Published on June 8th, 2017
Sam is the co-founder of uuptick, a stock analysis platform for investors like you. He operates the platform with his father Robert Kovacs, who shares the father and son team’s analysis on Seeking Alpha. As dividend growth investors, uuptick is being developed to solve many of the DGI community’s pain points.
What is the best way for you to reinvest your dividends?
Many dividend growth investors use Dividend Reinvestment Plans (DRIPs) to automatically reinvest the dividends in new shares. Brokers also offer synthetic DRIPs, which achieve the same effect. The differences between both are mostly technical.
But why do investors use DRIPs? Are they right for you?
And more importantly can you do better than using dividend reinvestment plans?
In this article, I will:
- Mention a few key advantages and disadvantages of DRIPs
- Run a 15-year portfolio simulation to see how DRIPs do
- Debunk a couple dividend myths which too many people believe.
- In doing so you’ll learn some more about Greek mythology, a weird Pizza store owner, as well as a mis-attributed Mike Twain quote.
Without further ado…
Dividend reinvestment plans offer investors 3 key advantages
- Dividend reinvestment plans are a hands-off strategy. Once you set the DRIP you can forget about it as long as you are happy owning the company. Come back in 10 years, and you will have a load more shares if everything goes well.
- DRIPs offer the possibility to purchase fractional shares. This is cool when you start with lower portfolio values because you can reinvest the totality of the dividend and not round down to the lowest number.
- DRIPs also reduce biases you have as an investor. As investors, we have loads of biases. And anything we can do to help reduce their effect is good. Investing in dividend reinvestment plans removes your focus from day to day movements as you buy more shares every quarter regardless of the price.
But dividend reinvestment plans also have a 2 key disadvantages.
- DRIPs make you purchase shares when they are expensive. The obvious rebuttal to the 3rd advantage. Maybe if you were making discretionary decisions you wouldn’t keep buying more of a stock which has a current yield of 1%, even if your yield on cost is much higher.
- It can be hard to liquidate a position accumulated in a DRIP. In many cases you will have to contact the company, and it can be quite a bit harder and slower than unwinding a position with your broker. If you use a broker DRIP this sorts out this problem but also removes the advantage of partial shares.
I wanted to know at what cost the advantages of DRIPs boasted by the dividend growth investing community came.
So, I ran a simulation over the last 15-year period.
To do so, I compiled price and dividend data of the 10 dividend stocks which have the longest streak of consecutive dividends. I pulled these stocks from David Fish’s list. Here are the 10 securities.
- American States Water Co (AWR). Dividend streak: 62 years
- Dover Corp (DOV). Dividend streak: 61 years
- Northwest Natural Gas Corp (NWN). Dividend streak: 61 years
- Parker Hannifin Corp (PH). Dividend streak: 61 years
- Genuine Parts Company (GPC). Dividend streak: 61 years
- Procter & Gamble (PG). Dividend streak: 61 years
- Emerson Electric co (EMR). Dividend streak: 60 years
- 3M Co (MMM). Dividend streak: 59 years
- Vectren Corp (VVC). Dividend streak: 57 years
- Cincinnati Financial Corporation (CINF). Dividend streak: 57 years
These are stocks which have been paying dividend for ages (all are Dividend Kings). Even 15 years ago, every single stock on the list had been increasing dividends every year for over 40 years.
I created a mock portfolio of $100,000 and assumed a perfect split of $10,000 dollars in each of the 10 securities on the first trading day of 2002.
I then run two simulations.
The first simulation assumed that investors would use dividend reinvestment plans for all the securities. On the day they received the dividend, they automatically purchased stocks from the same company with the dividend, at no cost.
In the second simulation, our mock investor would make a monthly purchase on the first day of trading. Knowing that he has invested in safe, solid, blue-chip stocks, he simply invests the dividends received during the previous month in the stock with the highest forward dividend yield.
Now before I start, I must disclose that both these mock portfolios suffer from survivor bias. The investments are all made in stocks which we know are still around, increasing dividends 15 years after the simulation starts.
This has no effect whatsoever in comparing the results of the two simulations, but investors should keep in mind that in real life, they could end up having stocks in their portfolios which cut their dividends, or even go out of business. I briefly address how you can try to avoid this happening to you below.
Now that I have said that, let’s have some fun.
We will call the portfolios the DRIP portfolio and the dynamic portfolio for simplification.
The DRIP portfolio underperformed the dynamic portfolio over the 15 year period…
…But it would be unfair to conclude that returns were significantly better. The portfolios performed in a similar fashion throughout the years.
(Total performance since inception)
As you can see in the table above which shows the total return since the beginning of the simulation, the dynamic portfolio’s return only outperformed significantly from 2014 forward. This is mostly due to divergences in portfolio weights.
The dynamic portfolios overperformance came from buying the securities which yielded the most at any given time, which meant that investors were buying the cheapest of stocks in respect to yield. This meant that in downturns, the portfolio went down less since stocks were being bought at cheaper prices. You can see the details of yearly returns below.
But it is when you look at dividend income that it gets exciting.
While looking at overall portfolio value is nice, as dividend growth investors we are more focused on the income stream. The idea is that this income stream will grow overtime, and ideally it will see investors through retirement.
And nobody will be surprised to learn that the income generated from the dynamic portfolio beats the DRIP portfolio hands down.
Since you are only ever buying the stock which yields the most, you will be getting more income. The math is obvious.
The table below shows the yearly income generated by each portfolio
(Yearly dividend income)
Within 15 years of actively investing in the stock which yielded the most, an investor would have 11.7% more income yearly than simply by DRIP-ing.
Now don’t get me wrong, I’m not suggesting that as an investor you replicate this strategy.
First, because you don’t have the benefit of knowing ahead of time which companies will survive, and second it will lead to your portfolio being unbalanced and weighted too heavily in a few securities.
The goal of the simulation is to challenge some of the dividend growth investing mantras which are found all over the internet. (Luckily not on Ben’s website. He wrote these cool “8 dividend rules”. I agree with most of what he says there.)
Two dividend investing myths which need to be debunked
Like the misattributed Mike Twain quote says: “It’s not what you don’t know that gets you killed, it’s what you know for sure, that just ain’t so”.
- Don’t chase high yields.
This comes from a good place, and is a good reflection of the society we live in. You are told not to overreach because it is dangerous.
And it is true it is dangerous. We all know of the story of Icarus who fled the Island of Crete with wings designed by his father Daedalus, only for the wax which stuck the wings to a frame to melt as he got too close to the sun.
The main takeaway from the story is that Icarus shouldn’t have flown too close to the sun. If he hadn’t flown so high, he might have made it alive.
But we tend to forget that before taking flight Daedalus warned Icarus not only to fly to close to the sun, but to also avoid being too close to the sea, because his wings would become too heavy with the water which is sprayed from the waves.
I talk about this analogy because the exact same thing is happening in the dividend growth investing community.
Investors remember they shouldn’t chase high yields and that dividend growth is more important. Both these are true, but the result is that investors settle for below average yields. Of the 109 Dividend Champions in David Fish’s list, 41 yield less than 2%. So while the dividends from these companies will likely keep growing, in the first years, you won’t even have enough of a cash return to compensate for inflation (~2.5%).
At a 10% required return, a stock yielding 2% would have to grow its dividend by 7.8% in perpetuity to justify the price, whereas a stock yielding 4% would only have to grow its dividend by 5.7% in perpetuity to justify the price. While the difference between 5.7% and 7.8% might seem small, it is huge when compounded over long periods of time, making 7.8% growth much harder to sustain.
This means that by buying stocks which have higher yields you have an embedded margin of security because the company won’t need to meet aggressive dividend growth goals to meet your required return.
It goes without saying that this is provided you pick stocks who can keep paying and raising the dividend.
While the growth effect on your future income is important, there is also a yield effect. If you and I buy the same stock, only you buy it at the beginning of the year when it is yielding 2% and I buy it at 3% the same year following a correction, I will ALWAYS have a 50% higher yield on cost than you. That means forever, regardless of dividend growth, you will never catch up. Which means for every dollar the stock pays you, I will get paid one dollar fifty.
The portfolio simulation shows this effect perfectly. These stocks grew their dividends over time, but investing in those which had the best yields produced the most income.
New dividend motto: Don’t chase high yields, but don’t settle for low yields.
- Don’t time the markets.
Going back to my last example, where I got more dividends than the other investor because I bought the same stock but at a better price, it is only achievable if you do time the market.
Once again not timing the market comes from a good place, but dollar cost averaging is not the answer.
The idea behind not timing the markets is that very few investors have managed to do so successfully. And I am not saying I am able to, at least not in the way which the motto intended.
The idea behind not timing the market is that you shouldn’t purchase a stock with the intent of selling it in the short-medium term, at a profit.
But a lot of investors have taken to heart that they shouldn’t even attempt to buy at the best possible price and that if they just buy great companies which grow their dividends, they will be fine.
And they probably will be fine. They will be “business class fine”. I think as investors we should not just reach for business class fine, but for “first class fine”. Sure, the extra leg room is a step up from economy, but they have beds in first class.
The only way to achieve the higher returns combined with a lower probability of bad returns is to time your purchases.
Every asset has a right price. The estimation of what the right price is subjective. But as investors we need to have a target price and purchase at that price. It could be as simple as looking at the historical dividend yield and committing to buying only at the top of the range.
Let’s imagine that next week when you come home from work you bought 1 dollar worth of pizza from the pizza place down the street. It’s an unusual pizza place, because the owner changes prices daily.
The first day, he quotes $1 per slice. So, you get 1 slice. The next day he quotes $5 per slice, so you get 0.2 slices. The next day he quotes $0.10 per slice, so you get 10 slices.
You feel quite good about that last day because the 10 slices of pizza for $1 made up for that fifth of a slice you got on the previous day. Congratulations you have effectively signed up to the first Pizza DRIP club.
But then your friend, let’s call him Sam, comes along. Sam likes pizza, because pizza makes him happy. But Sam doesn’t want to pay more than $1 per slice for pizza. He gets 1 slice on the first day. On the second he goes without because he was unwilling to pay $5 for a slice of pizza.
The last day, he comes back with $2, because he didn’t spend his pizza money the previous day. The price has dropped to $0.10 per slice. He gets 20 slices of pizza, because he realizes what a bargain the price is. He eats a few, which makes him happy and puts the rest in the freezer.
Which approach makes common sense?
If you are like me, the latter approach is more appealing. Approach stocks the same way. Determine which stocks you are willing to buy. Determine a price with which you would be happy with them. If you prefer you can figure out at what yield you would be happy to own a stock, and figure out the price from there. Then be patient.
New dividend motto: Do time your purchases.
So how do you find DGI stocks with the most attractive yield and growth profiles today?
- You need an investment framework. You need to determine how you pick dividend growth stocks. Ben’s 8 rules are a good start. I have co-written a free eBook describing the S.A.F.E dividend methodology.
- Follow good authors on Seeking Alpha. This will give you a bunch of ideas. You will be able to find stocks which you think fit your profile.
- Determine your price.
- If you want to take this seriously, consider signing up to my company, uuptick’s FREE newsletter here. We will send you a copy of the eBook, as well as a weekly newsletter with the list of S.A.F.E dividend stocks which make it into our screener.