Data sources can be misleading about your returns.
Most sources ignore dividends and only show price returns. When a major news network reports what the market did that day, they speak only of price returns. "The Dow went up 118.86 today." The charts on CNBC, Morningstar, Seeking Alpha, Yahoo - they are all price charts. Price-only charts. Your brokerage's displays are probably price charts. Mine are at E-Trade.
This is the basic price chart on E-Trade for AT&T (NYSE:T), the one you get if you click on the ticker symbol. It shows price only, and just 5 days of prices at that. Displays this short are geared to traders, not to investors.
Displays that ignore dividends ignore a significant source of returns for many stocks. On E-Trade, using "Advanced Charts," I can get six kinds of charts, but none of them shows dividends, total return including dividends, nor the impact on total return if those dividends are reinvested.
A few data sources are geared toward dividends. David Fish's Dividend Champions document displays all stocks traded domestically that have five or more years of consecutive dividend increases. Among the data displayed are each stock's yield, payout, payout schedule, most recent increase, last year's increase, and dividend growth rates for the past 1, 3, 5, and 10 years. Because all of those numbers are calculated in a uniform fashion by an expert in the subject, stocks can be compared on various dividend metrics accurately and with confidence.
What if you reinvest dividends? The return picture changes dramatically if dividends are reinvested.
Let's make a simple example out of the S&P 500. The ETF (NYSEARCA:SPY) is a popular investment for those trying to replicate the returns of the S&P 500 index. Over a short period of time, accounting for dividend reinvestment does not make much difference. Here is what two years (2013-14) looks like, comparing price return to total return with dividends reinvested.
Reinvesting SPY's dividends makes only about a 6% difference in total returns over a two-year period compared to price alone.
But if we lengthen the time period out to 10 years, the difference becomes dramatic.
For the 10 years ending in 2014, SPY's returns with dividends reinvested were 38% more than SPY's price change alone. A price-only chart gives you no clue that this happened.
When I reviewed my Dividend Growth Portfolio a few weeks ago, I was struck by the fact that its income had increased 15% in 2014 over 2013, even though not a single stock in the portfolio had increased its payout that much. How could that happen? Is it a math error?
No, it is the result of reinvesting dividends. I reinvested about $3000 last year, or about 4% of the portfolio's value. That bought about 4% more assets, so all else equal, the new assets generated about 4% more income.
That income was on top of the income that previously owned assets generated. That is why the portfolio as a whole had a cash flow increase larger than the increase from any single component.
Making money off of money already made, of course, is compounding. Compounding occurs when an amount earned on an investment is reinvested. That creates additional earnings that would not be accrued based on the original investment alone.
Thus there are three "levels" of return:
- Price return: The change in price over the time period being investigated. Note that price return can be positive or negative.
- Total return: The change in price plus dividends received. Note that while the change in price can be positive or negative, the dividends are either zero or positive. There is no such thing as a negative dividend.
- Total return with dividends reinvested: This is a multi-level calculation. As dividends are received, they are reinvested. The total return for the original investment is price change plus dividends received. But the reinvestment of those dividends purchases additional assets that will generate their own returns. The total return of the investment operation is the sum of all of the layers of returns.
Let's illustrate that with a common example. Johnson & Johnson (NYSE:JNJ) is a dividend growth stock. Here is its price and dividend history for the past 10 years.
You can see that JNJ's dividend (the red line) has been positive and has increased every year. Its price (blue line), on the other hand, has gone up and down. It took a dive during the recession, stayed about flat for three years, then zoomed upward starting in 2013.
What were JNJ's three returns?
[Notes: For this and all the tables to follow, I used Yahoo Finance's historical returns, including its lists of dividends. For example, JNJ's opening price on 1/24/2005 was $61.85, and its closing price on 1/23/2015 was $102.20. Thus JNJ's price return was +65.2%. Total dividends paid between those dates were $20.185, so JNJ's return from the dividends was +32.6%, and the total return from price change and dividends (second column) was +97.8%. Total return with dividends reinvested is per the calculator at longrundata.com.]
Some of the dynamics of how this happens are interesting. You can see that during the flat price periods for JNJ (during which periods the stock was repeatedly referred to as "dead money"), the dividend reinvestor actually gained a long-term advantage. That is because the reinvested dividends bought more shares than would have been the case if JNJ's price had been moving steadily upwards. Those "extra" shares ended up making a disproportionate contribution to JNJ's total return as time moved on.
Warren Buffett has pointed out this non-intuitive advantage of stagnant prices many times. Here is how he put it in Berkshire Hathaway's (NYSE:BRK.A) 2011 Letter to Shareholders:
The logic is simple: If you are going to be a net buyer of stocks in the future…you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance…Charlie [Munger] and I don't expect to win many of you over to our way of thinking - we've observed enough human behavior to know the futility of that - but we do want you to be aware of our personal calculus. And here a confession is in order: In my early days I, too, rejoiced when the market rose. Then I read Chapter Eight of Ben Graham's The Intelligent Investor, the chapter dealing with how investors should view fluctuations in stock prices. Immediately the scales fell from my eyes, and low prices became my friend. Picking up that book was one of the luckiest moments in my life.
Speaking of Buffett, as we all know, Berkshire does not pay dividends. That means that the three levels of return are the same. Price return = Total return = Total return with dividends reinvested. That is true of all stocks that do not pay dividends, because there are no dividends to collect or reinvest. Total return comes from price changes only.
The following table shows a few Dividend Champions selected at random. It shows the three levels of return, allowing us to see what the actual returns look like when we shift our gaze from the ubiquitous price charts and include the impact of dividends. The last column shows how much of the total return was provided by price.
When a company does not pay dividends, all compounding happens within the company. That is the case with Berkshire. Its assets generate enormous amounts of cash each year, which is collected by headquarters and then redeployed to create even more cash next year. That is compounding.
A Berkshire shareholder receives the benefit of this compounding via BRK's share price, which is an interpretation by the market of BRK's business value. As with all stocks, BRK's price goes up and down.
An individual investor can set up a Grahamian "investment operation" that follows the same general model. That is what I try to do as a dividend growth investor. I collect cash from my assets, then I redeploy that cash to collect even more next year. That is compounding.
A few writers have been critical of that model for the reason that it shifts the burden of making decisions and compounding from the company to the shareholder.
I don't see that shift as a "burden." I see it as fun and rewarding. I accrue dividends rather than drip them back into the stocks that sent them to me. Then a few times a year, I go on a shopping trip and reinvest those dividends. The shopping trips are happy occasions. They are not burdensome at all. I like trying to improve my portfolio and seeing the results of my decisions.
Not only that, I like having some of the value of my assets made available to me via dividends. Dividends provide insights that are valuable, and they allow me to establish and track an income stream for future use in retirement. If the value of your future income stream is locked up entirely inside stock prices (for later conversion to income), progress toward your ultimate goals is hard to track, because prices vary so much. Dividends have much less variability.
And as can be seen from the table of returns, keeping all compounding inside the company does not necessarily lead to the best total returns anyway.
Disclosure: The author is long MCD, HCP, CVX, KO, PEP, T, JNJ, PG.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.