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"Investing is simple, but not easy." -- Warren Buffett

To say the least, investing is not easy. However, I believe it's not the actual mechanics of investing that make the practice difficult; but the emotions and lack of clear thinking.

It just so turns out that one of Warren Buffett's most successful investments was Coca-Cola (NYSE:KO), which he began purchasing in the late 80s. Today, KO is often included amongst the top stocks for income investors, dividend growth investors, and so forth (I do, however, realize that many do not consider 2.80% yields as adequate for their needs). The decision to invest in Coke in the early 80s wasn't an easy one. Despite the crash of '87, Coke's share price had moved sharply higher over the past five years, the company's business had grown immensely, but the stock appeared fully valued.

What made the decision simple for Buffett was plainly following his criteria of investing in fantastic businesses at relatively fair prices. Buffett saw incredible international sales potential, good management, and a nearly impenetrable business model. Despite a price that maybe wasn't a bargain on a short-term basis, Buffett likely projected out the future cash flows and owner-earnings, discounted them back to the present, and utilized a margin of safety. The mechanics were as simple as they come. The emotional difficulty of buying after years of solid share price ascension, however, would have made it hard to pull the trigger for many value investors.

Over the next few decades, Buffett would go on to receive billions in dividend income from Coca-Cola. Presumably, Buffett reinvested those dividends when he saw Coke's shares at a discount to intrinsic value. Buffett now believes Coke's dividend will double over the next ten years. As if that isn't good enough for Berkshire's income, the key concept here is yield-on-cost. Though Buffett didn't acquire all of his shares in 1988, he started buying when shares were trading around a split and dividend adjusted $3.75. At today's 2.80% yield, Buffett's initial investment actually nets him a 50% yield. Finally, because of the phenomenal business operations, Buffett has made obscene equity appreciation profits, with more likely to come. While most of Berkshire's annualized returns (22%!) came from strategic deal-making and massively profitable businesses, the dividend proceeds from stocks held by Buffett's insurance subsidiaries undoubtedly juiced those fantastic returns.

I believe this example is how any investor, armed with the ultra-powerful tools of time, confidence, and discipline can beat market returns. I'd like to note that several Seeking Alpha contributors have written fantastic, far more in-depth pieces on how to be a successful dividend investor, so I'd like to point you here, here, and definitely here.

Key Concepts

While becoming a dividend millionaire sounds a bit cheesy, it's a very real and common sense-driven strategy.

The first thing you'll need is time. The more the better. If you're a parent, either teach your kid to invest, or start a portfolio for him or her as a starter. When they turn 18 (age varies in some states) you can turn over control, provided you're comfortable with their abilities. Compound interest grows exponentially, so even ten years can mean the difference in millions in investment income much later on.

Regular contributions to your dividend portfolio are very important in building massive income potential. The more you can invest in the beginning, the better. Without a reasonable initial investment (i.e. about $10,000), reaching a total value denominated in multi-millions by retirement is relatively unlikely. Of course, most 18-25 year olds don't have $10,000 lying around, so monthly contributions are an excellent way of both dollar-cost averaging and investing for your future. Unfortunately, calculating returns encompassing both monthly contributions and dividend yield appreciation is extremely difficult, so this calculation shows the effects of dividend reinvestment without the added benefit of monthly contributions. This example displays the power of automatic dividend reinvestment; the effect is exponentially magnified when monthly contributions are made.

*(Calculations performed via this DRIP calculator -- obviously, the calculation is not perfect since entry prices, equity appreciation, dividend appreciation, and other factors will vary, but over the course of several decades, the discrepancies are relatively minor).

This example uses a 25 year old with just enough money saved up (and maybe some seed money) to buy 150 shares of KO at $67.50.

Notes

  • Annual dividend growth rate: 7% (this implies about 4-6% annual earnings growth, and a significant increase from the current payout ratio of about 33%. The annual growth rate could very well exceed 7%, but I think this is a relatively safe number).
  • Stock price growth rate: 4%
  • 50 Year time-frame (A retirement age of 75 seems very likely for our fictional investor given improvements in life expectancy, future changes or insolvency of social security, etc.)

Results

  • Annualized return (Also known as CAGR): 10.47%
  • Total value: $1.47 million
  • Over $1 million in reinvested dividends
  • Without reinvestment, return would have been 6.09%

A 10.47% CAGR is excellent considering the following:

  • No additional contributions
  • Total market return is historically ~10%
  • On a risk adjusted basis, companies like KO have been shown (.pdf) to return the highest alpha
  • Our fictional retiree is now sitting on 3,062 shares which pay $55.38 in annual dividends per share (assuming a 7% 50-year compounding rate with the initial $1.88 that KO currently pays)
  • This equates to $170,000 in annual dividend income, should our retiree decide to stop reinvesting the proceeds

$170,000 income on an initial investment is fantastic considering our initial investment of $10,000. Additionally, as KO continues to grow their dividend, income will only increase.

Conclusions

  • Timing is critical. If our retiree had begun 10 years earlier (if his parents had done it for him), he was have a total value of $7.74 million, which would spin off $1.27 million in annual income. To compensate for these lost years, our retiree could have made monthly contributions of a reasonable amount depending on his annual budget surpluses
  • As is often discussed in the dividend growth community, intelligent and frugal management of your personal budget is essential. The more you can save and invest, the more the power of compounding magnifies itself, thanks to exponential growth
  • This calculation isn't perfect. We have no idea if the inputs are going to hold true, and the timing of our reinvestments may have altered our results for better or worse, if we had temporarily chosen to reinvest our proceeds into cheaper securities.
  • This example shows how anyone with time, decent business sense, and some seed money can produce an incredible amount of income, and achieve risk-adjusted (and real total) returns far greater than the historical market averages. Additionally, this strategy provides a calm, steady, and simple (as Buffett has found) way to vastly grow your wealth and prepare for retirement).

Now that we have seen the wonderful effects of the reinvestment of dividends in excellent companies, please continue to part 2 to see my 10 recommendations for the next several decades, aimed towards young investors hoping to successfully utilize this strategy.

Source: 10 Dividend Millionaire Stocks, Part 1