The Power of Dividends

Two good articles in today's Wall Street Journal: "Stock Dividends Make a Difference" and "Hedge Funds Gain in July but Underperform Stocks." With these topics in mind, I think now is a good time to explore the power of dividends over the long-term and why you should seek out companies that have been reliable in paying dividends over time. A future post will explore hedge fund performance.

Basic Premise

The power of compounding reinvested dividends over a long period of time is nothing short of miraculous. Think about it. Let's say you invested $10,000 in a stock with a 5% dividend yield paid out annually. After a year, you'll have $10,500 assuming no change in stock price and you'll earn 5% on $10,500 instead of just the original 10k the next year. That may not sound like a huge difference, but over the course of time, this continual building upon itself really adds up.

After 20 years, assuming the stock price hasn't gone up (or down) one penny, you'd have a staggering $26,532.98! An increase of 165% and that's not including any capital appreciation in the stock price. Essentially, reinvesting dividends is like an automatic money-making machine that never stops even if the stock doesn't go up one penny!

Real-Life Examples

Consider these real-life examples to further illustrate this point.
  • Johnson & Johnson (JNJ) - If you had invested $10,000 in JNJ back in 1975, you'd have approximately $752,750 today (a 7,427.5% increase). Your 129 shares you purchased in 1975 would have turned into 12,500 shares after splits and dividends.
  • General Electric (GE) - Even though it's been battered tremendously in the past year, if you had invested $10,000 in GE in 1975, you'd have about a cool $1.49 million today. Your 259 shares purchased in 1975 would have turned into 38,461 shares.
  • Coca-Cola (KO) - To illustrate this point even clearer, let's shorten the timeframe tremendously and choose a stock that hasn't performed nearly as well. Coca-Cola is down nearly 20% in the past 10 years. But if you had invested $10,000 in KO in 1999, you would have now approximately $12,400, for an increase of 24%. Your 167 shares would now be about 210 shares. Not nearly as impressive as the other examples, but the stock has performed poorly and we cut the timeframe in half. And KO's dividend yield isn't earth shattering either at 3.2% currently. It's just been reliably paid, and that reliability pays off.
I could have illustrated this point with many other companies including Pepsico (PEP), Proctor & Gamble (PG), Colgate-Palmolive (CL), and many more. The point is that they all pay reliable dividends. Not only do the dividends themselves pay handsomely and build upon themselves over time, but dividend-paying stocks have outpeformed non-dividend paying stocks historically even when completely ignoring the dividends.

Capital Appreciation vs. Dividends

Frequently, it is posited that equities have gained an average of 10.3% a year since 1920. Well, the majority of this increase is because of payments in the form of dividends. As you can see in the graph below, for large cap companies from 1980-2004, capital appreciation has only accounted for about 25% of the return on investment, while dividends account for approximately 75%. This fact is lost on many investors seeking to maximize their returns over a long period of time. Looking at it another way, over a 20-year period, capital appreciation has returned 381.9% for the S&P 500, while reinvesting dividends in the S&P 500 on top of the capital appreciation has resulted in a 905.1% increase in your investments.


Not only that, but before even taking dividends into account, the capital appreciation of dividend-paying stocks have outperformed non-dividend paying stocks since 1970 as the graph below illustrates.

(Click to enlarge)
When choosing what stocks to invest it, check out the dividend payout ratio and confirm it's been consistent. A great site to look at is http://www.dividendinvestor.com/. They will give a star rating based on how many consecutive years the company has increased its dividends as well as key statistics such as the dividend payout ratio, dividend ex-date, pay date, current yield, 5-year average yield, availability of reinvestment plans, consecutive dividends paid, and much more. It also gives basic fundamentals such as P/E, share price, EPS, etc.

Conclusion

In the end, choosing dependable large-cap reliable dividend payers may seem like a boring strategy to some individuals. Trading in highly volatile tech small-caps without dividends may appear to be the only way to go for investors seeking the possibilities of tremendous returns. However, the evidence clearly indicates that these "boring" companies have the capacity for astronomical returns over the long-run. Dividend reinvestment and seeking out companies with reliable and reasonable dividend yields is one of only a few key strategies all long-term investors should adhere to if they want to preserve and gain capital for the future.

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