Striving to Consistently Outpace The S&P 500 Index
0% Management Fee, Performance Fee Only.
The Importance of Dividends
Dividends have always played an important role for investors. Taking a step back, we can see just how important dividends are for not only growth in investments, but also the health of a company. Automatically reinvesting the dividends produces enormous advantages for the investor.
An investor simply buying the market in the form of a mutual fund or ETF would have had excellent results by reinvesting the dividends. However, it should be noted that this option was not available until 1976 when the founder of Vanguard, Jack Bogle, launched the first mutual fund to mirror a market index. The first ETF to track a market index was invented in 1993. Let’s look at an example of how powerful dividends are when reinvested. We will use the time period from 1928 to 2019 for the S&P 500 Index.
If an investor had automatically reinvested their dividends, their annualized return would have been 11.95% versus only 7.94% had they not reinvested the dividends. This means that an investment of $1,000 would have grown to about $29,000,000 versus only $1,046,000, had the dividends not be reinvested. Some might say this time period is too long, so let’s look at a more realistic length of time. Results are still impressive when we take those averages and apply it to a 30-year period, given the fact that most Americans start saving and retire within this time frame, an investment of $10,000 would turn into $296,000 vs $99,000, when reinvesting dividends against not reinvesting dividends.
This dynamic is further amplified when applied to individual stocks. Let’s look at a hypothetical example. Suppose you buy $10,000 worth of shares from Company A trading at $100. At the beginning of the period, you would have 100 shares. Let’s assume further that Company A maintains a 2% dividend yield for 30 years. This means for every share, every year, you will receive $2. For example sake, we will assume the stock price does not change from $100 during that 30 year period. By the end of the 30 years, your investments would be worth about $18,000.
We can apply the hypothetical listed above to a Dividend Aristocrat for an investment period of 30 years. A Dividend Aristocrat is a company in the S&P 500 Index that has raised their dividend every year for at least the last 25 consecutive years. Currently there are about 65 Dividend Aristocrats with the top ones having a record of 57 consecutive years of dividend increases. Let’s further assume that the stock price of Company A has increased at a modest annual rate of 4% and increased their dividend by 4% per year with a starting dividend yield of 1.5%. A $10,000 investment would be worth about $50,000 of which about $10,500 came from dividends. If the investors had not reinvested the dividends, the end balance would be about $32,500. The investment during that period quintupled without spending a single additional dollar.
The advantage of automatically reinvesting dividends should be clear, but dividends provide another key factor, transparency. When a company pays out a dividend to shareholders, it is in essence, making a statement that it is producing excess cash flows that are better off sent back to shareholders. It tells the investor that the company is currently healthy and continuing to produce cash. The dividend can also be a good indicator as to when a company could be headed for trouble.
A key indicator to look for is the dividend payout ratio (sometimes referred to as the payout ratio). The payout ratio tells us what percent of the company’s net income is being returned to investors. For the most part, companies will state their intended payout ratio, say 35% - 50%. One can calculate this by dividing the Annual Dividend per share by the current EPS then multiply by 100. If Company A has such a mandate but the ratio is creeping up above such target, trouble could be ahead. Likewise, a company that has a payout ratio of above 60% could be risky. Companies that offer large sums of their net income in dividends could be forced to cut back. Wall Street does not take kindly to lowering or erasing the dividend, thus the stock price usually takes a dive. It is important to keep an eye on the company to make sure they are not taking on debt simply to keep up with the dividend. By being on the lookout, an investor can possibly get ahead of the dreaded press statement “We are reducing our dividend” or worse yet “we are eliminating the dividend for the foreseeable future”.
Dividend paying stocks are not the only vehicle to increase an investment, but they certainly offer investors great odds.
To view track record, please contact Greg Cavallini at greg@cavallinicapital.com.