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Dividend reinvestment programs are often seen as a great way to build up a retirement portfolio without requiring any additional investment. Simply purchase a stock and set it to reinvest its dividends and wait 40 years. My father followed this approach and it proved to be quite successful for several stocks. Dividend reinvestment essentially unleashes the power of compound interest, also known as the most powerful force in the universe, a notion often attributed to Einstein, but of slightly dubious origin.

In theory, dividend investment is very straightforward and should provide great results: purchase some stock and reinvest the dividends so that you're accumulating an even larger number of shares. Hopefully, the stock goes up and perhaps the dividend is raised, providing even more dividends with which to buy more shares. Let this process repeat over time and voila, a solid retirement portfolio. However, what if the stock price doesn't keep rising? What if the dividends are cut? Then what happens? Are you just throwing good money after bad?

I decided to look at a couple popular dividend stocks: two classic dividend companies: AT&T, Inc. (NYSE:T) and The Coca-Cola Company (NYSE:KO), and two very popular dividend stocks on Seeking Alpha: Frontier Communications (NASDAQ:FTR) and Annaly Capital (NYSE:NLY).

The following table shows some high level figures:

Select Dividend Stocks

Ticker Name Closing Price 11/9 Forward Dividend Forward Dividend Yield
T AT&T Inc. 28.91 1.76 6.1%
FTR Frontier Communications 5.69 0.75 13.2%
NLY Annaly Capital Management Inc 16.28 2.40 14.7%
KO Coca-Cola Company (The) 67.03 1.97 2.9%
Source: Yahoo!Finance, forward dividends reflect author estimates based on trailing dividends and recent growth pattern. NLY forward dividend assumed to be 4x its most recent quarterly dividend.

My analysis will look at the outcome of purchasing shares of each on 12/1/2005 and then reinvesting the dividends. I made some rough assumptions around the dividend payment dates relative to the ex-dividend dates which are readily available from Yahoo!Finance. Dividend.com provides the estimated number of days after the ex-dividend date that the dividends are paid. The assumption is that on the payment date, the dividends would be reinvested in the stock at the closing market price for that day.

The following charts shows the performance of each of these four stocks and identifies which change is attributed to dividends received, appreciation or depreciation of initial investment, and change in value of the dividends reinvested back into the stock. Note that dividends received includes both dividends from the initial investment and dividends from shares from reinvested dividends.

T shows good performance overall with an increase in value of 57%. The initial investment is up 14% over that time frame since the stock rose from $25.30 per share to $28.91 per share. However, there was just a slight loss from reinvesting dividends, but nothing significant. It should be noted that while the shares from invested dividends did not appreciate, they did help produce more dividends which were captured in the dividend bucket. So this is not the same as just parking all your dividends in a money market account instead of investing back in the stock.

NLY shows an even higher return of 165% over the time frame. This includes a solid return on the initial investment and a staggering amount of dividends paid to investors. While those reinvested dividends did not appreciate like T, they did help produce future dividends. In this case almost 30% of dividends are from dividends on shares purchased with reinvested dividends. One can clearly see the power of compounding here.

FTR shows a bit of the nightmare scenario for reinvesting dividends. The initial investment has performed horribly as have all subsequent purchases from dividend reinvestment. Even with significant dividends, the investment is still down 22%. This is not surprising since the stock closed at $13.07 on 12/1/2005 and is now trading at just $5.69 per share. In addition to poor returns, this is also a tax disaster.

The next stock is KO:

KO is up 85% but also shows the desired pattern for dividend reinvestment. The initial investment has performed well, increasing 56%. As the lowest yielding stock reviewed, it also showed a solid gain of 23% from dividends. Furthermore, those invested dividends also appreciated, tacking on another 6% gain. This is clearly a winner from the perspective of dividend reinvesting. A more careful look at the dividend bucket shows that 92% of those dividends came from the initial investment while 8% reflect dividends received on shares of stock purchased by reinvesting dividends.

Overall, dividend reinvesting appears to often be a solid strategy as long as the company has good consistent performance. However, it should be noted that there are two downsides. The first is somewhat trivial today: keeping track of all the cost bases for the various purchases from re-invested dividends. The second is that one does have to pay taxes on the dividends received and re-invested. Since you have re-invested all those funds, the taxes have to be paid out from other personal sources. This situation is further aggravated in the case of FTR, where the overall position is net down, but you've still been paying taxes on all those dividends.

The final note is that this analysis looked at a 6 year time frame. The relative size of the buckets would change over longer periods of time.

The appreciation of the initial investment would contribute a much smaller portion of the total return, while the dividend and appreciation (hopefully) of reinvested dividends would become a larger driver of overall return.

Source: Dividend Reinvestment: What Some Winners and Losers Look Like Over Time

Additional disclosure: Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.