In two previous articles, here and here, I looked at the power of reinvesting dividends. The longer the time period and the higher the dividend yield the more compelling dividend reinvestment can become. However, successful investing requires an understanding of benchmarks for comparison and also a careful understanding of hidden costs. This article will look at the benchmark consideration and compare the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) against a similar approach with The Coca-Cola Company (NYSE:KO).
For comparison, the initial investment date will be 1/29/1993 which maximizes the use of SPY. The initial amounts will be 100 shares of SPY which at that time was equal in value to about 104 shares of KO. The assumption is that all dividends would be reinvested upon payment. The first chart looks at SPY.
SPY has shown strong price appreciation over the time period and produced a few dividends. Due to dividend reinvestment, 28% of dividends in the next payment will be based on dividends earned on shares purchased with reinvested dividends. The compound annual growth rate is about 7.5%. The next chart shows that KO has outperformed SPY over this time period.
This chart shows KO with the slight outperformance of 8.4% compound annual growth. Most of this was due to the higher appreciation of the initial investment and then some was due to the higher dividend rate at KO. On the current dividend payment, 30% of dividends were from shares purchased with reinvested dividends. Since KO has a slightly higher forward yield, this trend should continue. However, over this time period KO has only produced about $500 more of dividends.
The next consideration is to understand tax implications. While KO produces more dividends, this also means it has a higher tax liability than SPY on a year-in, year-out basis. Assuming the current qualified dividend rate of 15% for the entire history (not a correct assumption, but rather a simplification) shows that KO created a tax liability of $901 while SPY produced $849 on a present value basis.
In reality, applying the older tax rate for dividends toward earlier dividends would show KO with a larger disadvantage; however, it would still be relatively small. What this does illustrate though is that these tax hits are not insignificant.
The $901 would effectively lower the KO return from 8.4% to 8.2%. It should be noted that these calculations are not adjusted for the unrealized tax liability on the appreciation of the individual shares purchased. For KO, this would be almost $1700 assuming the long term capital gains rate of 15%. So while the comparison to SPY is not impacted, a $901 hit across $20,102 is actually still meaningful. Thus, when comparing a DRIP stock against an investment without dividends it is important to account for these intermediate taxation issues which do create some cash flow drain.
Therefore, in hindsight, KO provided almost a full percentage point better performance than SPY. However, on a risk adjusted basis was that sufficient? KO has a much lower beta than 1, but obviously is just a single company operating in a specific sector while SPY is highly diversified across industries and companies. I suspect that there are many dividend stocks that would lose to the SPY without even considering taxation issues.
So what should an investor do with this information? One of the clear takeaways is that taxes matter. As noted, the taxes on the dividends alone had a measurable impact on the KO return. Investing is not just about picking stocks, time should be invested in figuring out the most tax efficient way to make investments. Looking at how various retirement savings accounts can be used and what types of investments should be placed in them is also critical.
Disclosure: I am long SPY.
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.