Dividend investing, an overview
This note is intended to simply demonstrate the arithmetic behind income investing and is NOT intended to provide any indication of future returns. Tax, in the main, has been disregarded, but would be payable by virtually any investor, broking & holding costs have also been disregarded.
Warren Buffett describes his preferred holding strategy as “forever”
Dividend stocks pay you to own them
NB – this note is intended to demonstrate the sanity behind the concept of dividend investing: the principle of compounding. For ease, it ignores tax and reinvestment charges but you must be aware these may have a material effect.
Between 1926 and 2012 £10,000 invested into the S&P500 in the US would have grown to a tad over £1,342,000. Not a bad end sum (ignoring inflation), but had the dividends been reinvested the end sum would have been £39,384,367. The simple maths of compounding is oft forgotten in the markets but this is fundamental to accruing material gains from investments over time.
There are many intelligent methods of making profit from investments, however there is a time-proven method of cutting investment costs and reducing overall risk. Dividend investing depends on two key components: long term buy and hold, and cash generation by the investment you own.
Anyone who has ever owned a credit card will probably have had demonstrated to them at some time just how quickly interest adds up, creating a financial millstone. The converse is also true – dividend investing can demonstrate just how fast (relatively speaking) a portfolio can add up; when companies increase their dividends your income increases.
There are many questions to ask in dividend investing, the main ones being...
How long has the company paid dividends?
(the dividend yield and history)
In the UK, Foreign & Colonial Investment Trust started the ball rolling in 1868! In the US there are equally good payers such as Colgate Palmolive (NY:CL) that has paid dividends every year since 1895 and Proctor & Gamble (NY:PG) (yield 1.9%) since 1891. The fundamental role of a long term company is to make profit, and to share that profit with the owners, the shareholders (don’t mention the banks and bonuses).
Are the dividends sustainable?
(the dividend payout ratio)
GlaxoSmithKline pays out 82% of its earnings; WPP pays 44%; British American Tobacco 67% and Pearson 53%. Normally a payout ratio below 70% is ‘good’. The payout is that share of the cash that has been generated.
Are the dividends growing?
(the dividend growth rate)
Foreign & Colonial Investment Trust and a host of others have raised their dividends for the past 46 years (since the late 60’s). City of London for 51 years, Bankers and Alliance Trust for 50 years (this isn't a fluke).
A competent strategy is to hold a selection of dividend-payers diversified across different industries, which continually raise their dividends, and to reinvest those dividends back into the stock. You end up with a simple dividend-producing machine.
It's just maths.
Investment Trusts can be higher payers if the share price is at a discount. For example, City of London holds all the usual dividend payers (VOD, BAT, Shell, SSE) and the trust share price is at a 4.33% discount, so an investor gets the same yield but only has to pay 95.7p for £1’s worth of stock. With Foreign & Colonial the discount is 10%. (June 2013)
Dividend increases drive your dividend yields
Why are dividend increases important?
Let’s look at a hypothetical scenario where you invest £100,000 into a share priced at £10 and which has a dividend of 50p, with both dividend and share price rising at 10% per annum:
Key points for dividend investors
In 20 years the dividend pay rate is still 5% of the share price, BUT because it is calculated by the company in £.s.d. it now equals 28.8% of the original share price you paid.
After 20 years you now have stock which is valued at £600,000 and you also have an income of £28,800 per year. All from a single commitment of £100,000.
If the dividend is not cut (and there are no guarantees here) you will receive a rising income every year, irrespective of bank interest rates. NOTE: if you had bought the stock via an ISA, the comparable interest rate on a cash account would be 48% for a 40% tax payer. This is why ISAs are fundamental in UK retirement planning.
Between years 8 and 9 from the dividend income alone (without any stock appreciation) your annual rate of return would be at 10% and growing.
Remember, in an ISA, that income is tax free;
Remember, in a SIPP, that income may well be higher than an annuity rate.
The power of dividend increases is huge but it needs two things; time and your patience. An investor needs to focus on the end goal: will I be satisfied with a 10% annual return on my investment portfolio and have I the patience?
Compounding dividends
Compounding dividends are the investment that makes money, added to the money that the money has already made. By creating this virtual cycle, you will have created your very own dividend money machine. Dividend reinvestment will buy you more shares, and they in turn will earn you more dividends.
By systematically reinvesting dividends, which are normally paid quarterly or bi-annually, you automatically benefit from pound/cost averaging with an ever increasing amount of shares without committing any new cash. Investors who do not need to draw income and who automatically reinvest have created their own ‘money machine’.
Take a hypothetical example of an investor who owns 10,000 shares of a £10 share that yields 5%, and reinvests the dividends paid. (For simplicity the stock price remains at £10 and the dividends are not increased.)
Key points for dividend investing
By harnessing the power of dividend reinvesting, in less than 15 years the investment would have doubled in value to over £200,000 and shares owned to over 20,000.
This return does not take into account any dividend increases or even any stock price appreciation. The return is solely based on the dividend reinvestment.
Locating a diversified basket of stocks that pay a dividend, have a history of paying a dividend and increase the dividend regularly is a great step towards creating a private money machine.
If you are receiving a consistent yield do you care about the share price?
Share investing in the current market can lead to sleepless nights, and the explosion of media reporting only helps to unsettle investors, scaring them into forgetting the reason they invested in the first place and creating lemming-like bailing out in falling and crashing markets. Economies are cyclical, and are directly controlled by us, the humans, who have frequent emotional and irrational reactions to all we see and hear every day. Holding an investment that is valued for you every minute of the trading day creates doubt and fear of loss.
It is important to remember that a loss only belongs to the investor when he sells the asset. In our firm we only recommend investing in assets; things that are there every day but which are valued in their own markets. Those assets will rise and fall in value; there are better times to buy, and better times to sell but we, like you, have no crystal ball, and investments we recommend will sometimes look dire. With dividend investing, investors need to shift the focus from the daily value of the asset and focus on the accruing value of the income; after all, eventually the cost of the asset will have been paid back in full.
Foreign & Colonial Investment Trust demonstrates this quite clearly when an investor looks at the share price and dividend side-by-side over the past ten years:
Over the past ten years....
The share price has moved from 273p to 766p, an increase of 281%
A £10,000 investment is now worth £28,100
The dividend has risen every year from 6.65p to 11.6p, an increase of 174%
A £10,000 investment would have received £5,022 gross income over the past ten years
If reinvested gross, the shareholding would have grown from 4,386 shares to 5,402
and the value would be £41,376, an increase of 414% …
With a growing annual income of £626 in year 10
Steady Eddy? Better than cash? Value for money?
Foreign & Colonial is a long in the tooth ‘widows and orphans’ company that could only ever be described as long term conservative.
Others are more aggressive which can create different problems, consider Barclays in the chart above.
The share price moved from £4.45 in January 2000 to £3.57 in 2010, a fall of 20% over ten years, and was a very scary hold over 2008/09.
Dividends collapsed over that same period from 52.5p to 2.5p
The total gross dividends declared over the period equal £7,313, or 73% of the original £10,000 investment
Reinvestment of dividends on a gross basis would have paid back the initial investment in year 6, having been invested during the market down turn of 2000-03
The average gross dividend between 2000 and 2008 was 8% of the original share price
The Barclays share price fell to 55p on 9th March 09, less than the 61p dividend paid in 2001.
But beware the single company - at the end of 2017 it's share price was £2, with a measly 2016 dividend of just 3p.
This shows that simply looking at the current value of the share is totally misleading when assessing ‘have I made any money?’
This note has been focused on dividend investing, but it probably should have been on ‘yield investing’ because the same principle applies with all yielding investments, be it an income-producing ETF, an equity income unit trust or a property fund.
With all these examples the focus is on finding assets that pay you to hold them; after all, if you own a blue chip with a 4% net yield that’s 400% more return than you’re likely to get at the bank, and if you’re a long term investor do you really care about what happens to the share price in the meantime? The ‘Power of 72’ rule shows that a 6% net yield will pay back all your initial investment after 12 years. (June 2013)
Words on investing from the Sage of Omaha, Warren Buffett
“Time is the friend of the wonderful company, the enemy of the mediocre. Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years. I don’t look to jump over 7-foot bars: I look around for 1-foot bars that I can step over.”