The Hidden, Wealth-Building Power of Rising Dividends

Wednesday, 25 Apr 2012 10:57 AM

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Here’s a simple quiz: How do investors make money on stocks? If you said “the price goes up,” think again.

Take the S&P 500 Index. During the past five years ending Mar. 31, the price of that broad selection of stocks is down by 3 percent.

Now consider the S&P 500 Dividend Aristocrats. The subselection of stocks includes only companies that have increased dividends every year for at least 25 years. The return on that index stood at 2.77 percent.

Now, we’re already talking about a nearly 6 percent gap in performance. But that’s just price. Dividend investors also get to count the money they get paid to hold those stocks, the dividends themselves.

Add in that, and the “total” return comes to 5.96 percent. The gap now is a shocking 9 percent.

Against inflation, the real return on those dividend-payers is 3.26 percent.

That’s far above the real return on Treasurys. The 10-year pays 2.22 percent, but that meager return is currently negative once you figure in 2.7 percent inflation.

What about the wealth part? Here, rising dividends are the key.

“What you are getting paid today in a dividend is not what’s important,” George Fraise, manager of the $3.1 billion Sustainable Growth Advisers, sub-adviser for the John Hancock U.S. Global Leaders fund, told Bloomberg News.

“The key to dividend investing is to focus on companies that will be able to grow that dividend payout over time.”

Perhaps, you might think, dividend stocks got a short-term bump up thanks to low interest rates.

Think again. Ned Davis Research found that, over four decades, the annualized return on stocks that increase dividends annually came to 9.4 percent, reports Bloomberg. Dividend-payers that did not increase the payouts yearly returned 7 percent.

You might need the income now. In an era of rock-bottom interest rates, that’s understandable. But if you don’t need the cash now, dividend-payers are a solid track to long-term wealth.

Here’s how: You reinvest the dividends.

Let’s say you have a chance to buy XYZ stock at $20 with a 5 percent yield. You think it is a good choice, since it’s on the S&P “aristocrats” lists.

Life offers no guarantees, but you also believe that management is likely (and able) to continue its streak of raising dividend payments.

Your research shows that XYZ has increased the yield by 8 percent on average for decades. They promise to target that number going forward. So you buy 1,000 shares.

If you take your quarterly dividends and manage to continue to buy the stock at $20 (that is, the price goes nowhere), you still win. Over 10 years, your $20,000 one-time investment rises to north of $42,200 based just on reinvesting and rising dividend payouts.

Take it to 20 years, and your money mushrooms to nearly $216,000. You don’t put in a single dime after year one. You simply don’t take the income and instead buy the stock judiciously each quarter at about the same entry price. Or some other “aristocrat” stock on similar terms.

More importantly, the investment at the end of year 20 is throwing off $12,174 in income every three months. You could reinvest it, or take it out to pay living expenses.

The brilliance of such a patient investment plan is that you don’t need to worry about the stock declining in value (if it falls, the dividend yield is higher) and you never really have to sell the principle amount, so your capital-gains tax is nil.

You do pay dividend taxes, yes, but there are ways to defray those taxes using a tax-advantaged IRA or Roth IRA.

Feeling “aristocratic” yet?

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