Dividend Stocks Give Rewards For Putting Up With This

 |  Includes: BRK.B, CL, COP, CVX, KO, WBA
by: Tim McAleenan Jr.

If a seasoned investor met a beginning investor on an elevator and tried to offer a quick summary of the past 100 years worth of American stock market investing, the short explanation might sound a little something like this: "The American stock market has returned about 10% annually over the past century. Inflation ran about 3% per year over that time frame, giving long-term investors an average increase in purchasing power of about 7% annually. The price of admission for this 7% increase in yearly purchasing power is that investors have to weather unpredictable changes in the net worth of their investments, which often fluctuate by 20%, 30%, or even 40% per year."

We can toggle with the numbers a little bit -- maybe assume that inflation will run at 4% over the next twenty years and assume that the increases in purchasing power will be a little bit less than 7% annually going forward -- but the general narrative loosely holds. This is not earth-shattering news: the cost of admission for pursuing 10% nominal returns is that you have to stomach 20-50% declines in your net worth along the way.

To take a quick look at the price wreckage that occurs over the course of an investing lifetime, take a glimpse of the worst annual returns for the Dow Jones Index over the past century:

Yikes. An investor with a million dollar portfolio at the start of 1931 had less than $500,000 by the end of that year. More recently, an investor with a million dollar portfolio in 2008 saw his net worth fall to the $700,000 mark in 2008. Eck, somebody pass the Tums.

I don't know about you, but I want to be compensated for having to put up with my net worth falling twenty, thirty, or forty percent. A non-dividend stock grants you no reward for the journey travelled. Let's say you bought Berkshire Hathaway (NYSE:BRK.B) at $85 in 2010 and sell it for $120 in 2015, pocketing a 41% gain. But along the way, you had to witness the shares fall to $65 in September 2011. But because Berkshire does not pay a dividend, there is absolutely no 'thank you gift' that signals that you persevered through a time when your Berkshire net worth lost about a quarter of its value.

When I look at that Dow Jones chart above that chronicles the bad years of 20-30% losses, I think to myself, "Well, what kind of investor do I want to be when that time comes?" And I'm once again reminded why dividends appeal to me. When you own an excellent company like Coke (NYSE:KO) or Colgate-Palmolive (NYSE:CL) during a 25% price decline, you receive cash payments that are reinvested at a 25% price decline.

Over the past year, Walgreen (WAG) has traded between $30 per share and $45 per share. Let's say that an investor owns 1000 shares of the firm, and plans on reinvesting the dividends. At a current rate of $0.225 per share, that is a quarterly payout of $225. If Walgreen was still trading at $45 per share, the investor would receive 5 new shares of Walgreen which will now pay out $0.225 quarterly (earning dividends on dividends). But if Walgreen is still trading near $30 when the June 12th dividend payout comes, that $225 will now buy 7.5 shares which will pay out $0.225 quarterly (these dividends on dividends create an extra $1.68 of immediate income instead of $1.12). Let's fast-forward to 2016 and the shares of Walgreen are trading at $60 per share. Instead of having 5 shares worth $300, you now have 7.5 shares worth $450. You have an extra $150 thanks to the depressed price you were able to reinvest at during one particular quarter-this is your cash memento for putting up with these temporary declines in your net worth.

DRIP investors who dollar cost average into a stock generally understand this point quite well. If you're investing $100 per month into Conoco Phillips (NYSE:COP), you probably want to get the most bang for your buck and have each dollar invested buy as many future profits as possible. If Conoco trades around $60 per month for an extended period of time, you read monthly statements noting the additional 1.67 shares added to your balance, which pays out $4.40 in annual dividends. But if Conoco falls to $50 per share, you start adding 2.00 shares to your balance each month, which pays out $5.28 in annual dividends. When you look back later on five years worth of DRIP investing, you're likely going to have the most appreciation for the months when you bought the most shares, representing a higher amount of dividends and claims on a company's retained earnings. Of course, the moment when you buy the most shares is when the company is selling at the lowest price.

The dividends that we receive during times of market declines turn out to be quite nice consolation prices for putting up with this turbulence. But in many cases, it's a consolation prize that is most appreciated in hindsight. An investor owning 1000 shares of Chevron (NYSE:CVX) in 2008 saw his wealth cut in half as the stock fell from $105 to $55 per share. He might have been miserable seeing his $105,000 investment turn into $55,000. But Chevron paid out a $0.65 quarterly dividend in 2008. Reinvested at $55 per share, that $650 payout bought almost 12 new shares of Chevron stock. At the time, this might have been small consolation to the Chevron investor. But now that Chevron is trading at $97 per share, those 12 new shares have turned into $1,160 worth of value. Since steep market declines are an inevitable occurrence on the journey of long-term investing, we should make the best of the depressed price levels by owning dividend-paying firms that pay us quarterly cash so that we may sow the seeds to reap a great harvest later.

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