We’ve often talked about the importance of reinvesting your dividends and how, over the long-term, it can lead to a dollar cost average effect and help you grow more wealth. Just look at the example of the secret multi-millionaire, Anne Scheiber, who amassed $22 million from her apartment before passing away. I thought it would be useful to provide a real-life example from one of my very own personal retirement accounts. The power of the About.com model is that we can bring you content from those who are actually doing and living what we are writing about, so take a moment to peer into my own personal accounts to illustrate some concepts that we’ve shared over the years here at Investing for Beginners. (If you don't know anything about dividends, take a moment to first read All About Dividends, which will explain everything you need to know about what they are, how they are paid, and some of the more detailed information you aren't likely to see on the nightly news.)
On April 20th, 2005, I was sitting in an armchair in Princeton, New Jersey, reading some works by Charles Munger, the long-time business partner of Warren Buffett. I also had several U.S. Bancorp annual reports besides me and had been contemplating purchasing shares for some time. Unlike most of my positions, which are highly aggressive on the deep value side (volatility doesn’t bother me provided I’m assured that the shares are undervalued), I was looking for something that was: 1. Reasonably priced, 2. Run by good management with a substantial equity stake, 3. Provided a long history of ever-rising cash dividends, and 4. Possessed little wipeout risk. In other words, my goals in this particular investment were different in that I planned on only checking in with the stock every few years and profiting from the compounding of the reinvested dividends and underlying increase in per share earnings, not necessarily capturing some arbitrage difference between an unjustified discount and my estimate of intrinsic value.
As I stared out of the third-floor window of my residence, I resolved to pull the trigger and purchase a block of shares at the then current market price of $27.29 per share. Safely tucked away in a tax-free retirement account, every penny of future earnings was beyond the grasp of Uncle Sam. Within a few minutes, I had given instruction to my broker, the trade had been executed and I went back to my reading. At the time, the speculation in the real estate markets bothered me somewhat but having firsthand experience with the lending practices at U.S. Bank, I was confident in management’s focus on their plain-vanilla Midwestern business model.
For the past 3½ years, I’ve left those shares exactly where they were, never touching them with one notable exception: I instructed my broker to reinvest all of the dividends into more shares of the company. While I continued my aggressive portfolio, where most of my wealth is made, this self-imposed dividend-focused portfolio would cross my mind a few times each week. The recent credit crisis meltdown resulted in such extremely price swings, that I thought it would be useful for you to see how the power of reinvested dividends not only mitigated the damage, but made me richer – and with the right discipline, it can do it for you, too.
Each quarter, as the cash dividends were sent to shareholders, my broker continued to plow them back into more stock. The highest price I ever paid was $35.76 on October 16th, 2006. The lowest price was last month, on August 15th, 2008 when they were reinvested at $21.747 per share. When the market was up, my reinvested dividends bought fewer shares, when it was down, I got more shares for each dollar put to work. The result, over time, is a lower average cost basis than you are likely to achieve by trying to time the market.
Here’s how it worked out for me thus far. Thanks to reinvested dividends, in the past 3½ years:
I own nearly 17% more shares than I did when the original stake was purchased, all from reinvested dividends
The annual dividend rate has increased from $1.20 to $1.70 per share, giving me more cash income for each share of stock owned
The market price has increased from $27.29 to $33.94, or $6.65 per share in unrealized capital gains
The net result: An increase of roughly 45.348% in 3½ years while the broader market has effectively tanked, without a single penny going to taxes. All of this from what many would consider an unsexy business in an industry that has been decimated over the past few quarters! The key was the focus on the underlying earnings quality of the bank, and the probability that it would continue to generate cash for owners. (One tip off: When the current and former CEO’s receive as much, if not more, of their annual income from the dividends on their stockholdings as they do from their salaries and bonuses, it’s a good bet that they are going to act in shareholders’ interests. My hypothesis was that the bank was being discounted when it was unlikely they would suffer from the same mortgage troubles as the broader financial sector.)
