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Compounding and Dividend Growth Investing

It has been claimed that Albert Einstein referred to compound interest as the eighth wonder of the world. Compounding occurs when interest is added to the principal, thereby enabling the interest to earn interest in the future. In other words, it is using the money that money makes to make more money. The nonlinear gains that arise from compounding over many years can result in the accumulation of great wealth. For this reason, compounding plays an important role in many investing strategies.

Dividend growth investing is a strategy that takes advantage of the power of compounding over time. The strategy involves buying the stocks of companies that consistently pay and grow their dividends, then reinvesting those dividends to produce compounding of the dividend income stream. Although many dividend growth investors recognize the importance of compounding, it can be challenging to ascertain the effects of various factors on compounding over long time periods.

The purpose of this article is to explore how six factors - dividend reinvestment, dividend growth, capital appreciation, new capital investment, taxes, and time - affect the long-term growth of the dividend income stream. It is said that a picture is worth a thousand words, so I will be illustrating these effects in graphical form. At the end of each subsection I will provide a take-home message associated with the relevant factor.

Baseline Scenario

In the figures below, I will plot the projected annual dividend income from a hypothetical dividend growth portfolio over a 30-year period. To provide a baseline for comparison purposes, I assume an initial investment of $10,000, an initial dividend yield of 3.5%, a capital appreciation rate of 5%, and a dividend growth rate of 5%. At the start of each year, all dividends accumulated during the previous year are reinvested and $1,000 in new capital is invested. The portfolio is assumed to be held in a Roth IRA, so dividends are not taxed.

This hypothetical portfolio is assumed to consist of dividend growth stocks, which are companies that have increased their dividends for several years and are likely to continue increasing them in the future. By way of example, dividend growth stocks in my own portfolio include Abbott Laboratories (ABT), Chevron (CVX), Johnson & Johnson (JNJ), Coca-Cola (KO), McDonald's (MCD), Procter & Gamble (PG), and AT&T (T). There are many other possible candidates for a dividend growth portfolio; in fact, there are 473 companies with dividend growth streaks of at least 5 years, as reported in the Dividend Champions, Contenders, and Challengers list maintained by David Fish. For the purposes of this article, the exact composition of the portfolio is not overly important.

Figure 1 shows the growth of the dividend income stream for this portfolio over time under baseline conditions.

Figure 1 Baseline

Compounding is reflected by the nonlinear growth in dividend income over time. For example, it takes 9 years for annual dividend income to exceed $1,000, but it takes only 6 more years to reach $2,000, and 4 years beyond that to reach $3,000. In other words, the time it takes for a given increment in dividend income (such as $1,000) becomes shorter as we go out further in time, which is a nonlinear trend. (A linear trend would be one in which every $1,000 increment takes the same length of time.) After 30 years, the portfolio is producing $7,703 in annual dividend income, which is much greater than the $350 produced in the first year. This might not seem impressive in absolute dollar amounts, but it is not intended to be. Next we will explore what happens under various alternative conditions.

Take-home message: Compounding produces nonlinear growth in dividend income over time.

Dividend Reinvestment

As noted earlier, dividend reinvestment is at the heart of compounding. In the baseline scenario, all dividends are reinvested. Figure 2 shows what happens when only 50% of dividends are reinvested and when no dividends are reinvested.

Figure 2 Dividend Reinvestment

Here we see that growth of the dividend income stream slows considerably. When dividend reinvestment drops from 100% to 50%, the annual dividend income at Year 30 decreases from $7,703 to $5,255 (a 32% reduction). When dividends are not reinvested at all, the decrease is to $3,622 (a 53% reduction compared with baseline). These precipitous declines highlight the importance of dividend reinvestment to long-term compounding.

Take-home message: Dividends should be reinvested whenever possible.

Dividend Growth

As the name implies, dividend growth investing involves owning the stocks of companies that not only pay dividends, but grow their dividends over time. Dividend growth is important for protecting the income stream from a decline in purchasing power due to inflation. It also gives a boost to the compounding effect of dividend reinvestment, which I have seen referred to as "hypercompounding." In the baseline scenario, I assumed a dividend growth rate of 5%, which is higher than the inflation rate of about 2% to 3% over the past few years. Figure 3 shows what happens with selected dividend growth rates ranging from 0% to 9%.

Figure 3 Dividend Growth Rate

Notice I had to change the scale for this figure. It is clear that as the dividend growth rate increases, dividend income increases substantially, but it is a nonlinear relationship. That is, if the dividend growth rate increases from 5% to 7%, the annual dividend income at Year 30 increases from $7,703 to $17,487 (a 127% gain), but an additional 2-point increase to 9% results in dividend income of $44,082 (a 472% gain over baseline). For dividend growth rates below 5%, the picture is not very encouraging, especially with no dividend growth at all (dividend income at Year 30 is $1,281). Given the substantial increases in dividend income associated with higher dividend growth rates, many investors look for companies with double-digit dividend growth rates. A key consideration to bear in mind is how long such high rates can be maintained. In an analysis presented in a previous article, I found that companies with relatively high past rates were generally unable to maintain such high rates in the future, so it is important to assess the sustainability of a company's dividend growth rate.

Take-home message: Aim for a sustainable dividend growth rate that handily beats inflation.

Capital Appreciation

Many investors seek capital appreciation: They want the market values of their stocks to increase over time. In my baseline scenario, I assumed a capital appreciation rate of 5%, but considering the recent "lost decade" of negligible capital gains in the broad stock market, some might say that 5% is too optimistic. Figure 4 shows what happens with selected capital appreciation rates ranging from 0% to 7%.

Figure 4 Capital Appreciation Rate

As the capital appreciation rate decreases, growth of the dividend income stream increases. The reason is that a lower capital appreciation rate allows dividends to be reinvested and new capital to be invested at lower cost, increasing the number of shares that can be purchased and thereby boosting the future dividends received. Thus, if the capital appreciation rate decreases from 5% to 0%, the annual dividend income at Year 30 increases from $7,703 to $28,687 (a 272% gain).

Take-home message: A low rate of capital appreciation benefits dividend growth investors.

New Capital Investment

Young investors such as myself (I am 30 years old) often have regular job incomes that are sufficient to cover their expenses, so they are able to reinvest all dividends and also invest new capital from savings of their job incomes. Regular investment of new capital can help accelerate growth of the dividend income stream. In the baseline scenario, I assumed annual investment of $1,000 in new capital. Figure 5 shows what happens when new capital investment ranges from $0 to $5,000 (i.e., maxing out your allowable IRA contribution every year).

Figure 5 New Capital Invested Annually

Contributing $2,500 annually (half of the IRA contribution limit) increases the annual dividend income at Year 30 to $13,665 from the $7,703 baseline (a 77% gain). Maxing out your IRA produces an increase to $23,602 (a 206% gain over baseline). Not surprisingly, investing no new capital produces disappointing results (dividend income at Year 30 is $3,728). These results indicate that saving for investment by living below your means is important for building long-term wealth.

Take-home message: Regularly invest new capital by saving a portion of your job income.

Taxes

It is unfortunate that dividends are subject to double taxation, being taxed first at the corporate level and then at the individual investor level. However, it is possible to avoid the second level of taxation by holding dividend growth stocks in an IRA, where dividends can be reinvested tax-free. This contrasts with holding the stocks in a taxable account, where dividends are subject to the current tax rate of 15%. (What will happen to the dividend tax rate starting in 2013 remains unclear.) Figure 6 shows what happens when dividends are not taxed (the baseline scenario) and when they are taxed at 15% and 30% rates.

Figure 6 Tax Rate

The effect does not look particularly large, but annual dividend income at Year 30 decreases from $7,703 to $6,862 with a 15% tax rate (an 11% reduction) and to $6,117 with a 30% tax rate (a 21% reduction).

Take-home message: Legally avoid taxes on dividends by holding stocks in tax-advantaged accounts.

Time

One of the most important factors, which is represented in all the preceding figures, is time. Dividend growth investing is not a get-rich-quick scheme; instead, it has been described as a get-rich-slowly strategy for building a sustainable and rising income stream from dividends. Time is important because it is what ultimately allows compounding to have its effect. As shown in the figures, compounding is not particularly evident in the first few years, but it becomes very prominent after about 20 years. For this reason, one should approach investing with a long time horizon. Young investors are best-positioned because they have decades before retirement, during which time compounding can take place and new capital can be invested regularly. However, retirees can still benefit from compounding during their retirement years.

Take-home message: Adopt a long-term investing mindset and give time for compounding to work.

Conclusion

In this article I have examined six factors that affect the long-term growth of the dividend income stream. By understanding the effect of each factor, investors may be able to structure their strategies to amplify positive effects and attenuate negative effects. In addition, investors might be able to use two or more factors to their advantage in combination. To demonstrate the interactive effect that can be produced by multiple factors, I will conclude with a special case where the capital appreciation rate is 3%, the dividend growth rate is 7.2% (the rate at which dividends double every 10 years), all dividends are reinvested tax-free in an IRA, and $5,000 in new capital is invested annually. Figure 7 shows that, under these conditions, it is possible to receive slightly over $100,000 in annual dividend income after 30 years.Figure 7 Special Case

This is the kind of illustration that helped convince me that dividend growth investing is a powerful long-term strategy for building a rising income stream.

Source: Illustrating The Factors That Affect Dividend Growth Investing