DGI Lesson 10 (Part I): Reinvest Your Dividends SELECTIVELY to Enhance Your Returns

When you are a dividend growth investor, you receive quarterly dividends from each company (monthly from some). If all goes according to plan, each company increases its dividend once per year. (Some do it quarterly!) That’s the essence of dividend growth investing: You want to construct a portfolio that sends you a cash stream that rises every year.

If you are retired, you can take that rising cash stream as income and use it to pay your everyday expenses. Indeed, that is exactly what many retirees do.

But what if you are not retired?

Let’s say you are 30-40-50 years old. You don’t need the cash right now, because you are working and your salary pays your expenses.

Or what if you are retired, but you don’t need all the dividend cash, because you also have Social Security (and maybe a pension) to help cover your expenses?

What most dividend growth investors do if they don’t need the all cash is reinvest the dividends.

This creates a wonderful cycle of compounding. Your current investments deliver a stream of dividends. When you reinvest the dividends, you purchase more shares. The new shares throw off more dividends. The dividend payout rates are themselves rising all the while due to your companies’ annual dividend increases. You have a cash-generating machine!

This lesson and the next one form a two-part series in which we will discuss dividend reinvesting. In this lesson, I will discuss selective reinvestment, in which you let dividends accumulate for a while and then target your next purchase with your pile of dividends.

In the following lesson, noted dividend guru David Fish will discuss automatic reinvestment of dividends. That’s where you set up “drips” (dividend reinvestment programs) to automatically reinvest dividends back into the companies that paid them.

There is no “right way” to reinvest dividends. Selective reinvestment and automatic reinvestment are two ways to skin the same cat: You want your reinvested dividends to accelerate the building of your wealth and your dividend stream by being a cog in the money machine illustrated above.

The Basics of Selective Reinvestment—How I Do It

Here is my approach to selective reinvestment. I allow dividends to accumulate in my brokerage account to a certain amount that I have predetermined. In my public Dividend Growth Portfolio (DGP), which has a current size of about $68,000, I let incoming dividends accumulate until they reach $1000. That is my trigger to go shopping for more shares.

There is nothing magic about $1000. It is a nice round figure. Since my DGP has a current yield of about 4%, that means that it currently delivers about $2700 per year in dividends. That means I can go shopping (with $1000) every 4-5 months or so.

As time goes on and the dividend stream increases, my shopping trips will become more frequent. Next year, I expect to be able to purchase new shares 3 times (at $1000 a pop), compared to twice this year.

I just completed my final purchase for 2013 with accumulated dividends: I bought 12 shares of Philip Morris (PM) for $1045 in August.

Right after I bought them, the company announced an 11% increase in its dividend. My first dividend payment will be sent to me at the end of September. Because of the increase just announced, it will be 11% higher than the amount I was contemplating when I made the purchase! I love this kind of investing.

The Benefits of Selective Reinvestment

Now I want to explain why I selectively reinvest my dividends rather than automatically reinvest them.

First, selective reinvestment allows me to buy at good valuations. To show what I mean, let’s look more deeply at the stock I just purchased, PM. The first chart shows it price and dividend over the past 5 years.

What I want you to notice is that PM’s price (the orange line) went up fairly steadily from mid-2010 to early 2012, but that it has sort of flat-lined since then. Its dividend, of course, has been increased in the 3rd quarter of every year, including the most recent 11% increase described earlier.

If we look at the same 5 years on a FAST Graph, we can see the relationship of price to valuation:

If you have used FAST Graphs, you know that the orange line represents “fair” valuation, while the black line is the actual price. In 2012 and early 2013 (the last two years on the right of the chart), when the price flat-lined, you can see that PM was overvalued.

Simply stated, it cost too much compared to its inherent value. But the flat-lining of its price for almost 2 years allowed its fair value to catch up to its actual price. (The fair value kept increasing, because PM’s earnings kept rising even though its market price flattened out.)

A few weeks ago, PM’s price dipped down to where it just about touched the orange “fair” line. The stock became fairly valued, meaning that its actual market price was very near its inherent value.

Morningstar agreed. Their star rating system reflects their reckoning of valuation. They use a different approach from FAST Graphs. Here’s what is at the top of Morningstar’s page for PM:

Under Morningstar’s system, 3 stars means fairly valued.

So both systems showed me that PM was fairly valued. That’s when I bought it.

The timing of this was fortunate for me. I am retired, and my main money for investing comes from accumulated dividends. When they hit $1000, I don’t like to wait around before I put them to work.

So when shopping time comes, I make a quick check to be sure that each company on my watch list is still desirable – meaning no recent disasters that could threaten future dividends (like an oil spill). Then I value each stock as I just described. Finally, I select my purchase from among those stocks that are fairly valued or, better still, undervalued (selling for less than they are worth).

The second benefit of reinvesting selectively is that I can buy any stock that I want. When dividends are reinvested automatically, the funds are routed back into purchasing more shares of the companies that issued the dividends.

When I reinvest selectively, I can purchase more shares of something that I already own. But I can also use the funds to start an entirely new position. I can do this without selling anything to free up cash for a new purchase.

That is how several of the positions in my Dividend Growth Portfolio got started: With dividends collected from other companies. PM itself is a new stock in my portfolio. In my situation – with no new money coming into the portfolio from outside – that is an important consideration. I am on a mission to increase the diversification of my DGP, which means adding more stocks to spread the risks around. Selective reinvestment provides the funds to help me do that without having to sell something to get my hands on some cash.

Universal Benefits of Dividend Reinvestment

No matter what method you use to reinvest dividends, you will get the universal benefit from compounding. Compounding means to make money on money already earned. The “money already earned” is the dividend stream. You compound it by reinvesting the dividends to purchase more dividend growth shares.

Let me illustrate with my own Dividend Growth Portfolio.

In my portfolio, I reinvest dividends. I always have reinvested them since the portfolio kicked off in 2008. Here, we see the increase in the income stream resulting from those reinvestments.

The red line shows dividends without reinvestment. It’s a great result, reflecting an average 8% annual dividend increase for every stock in the portfolio. (Each stock has its own dividend growth rate, but 8% per year is an average for all of them.) The result is a steady annual increase in the dividend stream. The slope of the red line is 8%, reflecting the annual increases.

The blue line shows the actual dividend stream of my portfolio after it has been goosed by reinvesting all dividends. The blue line started to separate from the red line as soon as the first reinvestment was made (in 2009), and its lead widens as time goes on.

In the next 12 months, I estimate that my cash flow will be about 41% more than it would have been without the dividend reinvestments along the way. That is compounding in action! The gap will probably widen every year hereafter.

Conclusion

Dividend reinvestment accelerates the growth rate of the cash stream from a dividend growth portfolio. There are two basic ways to reinvest dividends:

  • Selectively, by accumulating dividends in cash and then making targeted purchases with lump sums.
  • Automatically, by “dripping” the dividends back into the stocks that issued them.

Either way, dividend reinvestment creates a compounding effect that over time will significantly increase the incoming cash stream from your dividend growth portfolio.

— Dave Van Knapp