CAGR would be higher than 10%
>
> Or let's suppose that you invest the XYZ dividend in fast growing
> MNO that is growing by 20% annually, again your total CAGR would
> be higher than 10%
>
> The conclusion is that at any time there is a best investment that
> is not necessarily reinvesting in the dividend paying stock which
> is just one of many options.

Jul 16 10:45 AM

[YoYoMama:]

This comment reflects a common misconception about dividend investing and those who participate.

The misconception is that dividend investors are idle stock squatters who buy, sit, and mindlessly reinvest or use DRIPS, paying no attention to the health of their portfolio.

The truth is many of us are active investors who change and rotate our portfolio based on market conditions and chart technicals. We look for the best entry points, employ stop losses, take profits, etc. You know - all the things that the "good" investors do.

We just happen to believe we should do this with stocks that pay us along the way. It creates more wealth when the market is good, and cushions us when the market is bad.


On Jul 15 10:30 AM captainccs wrote:

> This argument is one huge fallacy. Of course if you reinvest in a
> dividend paying stock you'll have more of that stock than if you
> didn't - no argument there, but that is NOT the issue. The test is
> to compare your total wealth after reinvesting in the "same" stock
> and using the money for something else, like buying another stock.
>
>
> Let's suppose you have 100 shares of stalwart XYZ that shows zero
> growth but pays a 10% dividend. If you reinvest those dividends in
> stalwart XYZ your CAGR is going to be 10%.
>
> Let's suppose that instead of reinvesting the dividend in stalwart
> XYZ you buy shares in stalwart ABC that pays 15% dividend and shows
> no growth, your CAGR would be higher than 10%
>
> Or let's suppose that you invest the XYZ dividend in fast growing
> MNO that is growing by 20% annually, again your total CAGR would
> be higher than 10%
>
> The conclusion is that at any time there is a best investment that
> is not necessarily reinvesting in the dividend paying stock which
> is just one of many options.

Jul 16 09:22 PM

[David Van K...:]

A couple of the comments above should be reinforced.

First, captainccs's comment that the reinvestment of dividends is a huge fallacy is simply wrong. So are his/her examples. Assuming a stock with no growth but a 10% dividend, if the stock is well-selected and raises its dividend yearly (or nearly yearly), the CAGR on the initial investment (called "yield on cost") will rise each year along with the rising dividend. That's because the cost is fixed at the initial cost, while the dividend payout keeps rising. Rising payout / fixed cost = rising yield. Not only that, the process is accelerated if the dividends are re-invested (either in that company or elsewhere).

Old Trader's comment that most dividend investors are trying to achieve a portfolio that throws off sufficient income to either support them fully or at least meaningfully supplement their various income sources is correct. Because of the rising yield on cost just described, this result is attainable, especially if the investor has enough years to let the dividend strategy play out. A dividend strategy is very different from a capital appreciation strategy (buy low, sell high). But even beyond that, most studies show that dividend-paying stocks, over time, show the best overall performance of all stocks, where overall performance comes from the combined effects of price increases and dividends.

Finally, YoYoMama's observation that serious dividend investors are attentive, pay attention to the health of their portfolio, change and rotate stocks based on market conditions and their stocks' performance, etc., is spot on. Following a dividend investing strategy is an active form of investing. It requires a well-conceived strategy and careful execution.

We just happen to believe we should do this with stocks that pay us along the way. It creates more wealth when the market is good, and cushions us when the market is bad.

Jul 16 11:21 PM