Long-term shareholders of McDonald's (MCD) may have noticed that the stock is not exactly trading at over $100+ anymore. For those who had been planning to sell the stock in the near future, this is no doubt bad news. However, for long-term shareholders of the company, the combination of the sustained (and growing) dividend payouts amidst a share price slump has provided the kind of reinvestment opportunity that may lead to boosted returns over the long-run.
Dr. Jeremy Siegel explained the reason why on page 244 of his work "The Future For Investors":
An important reason why these high-dividend strategies work so well is because of the basic principle of investor return. The principle states that stock returns are not based on earnings growth alone but on growth relative to expectations. For many of these dividend-paying stocks, investors became overly pessimistic at a dip in earnings growth, leading to lower-than-justified valuations and higher-than-average returns. For stocks paying a dividend, these lower valuations led to higher dividend yields, and investors were able to accumulate more shares at discounted prices. The return accelerator worked its magic on these stocks.
The technique of effectively managing the growth of dividend payouts so that: (1) dividend growth rates are less than earnings growth rates in good times, and (2) dividend growth rates are greater than earnings growth rates in bad times can be useful in delivering superior returns. Presumably, during times of particularly robust earnings growth, the price of a stock advances, thus diminishing the impact of the reinvested dividend. Yet, when a company uses its payout flexibility to raise the dividend by a greater rate than the earnings growth during more difficult times, the shareholders may reap better gains due to the combination of nice dividend raises coupled with a lower share price of reinvestment.
To continue with the McDonald's example, the company traded right below the $100 mark in April. And the firm has delivered somewhat disappointing earnings in the past two quarters - the company earned $1.32 per share in the second quarter of 2012 compared to $1.35 in 2011, and the company earned $1.43 in the third quarter of 2012 compared to $1.45 per share in the third quarter of 2011. Meanwhile, McDonald's has raised the quarterly dividend by 10% to $0.77 from $0.70.
For the purpose of an investor seeking to reinvest and steadily accumulate shares, this is an interesting change from the beginning of the year. If I owned 300 shares of McDonald's earlier this year, I would receive $210 that would buy me 2.1 additional shares (assuming reinvestment at the $100 mark). Now, however, an investor with 300 shares would receive a $231 quarterly dividend check that gets reinvested at $87, adding 2.65 shares.
My purpose here is not to sing the praises of stagnant earnings growth coupled with high dividend growth. By definition, that is unsustainable. I would love to be the long-term owner of stocks that grow earnings and dividends by 10% every year like clockwork. But the real world doesn't generally work like that. I wouldn't buy shares of McDonald's if I anticipated mediocre earnings growth going forward.
Rather, I am pointing out the advantageousness (if that's a word) of dealing with companies that have a margin of safety in their payout ratios to raise dividends by 7-11% rates every year (even when the growth rate at the time does not equal that) so that when lower earnings reports lead to lower stock prices, a rising dividend can be sedulously reinvested at the lower stock price.
This advantage is best applied to blue-chip companies that have a high chance of posting reasonable earnings growth over just about every five-year period, yet are experiencing a temporary bump in the road in terms of earnings growth. Five years from now, it is highly likely that the long-term McDonald's investor will look back upon the $231 dividend reinvested at $87 much more favorably than the $210 dividend reinvested at $100. The consistency of a rising dividend over the long-term can provide some salve for investors when earnings are temporarily flatlining, taking some of the sting out of short-term bad news for your core dividend growth holdings.