A Way To Reinvest Your Dividends Based On Yield

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 |  Includes: APD, BBL, DRI, FLIC, HRS, LMT, MSFT, O, PTY, TGT, WMT
by: The Part-time Investor

Summary

Dividend Reinvestment is an essential component to DGI.

You can reinvest by DRIPing, or by using a method based on valuation.

So far, PAAY (Percentage Above Average Yield) has worked for reinvesting in my portfolio.

One of the essential components of Dividend Growth Investing (DGI) is the reinvestment of the dividends. This reinvestment is one of the two parts of the double compounding that makes DGI so effective over the long term (the other being the year to year growth of the dividend). Although I'm not aware of any disagreement about the importance of dividend reinvestment, there are different opinions about how to actually carry out the reinvestment. Many choose to use DRIPs (Dividend Re-Investment Plans) in which the dividends are reinvested directly back into the company which paid them. Others choose to take the dividends as cash, and allow the dividends to accumulate in their account until they are ready to use that cash to either buy a new position, or to buy more shares of the some of the stocks that they already own, but ones which they choose themselves.

I have no strong opinion as to which method works better. As long as the dividends are reinvested, you will get the compounding effect that is so important. There are benefits to each method. With DRIPs the reinvestment is usually done automatically without the investor having to place any orders. Once the DRIP is implemented the process takes care of itself. The investor does not have to remember to place the orders. DRIPs are also usually performed commission free. This helps to keep the portfolio costs low. But the problem with DRIPs is that the valuation of each stock is not taken into account. A certain company may be wildly over-priced, but the DRIP will automatically buy more shares every time it pays a dividend. It may not be to your advantage to be buying more shares of a stock when it is over-priced.

By using the method in which you collect the dividends as cash and decide which stock to put that money into, you may be able to take care of this valuation issue. YOU decide which stocks are under or over valued, and which you would like to put more money into. Of course, the problem with this is that it gives you more work to do. You must go through the process of evaluating companies to decide which you would like to buy (or add more shares). This takes time, and you may make mistakes. You may decide a company is undervalued when it is actually overvalued. Also, once you decide what to buy, and place your order, you most likely will have to pay commissions on that order. So your transaction fees will be higher. But if you are able to effectively evaluate companies to adequately determine their valuations, then your long-term results could benefit from this process.

With my portfolio, due to circumstances beyond my control, I have decided to use both of these methods. Some of my money is in an options express account. For these positions, since DRIPs are available, and since there is no commission to DRIP my dividends, I have chosen to DRIP all the positions I hold in this account. To manually reinvest the dividends I receive in this account, without DRIPing, would be too expensive due to the commissions I would have to pay.

But most of my portfolio, about 85% of it (by value), is in a pension account at Univest Trust. For this account no DRIPing is available. So for most of my portfolio I have been forced to manually reinvestment my dividends. When I first opened the account I was not happy that I could not DRIP my dividends. But I soon began to realize that this could be an opportunity for me. If I had to manually reinvestment my dividends I could improve my results if I could figure out which of the stocks I owned we're the best value at that time.

But how to determine which were the best value? As I read and learned about DGI I learned to focus on the dividend yield, dividend history, and dividend growth when evaluating a company and I realized that a stock which had a yield higher than its usual yield, all else being equal, might be undervalued. I decided to try to use this idea to determine which of my stocks were undervalued, and therefore were good options for reinvestment. So I developed my Percentage Above Average Yield (PAAY) system. The idea is that those stocks whose present yields are above their average yield for the past year are undervalued, and the stocks that have the highest PAAY are the most undervalued, and therefore are the ones that I should be reinvesting in.

So I set up a spreadsheet in which each week I calculated a running 52-week average of the yield, the percentage above the average yield (PAAY), and the rank of each stock, compared to all the other stocks in the portfolio, as to which had the highest PAAY.

Let me give an example by showing the PAAY of Target (NYSE:TGT):

Date

PRICE

DIV

YIELD

AVE YIELD

PAAY

5/20/13

69.72

0.36

2.07%

3.21%

-35.68%

5/27/13

69.5

0.36

2.07%

3.19%

-35.09%

6/3/13

70.36

0.36

2.05%

3.17%

-35.47%

6/10/13

69.03

0.36

2.09%

3.15%

-33.80%

6/17/13

68.83

0.43

2.50%

3.14%

-20.40%

6/24/13

68.86

0.43

2.50%

3.13%

-20.13%

XXXXXXXX

XXXXXXXX

5/30/14

56.76

0.43

3.03%

2.70%

12.07%

6/6/14

57.68

0.43

2.98%

2.72%

9.59%

6/13/14

57.23

0.52

3.63%

2.75%

32.12%

6/20/14

58.29

0.52

3.57%

2.78%

28.41%

6/27/14

58.12

0.52

3.58%

2.80%

27.85%

7/4/14

60.39

0.52

3.44%

2.82%

22.26%

7/11/14

60

0.52

3.47%

2.84%

22.22%

7/18/14

60.01

0.52

3.47%

2.86%

21.32%

7/25/14

60.39

0.52

3.44%

2.88%

19.70%

Click to enlarge

Target's price has been dropping over the past few months so its yield has been increasing. Therefore its PAAY has been relatively high, in the 10%-15% range. On June 11th, TGT announced a 20% dividend hike, up to $0.52 per quarter. So at the close on 6/13/14, the yield increased to 3.63%. The PAAY, therefore jumped up to 32.12%. This was easily the highest PAAY of any of the stocks in my portfolio. To me, this is a strong indication that TGT was undervalued, and therefore was worth reinvesting in. As an aside, even at a PAAY of 12% on 5/30/14, TGT appeared to be undervalued. This was the highest PAAY of any of the stocks I was following at that time. Most stocks these days actually have a negative PAAY due to the increase in their market price over the past year, meaning they are over-valued compared to their usual yield.

Each quarter, once I know the PAAY of each of my stocks, I reinvest my dividends into each of the 10 stocks with the highest PAAY.

This is how I have been reinvesting my dividends for the past 15 months. But there comes a time when it's necessary to evaluate what you've been doing to determine if it's effective. My PAAY system makes sense academically, but does it work in practice? Since I've been doing it for over a year now, I thought it would be a good time to see how it's been working.

Results:

Using PAAY, and as reported in my July 2013 portfolio update, I bought the following stocks in the stated amounts:

Air Products (NYSE:APD), 7 shares @ $86.73

BHP Billiton (NYSE:BBL), 11 shares @ $58.10

Darden Restaurants (NYSE:DRI), 13 shares @ $51.62

First of Long Island Corp (NASDAQ:FLIC), 22 shares @ $30.12

Harris Corp (NYSE:HRS), 14 shares @ $46.25

Lockheed Martin (NYSE:LMT), 7 shares @ $96.41

Microsoft (NASDAQ:MSFT), 23 shares @ $28.62

Realty Income Corp (NYSE:O), 14 shares @ $45.19

Pimco Corporate & Income (NYSE:PTY), 30 shares @ $21.7

Wal-Mart (NYSE:WMT), 9 shares @ $75.16

Here is a chart of the price at which each stock was bought, the price of the stock on 7/22/14, the value of the position at each of these times, the dividends collected since they were bought, and the return of each position. For ease of calculation, it was assumed that the dividends were just held as cash, even though in reality they were reinvested.

APD

BBL

DRI

FLIC

HSR

LMT

MSFT

O

PTY

WMT

Shares

7

11

13

22

14

7

23

14

30

9

Price Bought (4/1/13)

$86.73

$58.1

$51.62

$30.12

$46.25

$96.41

$28.62

$45.19

$21.7

$75.16

Start Value

$607.11

$639.1

$671.06

$662.64

$647.5

$674.87

$658.26

$632.66

$651

$676.44

Price Now (7/22/14)

$130.2

$70.13

$44.22

$36.35

$73.33

$167.63

$44.77

$45.29

$18.42

$76.51

Dividends Paid

$26.11

$25.96

$35.1

$28.38

$28.7

$44.03

$29.9

$38.206

$109.8

$21.33

Final Value

$937.51

$797.39

$609.96

$828.08

$1055.32

$1217.44

$1059.61

$672.266

$662.4

$709.92

Total return

54.42%

24.77%

-9.10%

24.97%

62.98%

80.40%

60.97%

6.26%

1.75%

4.95%

Click to enlarge

A total of $6,525.14 (including commissions) was invested in the above stocks on April 1st, 2013. By July 22th, 2014 the value of those shares, including dividends collected, had grown to $8,549.89. This is an increase of 31.03%. By comparison the value of my entire portfolio (not including new money invested) increased by 27.37% over the same time period, and the S&P 500 (to give a market benchmark) had increased from 1,562.17 to 1,978.22, an increase of 26.63%.

Conclusion:

These results show that the stocks chosen using my PAAY system did in fact perform better than the rest of the portfolio, and better than the S&P 500, over the next 15 months. And this was during a time when the portfolio, as a whole, performed quite well. Yet the PAAY performed even better. This certainly does not prove that over the long run PAAY will be an effective way to find stocks which are undervalued, but it at least shows that the idea has merit. And so far it is working. And for DGIers, who focus on their stocks dividends, it makes sense to use a system that uses the yield to determine valuation, rather than any other metric.

Reinvesting your dividends is essential to maximize your dividend income. But by finding an effective way to reinvest the dividends in undervalued shares you will also improve your total return. I believe that the PAAY system is one way to accomplish this. I will continue to follow all my reinvestments to be sure that PAAY continues to be an effective method for reinvesting dividends.

Thank you for reading my article. I welcome your comments and criticisms.

Disclosure: The author is long TGT. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.