A Raging Bull Market And The Price Of Reinvesting Dividends

| About: The Procter (PG)
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Summary

The overall market is overvalued by historical standards, making dividend reinvestment progress slow.

Collecting cash instead of automatic dividend reinvestment can increase gains.

However, the power of compounding cannot be ignored.

Is the market so overvalued that it's not even worth using DRIPs at the moment? That was my thought the other day as I received my latest round of dividend payments and noticed that my shares received in exchange were pretty low. If you would not buy at the current prices with your active income, why should you buy with your passive income?

I have put together a scenario with Procter & Gamble (NYSE:PG), a dividend champion and core holding in many portfolios, using historical data. While of course history in the stock market is no indicator of future results, it is better than completely flying blind. I believe a dip in the future is inevitable, so the question I pose is: Can a properly timed purchase using collected dividends beat returns on a DRIP?

I want to run two scenarios with the first one being if there is a steep decline in share price. I went back to the year 2006 to start my theoretical purchase so it would run through the Great Recession. We will use 100 shares purchased in September at a price of $62.85 as the starting point. My process for selecting this time and when to stop was as follows:

  • My purchase price for PG was $78, and the current price is ~$91, a ~17% increase.
  • I went to the last bull market peak in January 2008 and found the price to be $73.58. A ~17% decrease from there working backwards led to September 2006 and a price of $62.85.
  • I wanted to get a full peak/bottom cycle so I started in September 2006 and collected results until January 2010. The cycle had a peak of $73 in Jan 2008, a bottom of $47 in April 2009, and returned to approximately the purchase price in January 2010.
  • For simplicity, I'm assuming a purchase price of $50 for the timing the market scenario at the beginning of April 2009 (close to the bottom, but like in the real world, not perfect).

*Data is monthly highs from Yahoo! Finance.

As you can see in the tables, it is possible to beat the returns of a DRIP with timing during a steep market decline. Collecting cash and choosing when to reinvest gives you the advantage of lowering your average cost per share, but this does come at the expense of losing out on partial shares paying dividends. Also, this almost cherry picked example only showed an advantage of 1.2% and is predicated on the huge IFs of having a significant enough drop in stock price and the foresight/knowledge/luck of purchasing when the price is near the bottom.

The second scenario I ran was a metric-driven approach of when to reinvest dividends and when to hold onto cash. I started this theoretical run with a purchase of 100 shares five years ago. At the time of purchase on 3/20/2012, PG was trading at a P/E ratio (using 2011 earnings) of 17.2. This is historically a good value based on P/E ratio alone, so I decided that anytime the ratio was above 17.2, the dividends would be held in cash, and whenever the ratio fell below this threshold, any cash accumulated would be used to buy more shares and the dividend would be set to reinvest.

Once again, timing does have the potential to beat a reinvestment plan, but the gain is so insignificant (0.6%) that it is hardly worth the time of constant monitoring or the risk involved of missing significant stock price appreciation (i.e. DRIP resulted in 117.20 shares while timing resulted in 112.53 shares, and if the price continues to rise, DRIP will easily outgain timing).

Conclusion

There are certain advantages and disadvantages to both approaches. Timing allows you more control over your average cost per share and lets you retain more value during steep market decline since part of your holding is in cash. A DRIP is easy to use, allows you to collect dividends on partial shares, and allows for greater gains if the stock price continues to appreciate. Personally, I will stick with the easier method and let those dividends reinvest themselves.

Disclosure: I am/we are long PG.

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.