The Power of Free Money

The goal of every investor is to make money. Easier said than done, right? Mr. Market pushes stocks up and down, sometimes seemingly oblivious to earnings reports, consumer data, and all that research you did before buying in.

Take the cases of Abbott Laboratories (NYSE: ABT  ) or Disney (NYSE: DIS  ) , for example. Despite consistent revenue and income growth, these two stocks have been essentially stagnant for five years. Yet investors in both are earning a return on their money, even while they wait for Mr. Market (or the company) to come around. How? Well, those companies pay the only guaranteed return in the market: the dividend. Abbott Labs has a dividend yield of 2.6%. Disney's yield is 1%.

In a past article about the benefits of dividends, I highlighted the case of Kinder Morgan, an energy giant headquartered in Houston, Texas. The company pays $2.80 per share in dividends for an automatic 3.8% yield on an investment. Not bad for doing nothing.

If you'd invested $1,000 in Kinder Morgan in 1988 and pocketed your dividends, you'd hold shares worth $19,315 today -- and have collected $3,047 in dividends. That's a good return. But there's a way to get those dividends to work even harder for your portfolio -- through a dividend reinvestment plan, or Drip. If you reinvested Kinder Morgan's dividends each year, your holding would be worth $37,141 today. That's an extra $14,779, a phenomenal return -- and a testament to the power of dividends.

Following the publication of that article, I received a number of emails about dividend reinvesting from people who weren't familiar with the concept or how to do it. The Income Investor community members also posted the topic on our dedicated discussion boards. They were afraid they weren't getting the most out of the monster dividends lead analyst Mathew Emmert was recommending each month. These folks had heard about dividend reinvestment plans, but weren't sure how to enroll in them.

The almighty dividend
A dividend is a distribution of a company's earnings to shareholders. They are paid periodically on a per-share basis, which means the more shares an investor holds, the more he is paid in dividends. Investors can do one of two things with this money: Pocket it or use it to buy more shares. Investors who choose to buy more shares are reinvesting, or Dripping -- and as Mathew will also tell you, that's a profitable move.

There are countless examples of the power of reinvested dividends. Don't believe me? The table below highlights a few scenarios where reinvesting dividends can supercharge your portfolio:

Company

Initial Investment

Return

Drip Return

Drip Variance

Philip Morris

$1,000 in 1980

$71,582

$169,165

136%

Kinder Morgan

$1,000 in 1988

$22,362

$37,141

66%

Limited Brands

$1,000 in 1995

$3,802

$4,155

9%



Return is capital gains plus dividends; Drip Return is capital gains plus reinvested dividends. The Drip Variance is the amount the investment was enhanced by Drips. As you can see, reinvested dividends have a profound effect on total return, and that effect is compounded over time. In the case of Philip Morris, a steady Drip would have more than doubled your return with no additional fees or transactions.

Be a Drip
Right now, this looks great, but you're probably wondering how to start. Let me tell you: It's incredibly easy. Here are three simple steps to start Dripping your way toward market-beating returns:

1. Find a dividend-paying stock
More than 2,500 public companies currently pay dividends to investors. They run the gamut from big, boring utilities such as Income Investor recommendation TXU (NYSE: TXU  ) , which yields 2.4% and has returned nearly 60% for subscribers, to tech titans such as Microsoft (Nasdaq: MSFT  ) (1.2% yield), to smaller retail outfits such as Rocky Mountain Chocolate Factory (Nasdaq: RMCF  ) (1.7% yield). Of course, some dividends are bigger than others, some dividends are more likely to be raised than others, and some dividends are more reliable than others. How does one find the steady stalwarts among the bunch? That's where the Income Investor newsletter steps in. By taking a 30-day free trial, you'll have access to recommendations of more than 40 Drip-worthy companies and Mathew's analysis of which ones to invest in right now.

2. Enroll in a Drip
This used to be much more difficult than it is now. Before the advent of Internet trading, you had to enroll in a Drip through each individual company you owned. This was all well and good, except for when the company you wanted to reinvest in didn't offer a Drip. If this were still the case today, Barnes & Noble (NYSE: BKS  ) investors would not be able to Drip, despite the company's 1.7% yield.

Fortunately, most brokers today offer all investors the opportunity to Drip -- free of cost and regardless of whether the company they want to Drip into actually offers such a program. For example, low-cost Internet brokerage Ameritrade follows this policy:

Ameritrade offers dividend reinvestment on certain securities. The list is growing every day, so we will need to know which stocks you are interested in to determine if they are eligible. Please call a Client Services representative at 800-669-3900 to see if your security is eligible for dividend reinvestment.

Please be aware that if a security is eligible, you will need to be holding enough shares in your account so the dividend paid will generate one whole share. There is no charge for this service.

In other words, one phone call and you're golden. However, do note that Ameritrade will only allow you to Drip if your dividends will pay for at least one additional share of the company. There's no chance of reinvesting Verizon's (NYSE: VZ  ) last $.405 quarterly dividend unless you owned at least 78 shares.

I also looked into Charles Schwab's policy, which is even more convenient than Ameritrade's. If you trade through a Schwab account and want to Drip, just:

  1. Go to the Positions page.
  2. Click on the "Yes" or "No" listed under the "Div Reinvest" column for your selected position.
  3. Select "Yes" or "No" under "Reinvest Dividends?" for the selected position.
  4. Click on "Submit" to submit your instructions.

To Schwab's credit, the process is easy and there are no partial-share limitations. And the best part is that both Ameritrade and Schwab will reinvest your dividends for free! This is the only way I know of to have your broker add to your portfolio without charging a commission.

3. Sit back and watch your portfolio grow
I doubt you need any help with this one. Every time you reinvest, you own more shares, which means more dividends next time, which means more money to reinvest, which means more shares, more dividends, more money, more shares, more dividends, more money, and so on until you have more money than you know what do with (although I'm sure you'll find a way to cope).

Buy the numbers
In the end, investments in stocks or newsletters should be based on sound fundamentals. There are a lot of compelling cases to be made for dividend-paying stocks. They generally outperform the market, are less volatile than their peers, and support their earnings statements with actual cash. The most compelling case, however, may be the Drip. By constantly expanding a position without having to provide more capital, investors can exponentially increase returns.

The best candidates for Drips are stocks that increase dividends regularly and appreciate in the market. Mathew and his team at Income Investor keep their eyes peeled for just those kinds of opportunities and recommend two every month, including real estate investment trusts (REITs), master limited partnerships (MLPs), utilities, and foreign stocks. Income Investor is beating the S&P 500 by three percentage points since inception two years ago and would be doing even better if it Dripped. Try a 30-day free trial and take a look at everything the service has to offer -- with no strings attached.

For more Drip-related Foolishness, check out our Drip discussion board and our Fool's School. The latter will also start you on our 13 Steps to Investing Foolishly.

This commentary was originally published on May 19, 2005. It has been updated.

Tim Hanson never wanted to be called a "drip" until now. Tim does not own shares of any company mentioned in this article. Schwab is a Motley Fool Stock Advisor recommendation. The Motley Fool has adisclosure policy.


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