Seeking Alpha
Research analyst, portfolio strategy, portfolio management
Profile| Send Message|
( followers)  

Summary

  • A dividend growth strategy can produce extraordinary income streams when dividends are reinvested.
  • The magic of compounding offers another layer of financial security for investors with more of a time horizon before needing the income.
  • Combined with a portfolio consisting of many of the best dividend growth stocks, this might just be one of the alphas investors are seeking.

My previous article on dividend investing garnered nearly 600 comments thus far, and I believe blew enough holes in the belief that dividends do NOT matter in retirement, that some folks have reconsidered their own investing approach.

Of course, the more stubborn some folks are, the more they will refuse to acknowledge the significance of dividends for retirement in favor of a capital appreciation model that might or might not get them where they really want to be; financially secure without having to hold down a job.

Perhaps if we add the magic of compounding by reinvesting dividends over an extended period of time, a few more folks just might realize that a dividend growth investing strategy actually does work. Probably better than you ever might have thought.

Using My BTDP As The Model

Let's say you decided to invest in the core dividend stocks held in the Buy The Dips Portfolio, but do not need the income for another 10-20 years. You choose to reinvest the dividends back into the stocks in the portfolio, but you will not invest another dollar, ever. What will this simple strategy do for you when you finally need the income?

The BTDP portfolio consists of AT&T (NYSE:T), Exxon Mobil (NYSE:XOM), Johnson & Johnson (NYSE:JNJ), Coca-Cola (NYSE:KO), Procter & Gamble (NYSE:PG), Altria (NYSE:MO), McDonald's (NYSE:MCD), Chevron (NYSE:CVX), Apple (NASDAQ:AAPL), General Electric (NYSE:GE), Ford (NYSE:F), Microsoft (NASDAQ:MSFT), Wal-Mart (NYSE:WMT), Pfizer (NYSE:PFE), Annaly Capital (NYSE:NLY), American Capital (NASDAQ:AGNC), and BGC Partners (NASDAQ:BGCP).

I will use the following rules in displaying how compounding by reinvesting could work.

  • I will use a modest 5% dividend growth rate for each stock, except for 3 of our opportunity stocks. Since NLY, AGNC, and BGCP can fluctuate in either direction, I will use only a 1.5% growth rate for these riskier stocks.
  • I will set the time horizons at 3 levels; 10 years, 15 years, and 20 years.
  • I will not add a single dollar of additional capital to any stock.
  • The initial investment, which began about 6 months ago, started with about $110,000.
  • I will not add a single penny of capital appreciation, nor will I display any share price. The price used to calculate the results will be my cost basis when the portfolio began. If capital appreciation was added, the numbers would vary, more than likely to the higher side, but potentially with fewer shares at the end.

This is never a perfect science, but by being ultra conservative I should be able to show how the most important component of dividend growth investing, income, could grow.

(click to enlarge)

A simple glance at this chart shows, in today's dollars, how much of an income stream can be expected by using my ultra conservative guidelines for the calculations. I used the following tool to make all calculation:

(click to enlarge)

I inserted the link to the website for anyone to visit and use the tool themselves for their own personal portfolio results. Several things to remember, the results shown will be cumulative. In order to calculate the annual dividend income, I needed to divide the total dividends paid, by each time horizon (10,15,20) to obtain the annual income generated.

As the site explains:

The total value without dividend reinvestment equals the final stock price multiplied by the initial number of shares added to the sum of all dividends paid. The number of shares is simply the initial number of shares.

The total value with dividend reinvestment equals the final stock price multiplied by the sum of the initial number of shares plus all dividend reinvestment shares. The number of shares is the initial number of shares plus all the shares purchased with reinvested dividends.

The dividends paid without dividend reinvestment is the sum of yearly dividends paid on the initial number of shares.

The dividends paid with dividend reinvestment is the sum of yearly dividends paid on the initial number of shares and the reinvested dividends shares.

This simple calculation method obviously will vary for each investor for each stock owned. I believe that given the time horizons used, there can be absolutely no argument as to the strength of dividend reinvesting just by itself.

The only caveat is that you must remain disciplined enough to do absolutely nothing.

What Happens To The Numbers If We Add Multipliers

The initial amount invested will change the end result by various multipliers. If I doubled the initial invested, all of the numbers would change by a factor of 2x. An investor who has $550,000 to invest today, with a 10, 15 or 20 year time horizon might be looking at the following end results for an annual income stream:

1) Initial annual income: Roughly $25,000/year.

2) At the end of 10 years: Roughly $40,000/year.

3) At the end of 15 years: Roughly $60,000/year.

4) At the end of 20 years: Roughly $90,000/year.

Keep in mind that all I have done was to place an initial investment. Using a multiplier of 5x my investment in BTDP, the results are obvious, and the number of shares would be multiplied by 5 as well.

I still have not added a penny for capital appreciation.

While the annual income will be about the same in each time period, the value of the total portfolio will give you a more complete picture of where I will be at the end of 20 years.

  • Using a 4% annual growth rate of just the share price, the initial investment of $110,000 would be roughly $241,000
  • Using an 8% annual growth rate of just the share price, the initial investment of $110,000 would be roughly $512,000
  • By increasing the initial investment by a multiplier of 5x, after 20 years the total value of the portfolio would be about $2,560,000.

Again, this does not account for another penny being added to the portfolio, but obviously the numbers would be even more staggering if I add a regular monthly amount. For the simplicity of this article, however, it is very compelling to see how dividends matter without adding one cent to my initial investment.

There Is One Basic Ingredient To This Approach

After all is said and done, the only activity that you must not vary from, is to do absolutely nothing. No buying, no selling and just letting the money work by itself. The difference would be all over the map if you vary from this one single ingredient.

That being said, there are hazards that must be avoided from the start when building your own portfolio:

  • Don't chase the yield, select the stocks.
  • Invest for the long term by establishing your investment goals and avoid looking for the quick buck.
  • Focus on the current dividend, not on the share price. A higher share price than you might like will keep you from putting your money to work right now.
  • Putting too many eggs in one basket can derail your plan. Simply stated, diversify your initial investment as I have in the BTDP.
  • Don't let another day go by without doing something to let your hard earned money finally work for you. Procrastination is an awful "disease" when it comes to investing.
  • Unfortunately for dividend investors, tax is unavoidable. Dividends are first taxed at the corporate level and then again at the individual investor level. Of course, if stocks are held in an IRA, then the personal tax liability will be avoided as dividends can be reinvested tax free (or deferred at least). That being said, I myself will gladly pay taxes as I continue to grow my wealth.

Where Should You Begin

There are no one size fits all strategy to find your own 'alpha'. Some investors lean towards capital appreciation, while others lean towards income. Both of these strategies need you to decide what you are investing for, and that is your choice.

For myself, dividend growth investing has proven to me that it will enable me to reach my goal of having more income in retirement. I want to be able to count on the income while not worrying about market fluctuations. While I do have a few dividend opportunity stocks in the BTDP, they are not the core, and represent less than 15% of my total investment.

I recently wrote this article, which pointed out various stocks within this portfolio that are either at my target to buy price or close enough. Why not start with these?

I have updated the chart (which I will be doing on a weekly basis for Seeking Alpha) to reflect each share price as of 4:00PM Friday. The color coded column is simple to use: Green means I like the price to buy or add, yellow means I will wait for a better price, red means I am content to keep the number of shares I currently own.

I also have not included the dividend opportunity stocks, but I believe everyone knows why I consider NLY a buy right now, anyway.

Right now, based on my strategy, buying T, KO, PG, GE, MCD, WMT, and PFE makes sense in terms of the share price for each. I will also say that I believe putting money to work sooner than later is more important than the share price on any given day, but none of us want to overpay. I cannot time the markets so I keep it simple for myself by using my target pricing as displayed.

The Bottom Line

Whereas trading stocks is all about timing of the market, investing with a dividend reinvestment strategy benefits from time in the market.

As noted here:

For anyone considering investing in dividend stocks, there are four key points to remember in relation to dividend reinvestment:

  1. Reinvesting Dividends produces exponential growth of investments. The money made by way of dividends attracts dividends in the future, and there is a rollover effect that compounds the return. Where dividend growth is high, this effect is sometimes called hyper-compounding.
  2. To produce greater income in the future, dividend reinvestment should always be considered where dividends income is not currently required. If you take the dividend, the likelihood is that you will spend it. Reinvesting now produces greater gains over time.
  3. Reinvesting dividends when the stock price is depressed stores greater income potential for the future. When share prices are low, greater numbers of shares can be bought with dividends paid. This will lead to larger absolute dividends in the future and greater income potential when it is finally required.
  4. You should always use tax efficient investment vehicles to shelter investments from personal income tax.

I could not have said it better myself. Finally, I believe that I have shown that dividends matter even more when left to do what they like to do; compound over time.

Source: Retirement Strategy: How Dividend Income Grows To Staggering Levels By Reinvesting And Compounding

Additional disclosure: I might be adding positions for myself, in PG, PFE, and WMT in the very near future.