Dividend Reinvestment Value For Long-Term Investors

 |  Includes: CL, GE, IBM, JNJ, KO, V, XOM
by: Tim McAleenan Jr.

Today, let’s turn back the clock to 1950. The Viet Minh is attacking French Indochina, Wisconsin Senator Joseph McCarthy is claiming the State Department is filled with 205 communists, Visa (NYSE:V) credit cards are finding a place in the wallets of US consumers, the television remote is being invented, and Yankees shortstop Phil Rizzuto is on his way to an MVP season as the Yankees sweep the Phillies in the World Series.

Around this time, a magic genie comes up to you and asks you whether you’d want to invest $1,000 in shares of IBM (NYSE:IBM) or Exxon-Mobil (NYSE:XOM). He then tells these key facts about what the company will do between 1950 and 2003. During this 53 year period, IBM will grow revenue per share by 12.19% annually, dividends per share by 9.19% annually, earnings per share by 10.94% annually, and sector growth of 14.65% annually. Meanwhile, Exxon grows revenue by 8.04% per year, dividends by 7.11%, earnings per share by 7.47%, and sector growth of -14.22%.

Knowing these facts, which of the two companies would you think made a better investment over the long haul? I’ll tell you how I answered—I imagined that IBM would have handily outperformed Exxon over this period. But instead, Exxon posted returns of 14.42% annually while IBM returned 13.83% annually.

And to give you an idea of how significant that extra half percentage means compounding over a half century, the $1,000 worth of Exxon (originally Standard Oil) would have turned into $1,260,000 while the investment in IBM would have turned into $961,000. Either way, that’s not bad. Both of these companies were well-known large-cap superstars in 1950, yet they managed to turn thousand-dollar investments into million-dollar fortunes over the next half-century.

But still, it raises the question—if IBM grew its revenue, earnings per share, and dividends at a faster clip than Exxon, why did the shares of Exxon outperform? Fortunately for us, this is the question that Dr. Jeremy Siegel answers at the beginning of his book, The Future for Investors: Why the Tried and True Triumph over the Bold and New. On page 8, Dr. Siegel writes:

One simple reason. Valuation, the price you pay for the earnings and dividends you receive. Even though the computer giant trumped Standard Oil on growth, Standard Oil trumped IBM on valuation, and valuation determines investor returns.

From 1950 to 2003, the average P/E ratio for IBM stock was 26.76. For Exxon Mobil, it was 12.97. Along the way, IBM’s average dividend yield was 2.18%, while Exxon’s was 5.19%. Essentially, IBM stock was priced closer to perfection, and although IBM largely delivered, the company didn’t necessarily deliver growth that outstripped the expectations baked into the outsized P/E ratio investors were willing to pay.

Although Exxon only grew earnings per share by 7.47% over this period, the fact that the company was only trading at 12.97x earnings while paying out a dividend over 5% annually allowed the investors to earn outsized returns, even though IBM performed better by all growth metrics—the shares of Exxon were more attractively priced over the half-century stretch compared to IBM, and that's what allowed shares of the oil company to triumph.

As Dr. Siegel adds:

A very important reason that valuation matters so much is the reinvestment of dividends. Dividends are a critical factor driving investor returns. Because Standard Oil’s price was low and its dividend yield much higher, those who bought its stock and reinvested the oil company’s dividends accumulated almost fifteen times the number of shares they started out with, while investors in IBM who reinvested their dividends accumulated only three times their original shares.

Looking for solid earnings per share and dividend growth is very important, but as Benjamin Graham liked to say, “Price is paramount.” Instinctively, we know this. Johnson & Johnson (NYSE:JNJ) or Coca-Cola (NYSE:KO) could grow their earnings per share and dividends per share by 10% annually for the next thirty years, but if you paid $130 per share for each company, it would take a while for the company’s growth to offset the lofty expectations baked into the purchase price when you bought it.

The main lesson here is that dividend reinvestment over long stretches of time is a miracle worker, but the valuation of the dividends reinvested matters as well. So what’s the best way to handle this? Let’s say you own 1,000 shares of Colgate-Palmolive (NYSE:CL), which gives you $2,320 in dividends every year. You could reinvest the money in Colgate-Palmolive year-in and year-out, and you’d still probably earn returns that are far superior to the average investor.

Or, in an attempt to follow Dr. Siegel’s advice to reinvest in an attractive valuation, you could elect to take the Colgate dividends as cash, and reinvest the money into a security that you believe has better growth prospects not baked into the share price relative to the company that is providing the dividend income.

Let’s say, as our premise, that you believe General Electric at 13x earnings will outstrip future expectations relative to Colgate-Palmolive at 18.5x earnings. If you reinvested your Colgate dividends into General Electric, then you might be setting yourself up for better returns because it is not necessarily the growth of the earnings that determines your return, but the valuation of what you deploy your dividends into that can give your portfolio that extra half-a-percent edge over your investing lifetime.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.