Friday, July 4, 2008

Reinvest Dividends to Protect your Portfolio:

For patient investors, dividends that are reinvested in their originating securities can have a dramatic positive effect on investment performance. I like reinvesting dividends because 1) many brokerages offer this as a free service (known as DRIP or a dividend reinvestment plan), 2) it imparts the discipline of buying more shares regardless of a stock price drop and 3) new shares are acquired without requiring outside funds. In this article I will illustrate how reinvesting dividends in the original stock can enhance the returns of an investment if the stock price has dropped substantially.

When a stock price undergoes a severe price drop, an unaltered dividend payout will result in a dramatically higher dividend yield. For example, if a stock pays a $5 dividend with a $100 stock price, the dividend yield is 5%. If the stock price falls by 50% to $50, the new dividend yield would be a lofty 10%. With a higher dividend yield, a higher percentage of shares can be accumulated from the dividend payout than previously possible. It is these extra shares that will enhance the returns on your investment once the share price recovers. Of course, if the share price continues to decline over a long holding period, you would have done better to not reinvest the dividends. Hopefully with diligent value investing, you won't be in that situation.

Consider a stock that sells for $100 per share, pays a $5 dividend and has an intrinsic value of $151.5 per share. Suppose you buy the security with a 33% margin of safety making your entry price $100 (.66 x $151.5 = $100). If the stock price falls in the first year by 50% to $50 per share and takes another eight years to reach its intrinsic value of $151.5 per share, how would the dividend reinvestment strategy fare? The results are in presented in Table 1.

Table 1: Investment results with "stock A" after 8 years with a share dividend reinvestment strategy and having a year 1 price drop of 50%

The new shares represent the extra shares added from dividend reinvestments and the excess cash is the amount of cash left over after purchasing as many whole shares as the dividends allow in a given year. For this dividend reinvestment model it is assumed that the excess cash distributed does not generate interest. The intrinsic value of the company is reached with the stock price in the eighth year of the investment. The astounding observation is that even with a 50% price decline in the first year a patient investor who reinvests dividends would be rewarded with a total compounded return of 11.6% per annum after 8 years.

What if the stock price had only steadily climbed throughout the 8 years and we had reinvested the dividends in stock purchases under similar conditions as before? The results of this model are presented in Table 2.

Table 2: Investment results with “stock A” after 8 years with a share dividend reinvestment strategy and a steadily increasing stock price
The investment held for the full eight years modeled in table 2 yields a compounded return of 9.4% per annum. It’s remarkable to observe that the dividend reinvestment strategy with the sharp stock price decline outperforms the scenario of a steadily increasing stock price. The sharp price decline scenario produced an extra $3,590 or 17.5% over the eight years. This demonstrates how reinvesting dividends can protect your portfolio against early stock price drops and rewards patient long-term investors.

In the book “The Future for Investors”, Jeremy Siegel explains how reinvesting dividends can protect your portfolio against bear markets and help enhance returns of a portfolio. Perhaps the most compelling example that Jeremy illustrates is during the era of the Great Depression. In his book he shows that long term investors that allowed dividends to reinvest in the market would have fared much better with the Great Depression than if the Great Depression had never occurred and share prices and dividend yields had remained stable.

Stock price declines in companies that survive and thrive in the long-term are opportunities to acquire more shares at cheaper prices. For the long-term investor, an automatic dividend reinvestment plan will provide some protection against bear markets and enhance your portfolio returns when prices cycle back up.

1 comment:

Anonymous said...

Nice Read!

Best Wishes,