Tactics To Hyper-Compound Dividend And Income Streams

Includes: KO, MCD
by: Kurtis Hemmerling

How do you hyper-compound dividend gains? Isn't dividend re-investment as good as it gets? What other mechanisms are there for speeding up the process to either retire quicker or have more income when you start living off your income investments?

Initial logic would suggest that you need only choose great companies with a good expectation of high and sustainable earnings growth coupled with a high dividend growth number and a solid record of annual dividend increases. Did I leave anything out? The company shouldn't be overvalued either, but you also get what you pay for.

Let's put this "common sense" approach to the test.

Below we will contrast two hypothetical firms (prices are set using a simple valuation process, which is P/E multiplier plus the value of any cash):

1. Company Name: High Growth Systems

  • Earnings growth 10%
  • Dividend growth 15%
  • Initial payout ratio 30%
  • P/E ratio 15 (before adding in cash per share)

2. Company Name: Slow Moving Metrics

  • Earnings growth 7%
  • Dividend growth 8%
  • Initial payout ratio 75%
  • P/E ratio 12 (before adding in cash per share)

Assuming both companies could maintain earnings growth numbers, which would give you the best total return and annual income streams in 20 years starting with $100,000?

  • High Growth Systems: $1,182,997 total return and $41,214 in annual income
  • Slow Moving Metrics: $1,237,638 total return and $75,145.85 in annual income

Have a hard time believing this? Look at the charts (total return also includes value of that year's dividend):

High Growth Systems' 20-Year Chart

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Slow Moving Metrics' 20-Year Chart

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Clearly, we need to do more than simply find a good company with better-than-average earnings growth and high dividend growth and then hope for the best. We must consider valuation and determine if the higher fundamentals are worth paying a higher price.

One method is to simply compare the firms you have singled out as being superior and weight your portfolio towards those of the best value. This technique is explained below.

Hyper-Compounding Dividends in McDonald's and Coca-Cola

One of the basic principles of the Hyper-Compounding Income model is integrate valuation with a dividend growth system to grow income streams in record time.

My next suggestion will be very hard for many investors to swallow: Do not overly diversify, in that you should not hold all of the companies in your dividend short-list. Every six months buy only those with the best valuations (perhaps only 50% of your list, or the best 15 or 20 if the list is extremely big). Doing so may allow you to grow income streams faster than even the best company on your list. This tactic can deliver a total that is more than the sum of its parts.

To demonstrate this point we will look at two stocks: Coca-Cola (NYSE:KO) and McDonald's (NYSE:MCD). Our "common sense" approach is to diversify and hold both companies since we do not know which will perform better. We divide our $100,000 between these two stocks and simulate investing over the past five years. We maintain equal-weighting and re-invest the dividends quarterly if possible. Over the past five trailing years we would have earned:

  • 91.3% total return
  • Annualized return of 13.86%
  • Forward dividend will be $5,584.58, or a 5.6% yield on cost

But McDonald's was the better of the two investments. What if we were extremely clever and put all our eggs in that one basket over the past five years while re-investing dividends? Then we would have the following returns:

  • 115.04% total return
  • Annualized return of 16.5%
  • Forward dividend of $6,753.6, which is 6.7% yield on cost

This is a strong return. But could a dividend strategy hyper-compound the income stream so that we could still trade only McDonald's and Coke, but somehow get gains that exceed either one? If so, how?

Tactical Dividend Investing With Deep Value

If your goal is to maximize income, you need to keep an eye on capital gains and sell stocks that make large price runs and re-invest in deep value stocks. Why? Because if capital gains increase faster than dividend growth -- even for a short period of time -- you are missing out on the true power of your capital. Your yield just shrank and you could maximize the power of your capital gains by investing in a stock with proportionately better yields. Let's look at a real stock to illustrate.

Consider the year 2011 with McDonald's. Share prices shot up 30% and dividends increased only 14.75%. Because price growth exceeded dividend growth, the yield dropped 14.35% from what it was previously. This extra capital in the share price was not being fully reflected in income. By selling McDonald's and buying another stock of deeper intrinsic value, you could turn more of the capital gains of McDonald's into dividends.

But how do you determine which stock has better intrinsic value at any given moment? Many investors use a variety of valuation techniques, but I can show you the ranking rules used in the Hyper-Compounding Income portfolio. In this instance, we look at McDonald's and Coke to determine which has the best value metric as regards the following:

  • PE ratio excluding extra-ordinary items (trailing 12 months)
  • Forward PE ratio
  • PEG ratio
  • Price to sales (trailing 12 months)
  • Price to FCF (trailing 12 months)
  • Dividend yield

Whichever stock scores higher on the majority of the above is the stock we hold for the following six months. Remember that we only hold one stock at any given time, the stock with the best value metrics. We cut our potential stock universe in half and rotate into the company of best value to potentially grow dividends the fastest. The result after five years of investing?

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Source: Portfolio123.

  • 221.12% total return
  • Annualized return of 26.28%
  • Forward dividend of $10,085, which is 10.1% yield on cost

By rotating into the stock with the best value at six-month intervals, we convert capital gains into dividends quicker than holding either or both stocks for the same period of time. This is one method for income investors to hyper-compound their gains.

But this was only using two stocks. Would this method hold up in a much larger universe?

Hyper-Compounding in Larger Samples

This next test is carried out on a much larger universe of stock that have a history of at least 10 sequential years of increasing dividends. Our main tactic is to choose those stocks with the deepest value and sell them when share price growth exceeds fundamental growth (same ranking system as above). We will run this test starting in 2002 up until Aug. 28, 2012. We start with an initial investment of $100,000.

Total Return in Hyper-Compounding Income Portfolio Since 2002

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Hyper-Compounding Income Portfolio Statistics

The theory of hyper-compounding the dividends faster than each company can organically grow holds up under this larger sample.

Other Tactics to Grow Dividends Fast

This is by no means the only method to grow income. Some investors are superb at spotting superior companies and have developed intuition as to appropriate yield, dividend growth rate, payout ratios and valuation. They may "buy and monitor" while re-investing their dividends in the company of best value.

Others will sell deep-in-the-money covered call options to grow income faster (you still get dividends on shares held) at the expense of capping their capital gains. This is not my favorite method as capital gains are inaccessible for tactical allocation, and you are locked into the stock until option expiration date (unless you want to buy back your options). Your options could also get called away before ex-dividend date.

While there are other methods to grow dividends faster than buying and holding stocks long term, my preference is in this deep value portfolio re-balancing technique that hyper-compounds the income stream.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.