Some readers, especially the ones new to investing and money management, wanted to know various ways of achieving ‘compounding’ in their investment portfolio. I had written about this topic in my earlier posts : Compounding: The eighth wonder – Part 1 and Financial well-being – Part 2.
The way to achieve this compounding is through reinvestment of realized income/gains. Many of us invest in stocks and one of the most common form of realized investment income is the ‘dividend’ paid out by companies. Some companies distribute part of their earnings to shareholders in form of dividends, paid out at regular intervals. The shareholders have the option of taking the dividend and spending it or reinvesting it in the same stock or some other stock. I will be explaining the power of reinvesting of dividends with an example.
The company that I have selected for this purpose is Colgate Palmolive (ticker: CL). The reason I have selected Cl is because of it’s amazingly consistent dividend policy. Colgate-Palmolive has paid uninterrupted dividends on its common stock since 1895 and increased payments to common shareholders every year for 51 years.
It is important to note that this is by no means an endorsement or analysis of any particular stock or any attempt to project the future price of that stock. In fact, I have absolutely no idea where the stock price of CL will be at a certain point of time in future….you may want to keep a fly-swatter handy to use on people who claim they do. The idea is to use CL as an example to demonstrate the concept of compounding over a long period, by the disciplined process of reinvesting a steadily growing cash-flow. The same concept can be applied on other liquid cash-flow generating investments.
Let’s assume I invested $10,000 purchasing shares of CL on the first trading day of 1996. I would have been able to afford 142 shares on that day at market open (@ $70/share).
To put some context, over the 18 year period that followed, the following events took place:
The chart on the left shows the dividend payout for CL during this period (Jan 1996 onwards).
The CL stock had 3 stock splits* during this period.
1. 15th May 1997 : 2-1 split
2. 30th June 1999 : 2-1 split
3. 15th May 2013 : 2-1 split
To avoid showing discontinuities in the absolute per-share price, shown below are separate stock charts for the periods between these stock splits for reference:
Period: 1 (2nd Jan 1996 – 15th May 1997)
Period: 2 (16th May 1997 – 30th June 1999)
Period: 3 (1st Jul 1999 – 15th May 2013)
Period: 4 (16th May 2013 – 4th June 2014)
The interesting thing to note here is that even thought the stock price of CL took a beating during several periods viz. March-April 1997, June – Sept 1998, during the financial crisis of 2008, or completely stagnated during the 7-year period July 1999 to July 2006, it had absolutely no effect on the steadiness of the dividend growth. The company never failed to reward it’s investors with a steadily growing cash-flow.
All I needed to do after purchasing my 142 shares in 1996, was to just forget watching the stock price. I would have received a cash flow on each dividend payable-date (the date when the dividend is credited to my account). I would use this cash to buy equivalent number of CL shares from the market on the same day. This way in the subsequent dividend cycle, I would not only receive dividend on my original share holding, but would also receive the dividend on the additional shares that I would have purchased reinvesting the previous dividends. This is how the compounding would have been achieved.
It is relevant to mention here that many companies offer an automatic dividend reinvestment plan (DRIP) and CL is one of them. So I won’t even need to manually purchase the additional shares and incur additional transaction costs. I would just opt for the DRIP and my account would be automatically credited with the additional shares instead of a cash dividend.
How it would translate into numbers:
If I opted to receive the dividend in cash, then today I would be sitting on 1136 shares of CL. The 8-fold increase is only because of the three 2-1 splits (2X2X2). .
However if I opted to reinvest my dividends, then today I would be sitting on about 1616 shares (42% more than what I would have, if I did not reinvest) with a total market value of ~ $109,400 (please note this is after deduction of a 30% with-holding tax on my dividend income as I am a foreigner). An 11 fold increase in 18 years….surely can’t complain.
While my dividend yield in the initial years would have been < 2%, it grew steadily with the growth in dividend. In the year 2013, the yield on my investment would be > 9% post tax, with ample room for the dividend to grow in the years to come based on the current payout ratio (dividend-per-share/EPS). There is a marked difference between this way of investing vis-a-vis the more common form of investing with the hope of capital appreciation. You would have noticed that while a growth in share price would be more than welcome, the investment premise is not dependent on that potential appreciation. In fact in the initial years of accumulation, a drop in share price would be significantly more beneficial in the long run, as explained below.
Dividend reinvestment and share price
The best part about this is, with DRIP in place, I would have been perfectly fine forgetting to watch the stock price for 18 years. The most important thing to understand here is that the times that were bad for the stock price would actually have been good for me. As I am regularly buying new shares with my dividend cash-flow, I am actually better off if the market is in a sell-off. That way I am able to accumulate higher number of shares with the same dividend amount…..leading to higher dividends in future….which in turn would provide higher future compounding rate. In the process I am lowering my break-even cost with every purchase, and lower my purchase price the better it is for me in the long run.
What are my risks?
Every investment strategy has it’s risk and so does this one. While the share price falling temporarily is not a risk (actually an opportunity as we have seen), the main risks in this strategy are:
1. Reduction in cash-flow : If the company reduces or misses it’s dividend due to negative earnings growth, or change in dividend policy.
2. Bankruptcy : If the fall in share price is not a temporary phenomenon but a permanent problem and the company eventually declares bankruptcy. That way we would have acquired a large number of shares through compounding, which eventually would be totally worthless.
-We would need to mitigate these risks with our detailed analysis of the underlying investments. We used CL as an example, based on over 100 years of dividend history and over 51 years of consistent dividend growth. We found it to be a safe candidate to achieve the compounding we were looking for. However there are several instances in history where once fundamentally strong companies have eventually gone bankrupt. Rather than making a value judgement about a company’s fundamental strength (outside our current scope), we would use the simple money management and position sizing principles discussed in the previous post ‘What I learnt from poker’. We would control the total exposure to any single investment to a level where it will not kill us if we are wrong.
We will be looking at more ways of increasing the cash-flow yield on our investments in future posts. I feel really excited to think what this knowledge can do for my 11 and 7 year old boys, when they reach my age, if they decide to apply this with their teen-age pocket money in a disciplined manner.
*The simple definition of a stock split is “A corporate action in which a company, divides its existing shares into multiple shares. Although the number of shares outstanding increases by a specific multiple, the total dollar value of the shares remains the same compared to pre-split amounts, because the split did not add any real value. The most common split ratios are 2-for-1 or 3-for-1, which means that the stockholder will have two or three shares for every share held earlier” (source: http://www.investopedia.com)