As an investor, your returns come from three key sources: growth, dividends, and compounding. In the short term, the growth part of those returns might seem to be the most important. After all, it's the part you see every day, and it can change your net worth in a heartbeat.
Over time, though, the dividends from a company that takes its responsibility as stewards of its shareholders' money seriously and rewards its owners directly for their risks can really add up. And if you take those dividends and reinvest them, either in the same company or in other strong, shareholder friendly businesses, then you start getting the true benefits of compounding.
The difference two decades makes
As the days stretch into quarters, those dividends start making their appearance. And as the quarters turn into years, the dividends start to add up. Stretch those years into a couple of decades -- say 20 years or so -- and those lowly dividends can wind up making a significant difference in your net worth. That's especially true if the companies you own have a tendency to not only pay dividends, but also to raise them as their businesses grow.
While there aren't many businesses that have reached that elite cadre, once a company gets there, it tends to try to stay there. You see, in addition to the direct cash value of those dividends, corporate boards also know that those payments are also seen as a signaling device. Once a company becomes known as one with strong and rising dividends, it generally wants to keep that reputation, if for no other reason than its share price might fall (at least temporarily) if it loses it.
Twenty years ago, each of the stocks in the table below already had a 15-plus year reputation of raising their dividends. Had you invested $1,000 in each of them in 1991, the table shows what you'd wind up with now, depending on whether you spent your dividends, kept them as cash, or reinvested those payments:
|
Company |
Consecutive Years of Higher Dividends |
Stock Price Changes Only |
Dividends as Cash |
Reinvested Dividends |
Payout Ratio |
|---|---|---|---|---|---|
| Diebold (NYSE: DBD) | 57 | $4,797 | $6,741 | $7,571 | 70% |
| 3M (NYSE: MMM) | 52 | $4,311 | $5,662 | $7,569 | 37% |
| Hormel Foods (NYSE: HRL) | 45 | $7,333 | $8,536 | $10,881 | 29% |
| Sysco (NYSE: SYY) | 41 | $8,021 | $10,128 | $11,491 | 64% |
| W. W. Grainger | 39 | $9,958 | $11,162 | $13,617 | 31% |
| Abbott Laboratories (NYSE: ABT) | 38 | $4,718 | $6,722 | $7,988 | 55% |
| PepsiCo (NYSE: PEP) | 38 | $5,478 | $7,023 | $8,475 | 47% |
| Totals | $44,616 | $55,973 | $67,591 |
Source: Author calculations. Data from Yahoo! Finance as of Jan. 14. Includes spun-off shares distributed as dividends. Dividend streak information from DRiP Investing Resource Center as of Dec. 31.
There's almost $23,000 of difference between what you'd wind up with from reinvesting those dividends instead of spending them along the way. On a $7,000 initial investment, that's quite a return to be missing out on -- and an easy return to capture, so long as you don't absolutely need to spend those dividends, yet.
What can go wrong? And can you do something about it?
Of course, the past couple of years have been very rough on many formerly strong dividend paying companies, especially banks and other financial institutions. While there's no guaranteed way to avoid all dividend implosions, there are a few ways to protect yourself and your portfolio.
First, watch that payout ratio. The higher it gets, the less flexibility the company has to continue increasing its dividends -- or even keeping them steady. Anything above Diebold's 70% starts to get in the realm of worrisome.
Next, make sure you keep your portfolio diversified across industries. In the most recent meltdown, financial companies and other businesses that rely very heavily on debt that got hit the hardest. In the not-so-distant past, high-tech titans got slammed. While bubbles will form and burst, if your overall portfolio is spread across multiple industries, your investments as a whole can survive even if part of it gets damaged.
And finally, pay attention to the dividend behavior and patterns of the companies you own. Because dividends act as a signaling device, companies will often try to hold off an inevitable cut until it becomes obvious that it has no other choice. Before General Electric (NYSE: GE) cut its dividend, it held it steady for six consecutive quarters. That was in contrast to its long-held practice of raising those payments every four quarters like clockwork.
Make the returns you've been missing
Over the course of a long-term investing career, what starts as a small stream of dividend payments can wind up in a lake created largely from reinvested cash. All it takes is a commitment to own companies that treat their shareholders well and a willingness to keep buying more of the same. That's not so hard, is it?
