Editor's note: This story has been corrected to reflect that withdrawals from IRAs are made as ordinary income. A previous version stated otherwise. We apologize for the error.
For many investors, the only reward that matters is an increase in share price. The faster and steeper that ascent, the better. Movements in price are the most obvious and talked-about way to earn profits from the stock market. Every night, the news broadcast flashes the price and percentage change for the Dow, S&P 500, or Nasdaq -- not the price-to-earnings ratio (P/E) or yield for each index.
Look beyond those capital gains, however, and you might find a dividend. For long-term investors, dividends are far from one-time gains -- they can be the special sauce that provides market-shattering performance. For instance, a dividend can be a regular cash addition to your portfolio. It allows you to pick up more shares of common stock. Sometimes, it allows you to take advantage of opportune moments when the shares are on sale. But perhaps most important is that the dividend grows over time, just like sales and earnings.
Dividends in action
For evidence of the power of dividends, take a look at the payouts a company has made over the years. Put together a spreadsheet that begins with the core position (and cost basis), and calculate how reinvesting dividends would have purchased additional shares over time (generally each quarter). Although it takes a little bit of time, the power of dividends becomes quite clear. (To get started, all you need to do is find historical price data, which is available on sites such as Yahoo! Finance.) I've done such an exercise before (found here) for Wrigley
A few companies make this easier for us by providing a return calculator in the investor relations portion of their websites. Johnson & Johnson's
To research the historical performance of Johnson & Johnson, I punched in 100 fictional shares with a purchase date of July 28, 1980 (the first date allowed). The purchase price on that day was $80.13 for a total initial cost of $8,012.50. I'm well aware that $8,000 is not a small amount for many investors, but because Johnson & Johnson does not charge an initial setup fee or any fees for dividend reinvestment, the percentages work out the same regardless of the initial amount.
According to J&J's calculator, as of today (at a price of $60.97) those same 100 shares, with no additional contributions and dividends reinvested, are now approximately 3,327 shares and are worth more than $202,850. That's a total return of 2,431%, or approximately 13.3% per year. Remember that initial $8,012.50 investment? Each year, you'd now receive more in dividends than your initial cost basis. J&J does not provide a comparison to the S&P 500, but a quick glance Yahoo! Finance shows that over the same time period the S&P 500 returned 944% (9.8% annualized).
Dividend stock performance, July 28, 1980, to Dec. 22, 2005
|Company||Total Return||Annualized Return|
|Johnson & Johnson||2,431%||13.3%|
It takes time to get going
The time frame of this exercise reveals the most difficult thing about dividend investing -- it takes time. Dividends are cumulative and grow over time, so it can take several years before the true benefits take hold. And during periods of stock price decline or flatness, it can feel like you're treading water.
However, dividends do eventually take hold. In The Future for Investors, Jeremy Siegel espouses a long-term dividend reinvestment strategy based on research that showed how soundly dividend-paying stocks outperformed non-dividend payers from 1957 to 2003. Since 1957, Johnson & Johnson isn't one of the S&P's top 20 performers. In fact, its 13.3% return from 1980 to 2005 is still less than the 13.58% return the 20th-ranked company on the list, General Mills, earned from 1957 to 2003. Many familiar names did rank well: PepsiCo
Many investors believe that because dividends are taxed at a higher rate than capital gains, their effects are not as strong as advertised. This belief has some truth to it, but it is possible to maximize the benefits of dividends while laying out plans to minimize taxes and transaction costs. For investors with IRAs, investing in dividend-paying stocks makes a great deal of sense, because the dividends and the returns they earn while reinvested will not be taxed until withdrawn at which point they will be taxed at your income tax rate.
With a little patience, the power of dividends can be put to work in your account. Consider this very interesting email I received last month from a reader, which closed with the following paragraph:
Finally, I'm employed by a transfer agent. It's amazing how much cash some wealthy/long-term investors are receiving via their periodical dividend checks and/or reinvestment purchases. It is mind-blowing in some cases. If I hadn't seen all this with my very own eyes, I wouldn't believe it. It's certainly something to aspire to.
Foolish final thoughts
The best results from dividends require patience, a long-term time horizon, and excellent companies for your investment dollars. That last point is the toughest to master. You can improve your odds by focusing on good companies that have long-term competitive advantages and high returns on capital and equity. If you can get that for a fair price, you're well on your way.
That's the strategy I practice in my portfolio, and it's also the strategy that Mathew Emmert relies on in our Motley Fool Income Investor service. If you'd like to get started down the path of investing for dividends -- or are already on your way and just looking for additional ideas -- consider a free 30-day trial. You'll get access to Mathew's more than 50 selections, as well as mid-issue updates and subscriber-specific discussion boards. Click here to learn more. There is no obligation if you're not completely satisfied.