When the topic of dividend reinvestment comes up, there are usually two schools of thought that dominate the discourse on the topic. On one side, you have the folks who favor full dividend reinvestment into the companies that pay out the dividends. This approach is both automatic and ideal for smaller accounts because the frictional costs of worrying about deploying a $30 dividend check could be cumbersome. Additionally, this approach does not suffer from a time lag -- that is to say, when you reinvest your Coca-Cola (NYSE:KO) dividends back into Coca-Cola, your cash dividend immediately translates into additional stock ownership that can generate even more earnings and dividends.
The other approach to dividend reinvestment generally involves taking the dividends as cash, and then redeploying an accumulated cash position into an undervalued stock that stands to offer better share price appreciation, earnings growth, dividend growth, or some combination of the three. While this approach is not automatic and comes with the $9-$12 cost of making an additional trade, the benefit is that an active attempt to maximize dividend income or share price appreciation is taking place. This approach comes with a time lag -- if you take your Altria (NYSE:MO) dividends and try to buy ConocoPhillips (NYSE:COP), then you must put up with the period of time that your money is not working for you. This is generally tolerable, because the belief is that the dividend income will be deployed in a maximizing way to offset this.
But when I must decide which decisions to make with my own dividends, I do not fall into either camp. That is because I do not place a top priority on simplicity or the desire to find the most undervalued stock, but rather, to find opportunities that offer the least likelihood of permanent capital loss.
For instance, I would be perfectly content to reinvest the dividends from Johnson & Johnson (NYSE:JNJ) and Colgate-Palmolive (NYSE:CL) back into the same companies if they're fully valued because I am highly confident that the money reinvested is being added to a permanent capital base that stands very little chance of going bankrupt. Likewise, I could own JP Morgan (NYSE:JPM) and receive a nice dividend, but I would not reinvest back into the company (even if it was moderately undervalued) because I am aware that banks tend to collapse every generation or so.
Essentially, my guiding principle for portfolio construction is this: Always build in redundancies. I don't want to have a future failure wipe out my past successes. It's one thing if I make an investment in Wells Fargo (NYSE:WFC) that completely falls apart -- I could, however grudgingly, come to make peace with that. But I would be much more upset with myself if I spent 10 years reinvesting dividends back into Wells Fargo and then suffered a terrible loss. If I took my Wells Fargo dividends and bought shares of IBM (NYSE:IBM) for 10 years, then I at least "have something to show for it" in the event that something terrible happens to my Wells Fargo investment.
On the opposite side of the spectrum, there are a handful of companies that I would be completely comfortable reinvesting dividends at fair value because they offer the smallest likelihood of permanent capital loss. I'd be perfectly fine reinvesting into Pepsi (NYSE:PEP) or Kimberly-Clark (NYSE:KMB), because I know that they will be here 10 years from now. I have a very high level of confidence that, 10 years from now, the Pepsi and Kimberly-Clark reinvested dividends will not collapse on itself like a bad game of jenga.
Over the past couple months, I've been coming to the conclusion that the answer to most financial questions is a variation of "it depends." I certainly feel that way about dividend reinvestment. There are some companies that are worth reinvesting dividends at full value because they offer a very, very small likelihood of permanent capital loss in return. Likewise, there are some companies -- particularly tech and banks -- that I have little desire to reinvest dividends into because of the industries' historical risk of permanent capital loss. When it comes to dividend reinvestment, I think mixing and matching can be an intelligent way to go.