Enjoying The Fruits Of Your Dividend Labor

by: Eli Inkrot

A few years ago, I remember reading about a wine manufacturer that was low on cash but heavy on inventory. In light of these circumstances, the wine producer offered traditional bonds with an non-traditional payout method. One would buy the company's bonds in normal dollar increments, but the investor would receive bond payments not in cash but instead in bottles and cases of wine. At the end of the term, they would collect the principal back. If nothing else it was a resourceful bit of ingenuity.

To be perfectly frank, I have no idea where or when I happened to see this story; perhaps someone out there can help me out in this regard. But the point that I'm trying to underline is the fundamental thought process of the wine investor. More than any other investment circumstance, this particular investor had to make sure that not only did they enjoy the wine company's business, but also their product. They literally had to enjoy the fruits of their investment. Although it is true that the relative risk is somewhat limited to the debt holder, in this particular scenario the wine investor is fully invested in the product. I would liken this scenario to holding season tickets to your favorite sports team whilst breaking even on the purchase. That is, being able to enjoy a few bottles or cases of wine as bond payments is similar to being able to attend a few sporting events while you sell your remaining tickets at a small profit.

So why do I bring up these examples? Or I suppose more pertinently, why I do bring up these examples with respect to an income investment strategy? The answer is relatively straight-forward, but let's set the stage before we proceed much further. Now I have no idea what type of investment strategy you follow or even happen to prefer. Personally I, along with many other Seeking Alpha contributors, tend to lean toward towards a dividend growth strategy. But I'm not here to tell you what's correct for your personal situation. However, it does stand to reason that if you happened to catch the title of this article then you are at least somewhat inclined to take interest in dividend income. So let's work from this premise: imagine that you're an income investor mainly concerned with a growing stream of payouts over time. This of course doesn't preclude you from valuing capital appreciation, but rather it simply states that your lasting concern is generating a greater amount of passive purchasing power over the long-term.

Let's say that you own a collection of the usual DG suspects: Procter & Gamble (NYSE:PG), McDonald's (NYSE:MCD), Johnson & Johnson (NYSE:JNJ), Coca-Cola (NYSE:KO), PepsiCo (NYSE:PEP), Target (NYSE:TGT), Kimberly-Clark (NYSE:KMB), Emerson Electric (NYSE:EMR), Walgreen (WAG), you get the idea. Now, if your primary concern is a rising stream of income over time, then you're already making some strong steps forward. All of these companies have not only paid but also increased their dividend for decades on end now. Further, while history does not indicate future endeavors, there is at the very least a strong propensity for these companies to continue to increase their payouts through time. For example, on say a $30,000 investment in the aforementioned nine companies' one might receive $1,000 in dividends this year. In the next year perhaps this amount jumps to $1,060; $1,123 in year 3, $1,200 in year 4 and so on. More specifically, given that these companies continue to increase their payouts, then your income will likely rise whether you do anything or not. Of course there are two additional moves that you can make to "turbo charge" the results towards your end goal of increasing income over time: making additional contributions and reinvesting dividends. With certainty the math will dictate that these "bonus" factors will provide an added benefit. Of course the math would also dictate that the best amount to reinvest and contribute is everything you possibly can. While I fundamentally agree with the logic (and of course the math cannot be questioned) I am here today to advocate balance within one's investing life. That is, I am here to advocate that one enjoy, if only minutely, the fruits of their dividend labor.

In a previous article I have demonstrated the value of investing for an extra 10 years by simply cutting or reducing certain unneeded expenditures. Now I want to be perfectly clear that I still stand behind this fundamental logic. However, this article looks to suggest that a balance can be struck between rigorously reinvesting dividends and taking a few nights or shows on the town. Much in the same manner that one is ok with having an insurance premium or emergency cash in an account that is losing purchasing power over time, I am ok with one using a small portion of your dividends for reward rather than diligent reinvestments. That is, sometimes there are psychological benefits in our efforts that are difficult to quantify.

Here's the logic: it is overwhelmingly true that the best use of your current dividend payouts is likely to be put back to work into additional profitable opportunities. By doing so you are allowing the magic of compounding to work and will likely reap greater benefits in the future. However, I would like to make a couple of points. First, whether you will most need the future benefit in 5 years, 25 years or never is quite unknown. Second if you spend today and the next decade cutting out every single unnecessary expenditure that you might think about, then in reality you likely wouldn't be living now or in the future. As Carl Rogers would put it, "what we are to be, we are now becoming". More aptly, if you spend the present worried about reinvesting dividends rather than enjoying your life then it stands to reason that in the future you would continue on this path even once you have reached your applicable goals. Viewed in the reverse, I have known a great deal of people who had the financial means to not work another day in their life; yet day in and day out they go to the office. Perhaps Warren Buffett can better illustrate: "[the] chains of habit are too light to be felt until they are too heavy to be broken." What we are doing today we are likely to be doing in the future. It just so happens that it's easier to adjust today than it is 10 or 20 years down the road.

Of course the overarching qualifier for enjoying some of your dividend payouts is that one must both consider and understand their applicable opportunity cost. In fact I have previously detailed such a relevant exercise. Let's take a look at the difference between reinvesting dividends and not reinvesting dividends with a starting $10,000 investment in McDonald's in 2003:

McDonald's without Reinvestment
Invest Price Shares Dividend Payouts
Aug, 2003 $10,000 $23 434.783 $0.40 $173.91
2004 $27 434.783 $0.55 $239.13
2005 $32 434.783 $0.67 $291.30
2006 $36 434.783 $1.00 $434.78
2007 $49 434.783 $1.50 $652.17
2008 $62 434.783 $1.63 $706.52
2009 $56 434.783 $2.05 $891.30
2010 $73 434.783 $2.26 $982.61
2011 $90 434.783 $2.53 $1,100.00
Oct, 2012 $91 434.783 $2.87 $1,247.83
Value $39,565.22 Total Dividends $6,719.55
Click to enlarge

Here we see the substantial increase in value due both to McDonald's ability to increase its dividend payout by an average rate of over 24% a year in combination with the 16.5% yearly price appreciation. During this time we do not assume reinvestment and thus collect the dividends. That's $6,700 to spend over the course of a decade as you please. Considering that your principal value also increases by almost four times, that's not bad. Now let's look at what happens if you reinvested the MCD dividends:

McDonald's with Reinvestment
Invest Price Shares Dividend Payouts
Aug, 2003 $10,000 $23 434.783 $0.40 $173.91
2004 $27 441.224 $0.55 $242.67
2005 $32 448.807 $0.67 $300.70
2006 $36 457.16 $1.00 $457.16
2007 $49 466.49 $1.50 $699.73
2008 $62 477.776 $1.63 $776.39
2009 $56 491.64 $2.05 $1,007.86
2010 $73 505.446 $2.26 $1,142.31
2011 $90 518.139 $2.53 $1,310.89
Oct, 2012 $91 532.868 $2.87 $1,529.33
Value $48,490.97
Click to enlarge

Here we see that we start with the same amount of shares and payouts in year one. However, once the first year of payouts is received they are reinvested on an average basis each year. Moving to today we see an ending value of about $48,500 with 532 shares instead of 434 shares. Notice that I did not aggregate the dividend payouts as those would not actually be in hand. The difference, without doing time value of money calculations, is twofold. First we have a total value that is roughly $3,735.53 higher by reinvesting than by taking the payouts ($48,490.97 + $1,529.33 - $39,565.22 - $6,719.55). The second difference is the dividend payout going forward. Without reinvesting, one would receive about $1,250 in yearly income. With reinvestment, one receives about $1,530 in yearly income. To be sure these differences are significant. However, we have not yet explored what one might have been able to do with the $6,700, or $670 average yearly payout. While it is true that you could have reinvested these payouts in other profitable opportunities, that's not the lasting point. Perhaps you used that money to donate to your church, take your wife out for a nice quarterly anniversary dinner, used the money to pay your cable bill or start a new hobby. The point is that there might be better things to do with your dividend payments, mathematically speaking or not. In essence, one should make sure that the funds they chose not to reinvest are used in such a manner as to adequately make up for the foregone opportunity costs.

It should be noted that I am in no way am discouraging the reinvestment of dividends, either strategically or by a direct program. I myself allow my dividend payouts to aggregate and redeploy every penny that I can. In addition, it is paramount to understand your wide array of options. Moreover, perhaps you only take a tiny portion of the dividends to use as you please. But my lasting thesis is this: there should be a balance between meticulous reinvestment and enjoying the fruits of your dividend labor. It could be that you are just beginning and thus your dividend fruits are not yet ripe. But in general, small rewards can work as a focusing fortitude over the long-term. In fact, taking a small dividend payment once a month or once a quarter to pay for a dinner or a game night might even provide quantifiable motivation to keep on investing. Without balance, without fun all dividend reinvestment and no enjoyment makes the dividend growth strategist a dull investor.

Disclosure: I am long MCD, PEP, JNJ, PG, TGT, KO, WAG. 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.