Investors desirous of creating a common stock portfolio capable of providing them financial support in their retirement years have several options to choose from. The more aggressive investor might turn to designing and building an aggressive growth stock portfolio. However, aggressive growth stocks can be both risky and volatile. I wrote extensively about this approach in a previous article found here.
In contrast, the more conservative or prudent investor might prefer building a long-term portfolio comprised only of high-quality blue-chip dividend growth stocks. Of course, these are not the only options. Portfolios could be created as a combination of both pure growth and dividend growth stocks in any combination that would fit the individual investor's own unique goals, objectives and risk tolerances. However, the focus of this particular article will be exclusively based on the utilization of blue-chip dividend growth stocks during the accumulation phase.
Before I go on, it should be noted that this article is only addressing common stock portfolios. In other words, I am neither recommending only stocks, nor am I suggesting the exclusion of other asset classes as preferred choices. Instead, I'm simply dealing with investing in common stocks within the context of this article. The utilization of other asset classes employing fixed income, etc., would be the subject matter of separate articles.
Moreover, this article will be specifically addressing how dividends would, or should, be reinvested. Essentially there are two primary options or methods that investors can utilize to reinvest their dividends. The first option would be through a dividend reinvestment program, more commonly known as a DRIP program. With this option, the investor directs their custodian to automatically reinvest all dividends received from their stocks directly back into the company. Most blue-chip dividend growth stocks and custodians have programs set up to accommodate this option. For more detail on how DRIP programs work, I direct the reader to the excellent resource promoted by fellow Seeking Alpha author David Fish.
The second primary option that can be used to reinvest dividends I call "collect and invest." With this option, the dividend growth investor allows their dividends to collect or accumulate, and then chooses both where and when they will invest their accumulated dividends. Of course, this approach requires more work, effort and analysis on the investor's part. However, in spite of the extra effort, it is a preferred choice of many dividend growth investors. The central idea behind this option implies the opportunity to reinvest dividends only where and when attractive and/or sound valuation is manifest. More plainly stated, this option is preferred by those who do not want to reinvest in a stock at times when valuation may be too high, and therefore, too risky.
Frankly, I believe that both of these dividend reinvestment options have merit. Consequently, I will present what I believe are the merits and negatives of both with the remainder of this article. Then, I will leave it up to the individual to decide for themselves which method they would prefer. However, hopefully the correct individual decision can then be based on a careful weighing of the facts. In other words, I do not believe that one method is necessarily superior to the other in the purest sense. Instead, I believe there are extraneous factors that must be considered before the correct or most appropriate decision for each individual investor can be made.
DRIP: Advantages and Disadvantages
I'm a firm believer that investors in common stocks are best served when they have, and follow, a well-defined and designed investing discipline to guide them. Moreover, I am also a firm believer that if you have a well-designed investing discipline, it is critical that you stick with it regardless of what may be occurring in the short run. Frankly, because of our emotional makeup, applying a sound and disciplined investment strategy is very challenging for most people.
There are far too many distractions that can elicit strong emotional responses. Of course, as it relates to investing, the two big ones are fear and/or greed. However, of the two, I believe that fear is both the most powerful and the most dangerous emotional response. When people are gripped with fear, logic and common sense go out the window. Instead, the "fight or flight" response takes over. Consequently, knee-jerk reactions can, and will, dominate.
When an investor is gripped with fear, their emotions will more often than not play tricks with their minds, which often causes them to behave in ways that can be financially devastating. For example, investors will fearfully sell a perfectly good company at the bottom of the market, when logic would dictate that it's really a great buying opportunity instead. Consequently, they realize unnecessary losses. Personally, I contend that it's never a good idea to sell a valuable asset for less than it is truly worth.
Consequently, I believe that the greatest advantage of a DRIP (automatic dividend investing program), is that it takes emotion out of the equation. As long as the investor doesn't interfere, the fresh money coming from dividends is automatically and systematically allocated. This relates to the discipline concept I discussed above. The dividend growth investor initially makes one decision, and all future reinvesting decisions are in place and automatically executed.
However, in addition to the benefit from following a discipline, the DRIP investor also benefits from the concept of "Dollar-Cost Averaging" and the "natural investing intelligence" it provides. At its heart, "Dollar-Cost Averaging" automatically empowers the investor to be aggressive when they should, and conservative when more appropriate. To better understand how this happens, I offer the following definition courtesy of Investopedia:
"Definition of 'Dollar-Cost Averaging - DCA'
"The technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. More shares are purchased when prices are low, and fewer shares are bought when prices are high."
In addition to the advantage of removing emotion from the equation, the mathematics underpinning "Dollar-Cost Averaging" is quite profound. Investopedia goes on to explain the power, and what I call the natural intelligence of 'Dollar-Cost Averaging - DCA' with the following simple example:
"Eventually, the average cost per share of the security will become smaller and smaller. Dollar-cost averaging lessens the risk of investing a large amount in a single investment at the wrong time.
For example, you decide to purchase $100 worth of XYZ each month for three months. In January, XYZ is worth $33, so you buy 3 shares. In February, XYZ is worth $25, so you buy 4 additional shares. Finally, in March, XYZ is worth $20, so you buy 5 shares. In total, you purchased 12 shares for an average price of approximately $25 each."
Even more simply stated, "Dollar-Cost Averaging" works, and it works beautifully. In the long run, the dividend growth investor benefits from the discipline associated with this concept by ending up with a reasonably sound average cost on all the shares they accumulate over time. In other words, their average price paid is neither too high nor too low. Or, as Goldilocks taught us in The Three Bears, our average price ends up "just right."
It should also be obvious that an additional advantage of a DRIP investing strategy is the lack of time, effort and analysis it requires. Just like the old Ronco Rotisserie Oven commercial suggests, you just "set it and forget it." As long as you have the intestinal fortitude to stay the course, the DRIP dividend reinvesting strategy works. All it requires from the investor is a little understanding and trust. In the end, it's all about discipline. Finally, DRIP programs offer a low-cost method of investing small pools of money that a quarterly dividend distribution represents.
On the other hand, like all things good or bad, there are advantages and disadvantages. Even though a DRIP program provides a low-cost way to reinvest dividends, the small amount of money available from each quarterly distribution can be so small that it may lack any significant benefit to your portfolio's performance. Additionally, to my way of thinking, and from my long experience as an investor, a potentially big disadvantage to the DRIP strategy would manifest on a given stock that becomes significantly overvalued and stays that way for a long period of time.
For illustration purposes, I offer the following Earnings and Price Correlated F.A.S.T. Graphs™ on Medtronic Inc. (NYSE:MDT). Clearly, from 1999 to the fall of 2008 Medtronic's stock price was completely disconnected from its intrinsic value (the orange line) resulting in price moving sideways for the better part of 10 years. Note that business results (earnings growth) were above-average and quite consistent over that entire timeframe. I've drawn two red lines on the graph to illustrate how and why this would have been a bad time to be dripping dividends into Medtronic.
The following performance results associated with the above graph are produced with dividends reinvested. When the Reinvest Dividend at EOQ (End of quarter) performance option is selected, it provides a good simulation of a DRIP program. I direct the reader's attention to the End of Period # of Shares (black box) and the % Yield On Cost columns on the Dividend Cash Flow table. There are two takeaways that speak to the disadvantage of reinvesting dividends into an overvalued stock.
First and foremost, note the low beginning Yield On Cost (yellow highlight). It is approximately only one tenth of the more appropriate 2% current dividend yield that Medtronic offers, now that it's at fair value (see the above graph). Most dividend growth investors, including yours truly, would not invest fresh money into a dividend growth stock with only a 2/10 of 1% current yield.
Second, because the dividend yield is so low when price is significantly overvalued, you are not accumulating an adequate number of new shares to make a difference, at least in my humble opinion. To be clear, as previously mentioned, one of the big advantages of "Dollar Cost Averaging" is that your money becomes defensive when prices are too high. However, there is a limit to the benefit this offers during an extended period of overvaluation as seen in the Medtronic example.
However, in the spirit of fairness, and to bring more clarity to my point, I offer the following example on Kimberly-Clark Corp. (NYSE:KMB) in order to illustrate how shorter, or more temporary, bouts of overvaluation are overcome with a DRIP reinvestment strategy.
The reader should note that Kimberly-Clark Corp. generated approximately only half the earnings growth that we saw with our first example Medtronic. Moreover, in spite of this, Kimberly-Clark's share price was only occasionally overvalued during the exact same timeframe we saw in our example of Medtronic's chronic and extended overvaluation.
However, when you compare performance results on Kimberly-Clark over the same 15 year timeframe, we see the power and advantage of a DRIP strategy in action. For starters, a starting current yield of 1.9% (even though shares were technically overvalued), made more sense to a dividend growth investor. Moreover, this slower growing blue-chip dividend growth stock with dividends reinvested significantly outperformed the S&P 500.
Collect and Invest: Advantages and Disadvantages
The advantages of collecting the dividends from a dividend growth portfolio with the purpose of self directing them to their best investing advantage are numerous. However, I feel it is important to point out that this dividend reinvesting strategy applies more appropriately to the dividend growth portfolio in its entirety. In other words, it applies more to a whole portfolio management strategy than it does to a single individual stock.
The collect their dividends from their portfolio holdings and invest where you believe the best opportunities are approach is part and parcel of sound portfolio management. In addition to collecting dividends pending reinvestment, a portfolio manager can integrate collected dividends with the partial or total harvesting of overvalued holdings. Those accumulated funds can then be allocated to improve the portfolio's long-term performance and income stream.
However, as I go forward, I will limit further discussions about "collect and invest" exclusively to investing the dividend component of a whole portfolio. In order to illustrate the advantages of collect and invest, I offer the following mock portfolio review generated in order of highest estimated future total returns to lowest. I have highlighted two of the portfolio constituents, International Business Machines (NYSE:IBM) and Aflac (NYSE:AFL) as examples of attractively valued portfolio components that I feel warrant additional investment at this time.
In contrast, I highlight two overvalued portfolio constituents, Sherwin-Williams Co. (NYSE:SHW) and Nike Inc. (NYSE:NKE) to represent examples where I would refrain from adding additional capital to at this time. It's important to note that these decisions are based solely on considerations of current valuation. I consider all four examples to be high-quality blue-chip dividend growth stocks. However, I do consider the two overvalued companies as examples where current overvaluation is obvious. Therefore, as a long-term investor, I would not be comfortable adding new capital to either at this time.
Sherwin-Williams Company: Too High To Buy
The reason I suggest that the current overvaluation of Sherwin-Williams is obvious can be seen with a quick glance at the Earnings and Price Correlated FAST Graphs™ below. The reader should note that the black monthly closing stock price line closely tracked and was highly correlated to the orange earnings justified valuation line until late 2011. From this point forward, price has become clearly, untypically and consequently, obviously significantly overvalued.
As an aside, part of Sherwin-Williams' current overvaluation can be explained by an acceleration in earnings growth since 2010. However, even though earnings growth has accelerated to over 17% per annum from 11.1% seen on the 15-year graph above, this still does not justify its current high valuation.
Aflac Inc.: Too Low To Ignore
In contrast to what we saw with Sherwin-Williams, Aflac continues to represent a blue-chip dividend growth stock that is undervalued. Similar to what we saw with Sherwin-Williams, Aflac's stock price has historically been highly correlated to and has closely followed earnings (the orange line). However, since the Great Recession, Aflac's stock price has been consistently undervalued, representing an excellent opportunity to implement a DRIP strategy.
(For any reader interested in learning more about Aflac, I direct them to a recent article published by my associates at FAST Graphs found here.
Nike Inc.: Too High To Buy
The reason I suggest that the current overvaluation of Nike Inc. is obvious can also be seen with a quick glance at the Earnings and Price Correlated FAST Graphs™ below. The reader should note that the black monthly closing stock price line closely tracked and was highly correlated to the blue normal P/E ratio line in this example, indicating a historical penchant by the market to place a premium valuation on Nike. However, since the beginning of 2013, Nike's stock price has gone significantly higher than even its typical premium valuation. Therefore, Nike has become clearly, untypically and consequently, obviously significantly overvalued in 2013.
International Business Machines Corp.: Too Low To Ignore
IBM on the other hand is an equally high-quality blue-chip dividend growth stock with a comparable record of above-average earnings growth like Nike. However, the big difference here is that negative market sentiment is pricing their shares at a low valuation in spite of its consistent, strong and even accelerating recent earnings growth. This provides a great opportunity to DRIP dividends.
Disadvantages of Collect and Invest
One of the biggest disadvantages of the "collect and invest" dividend strategy is the time and effort required to successfully execute it. In addition to time and effort, it also takes the knowledge and skill to recognize when valuations are attractive or not. Although this can be accomplished quite easily, at least in my opinion, if the investor possesses the right tools, not many investors have them. Moreover, it also requires a high level of passion or interest on the investor's part.
Additionally, even with the right tools, emotion can get in the way of good judgment making it difficult to execute appropriately. Just as a DRIP strategy takes emotion out of the equation, the collect and invest strategy highly exposes the investor to the dangers of fear or greed. In addition to creating the opportunity for mistakes to be made, the emotional response can also delay the allocation of collected capital, thereby reducing the benefits of compounding.
Summary and Conclusions
I want it to be crystal clear that all of the examples I utilized in this article were for illustrative purposes only. The portfolio was merely a mockup of what a dividend growth portfolio might look like. I selected the 15 names in the portfolio in order to include examples that were fairly valued, undervalued or overvalued at the current time. I did this in order to illustrate the principles supporting a collect and invest dividend reinvestment strategy.
In a similar vein, the individual company examples were used to illustrate the advantages and disadvantages of both strategies - DRIP and Collect and Invest. More simply stated, I am not recommending any of the examples I utilized as good or bad investments at this time. My primary objective behind their utilization was to provide graphical support of the principles I was postulating.
In conclusion, I believe both dividend reinvestment strategies are valid and have merit in their own right. Personally, I embrace the collect and invest approach because I have the time, experience, inclination, passion and the right tools to successfully implement it. Since I am very fastidious about valuation, I simply cannot tolerate the idea of investing in a stock when I believe it is overvalued. In other words, if I wouldn't buy a stock with fresh money because I thought it was overvalued, I cannot justify reinvesting its dividends on the same basis.
On the other hand, I fervently believe in and support the concept of dollar cost averaging. I know that it works in the long run, and therefore endorse DRIP programs for those who find it more convenient. At the end of the day, I do not believe either strategy is better or worse than the other. It all comes down to each individual's own goals, needs, objectives, knowledge and experience, and of course, risk tolerances. Dividend reinvesting in high-quality blue-chip dividend growth stocks is a sound practice, and a great way to build long-term wealth and generate a growing income stream in the future.
Disclosure: Long MDT, KMB, IBM, AFL at the time of writing.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.
Disclosure: I am long MDT, KMB, IBM, AFL. 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.