From Beginning to Dividends
What To Do with Your Yield?
"All intelligent investing is value investing - to acquire more than you are paying for. Investing is where you find a few great companies and then sit on your ass." -Charlie Munger
Here at Ledger Island, we talk a lot about small/mid-cap companies and their potential to become more extensive growth stocks. If we find a company we see as a bargain now with a clear path to future gains, we put it on our watchlist and keep a close eye on it. Best case scenario? One of those stocks rises, and an initial $1000 investment (as an example only) has increased to a $5000 value over time. While purely speculative trading has multiple inherent risks, the research and time spent tracking it paid off in that example. But now what? You made $4000, and that's great, but you only have the money once you sell, closing you out from future gains. Maybe you decided to hold, and now its value is $9000. Then $12,000! You've made all the right moves, and you can now look at your brokerage account with pride and congratulate yourself on how smart you are. But now what? You will still have to either sell or trim (selling only a portion of the position to capitalize on gains while not closing the position completely) to take your profits. Only then can you spend it, pay bills, or open a new position, which means the whole cycle starts again; keeping in mind I painted a very rosy outlook where everything went right for years for that one payout. Speculative trading, short- or long-term, is one way to trade and make money, but it comes in waves. While portfolio surges are possible, you need to incorporate elements like dividends from value stocks to build a genuinely sustainable portfolio income.
Dividends are the earnings paid to investors based on an amount determined by a company's board of directors called the dividend payout. The actual payment size, or dividend rate, is set by dividing the payout amount by the number of shares held. Not all companies offer dividends, and some have previously suspended the practice for periods before returning them. The average annual dividend yield (or percentage of dividend compared to its current stock price) is roughly 1.47% (01/15/24) among the S&P 500 index. The dividend yield is significant because it offers insight for an investor to see the return on investment (ROI) now as it correlates future dividend payout with the current stock price.
So, if the annual DIVIDEND RATE (the amount to be paid) is $2/share and that equity is currently trading at $100/share, then the annual DIVIDEND YIELD (the percentage based on current value) is 2%. Not bad. If you are looking to buy 1000 shares for $100K, you can now weigh in the fact that you will receive $2000 back in dividends over four complete quarters in the position. If the company has a good track record of being committed to a healthy dividend long-term, you can factor in that level of dividend return for years to come. But there are no guarantees.
Things to Consider:
Dividends are typically paid out quarterly. That means the $2/share dividend rate from above is divided by the four fiscal quarters for a $0.50/share per quarter disbursement.
Disbursement for the quarter is paid to those owning shares by the company's "record date." That is the latest date an investor must have owned the stock to qualify for that quarter's dividend.
A company's board of directors can alter, reduce, pause, or discontinue paying dividends anytime. This may happen in response to a broader economic downturn or a company's need to reinvest profits for growth. A most recent example is Walgreens (WBA), which cut its quarterly dividend from $0.48/share to $0.25/share just this month.
Note: Now, that was a very broad outline of dividends. Our purpose today is to set the stage for us to discuss what to do with your dividends once you have them. In future How Tuesdays, we will cover more in-depth dividend topics such as:
Weighing A Dividend's Short-Term Value Over Long-Term Continuation
Key Dates in Dividend Investing to Plan Around
The Self-Sustaining Dividend Portfolio and more…
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Once you have done your research and bought a stock with a healthy dividend, the question becomes what to do with those quarterly payments. Unlike the speculative trading example, here, you receive funds without having to sell or trim the position. There are two schools of thought about dealing with a stock's dividend.
You can reinvest your dividend automatically into the same equity. This means that the quarterly disbursements will purchase whole and/or fractional shares of the company stock at its current price (or at a discount) and add to your position.
You can receive the quarterly dividend payments in cash.
There isn't a wrong choice. You can reinvest in some holdings and cash out on others based on the strength or weakness of the stock itself. Taxes are equally evaluated between capital gains or income depending on the dividend classification (qualified and non-qualified), not specifically on how you manage them. The path you choose should be best suited for your investment goals. Phil and I handle our dividends differently for a variety of reasons. Let us explain how and why.
Clint's Reasoning for Reinvestment of Dividends:
When I purchase dividend stocks, I always place more weight on the longevity and rate of increase on a company payout over another company's shorter track record with a higher yield. My long-term goal is to have stability and growth as opposed to inconsistent short-term dividend gains. A dividend reinvestment plan (DRIP) allows me to continue to grow my position without adding funds from the rest of my portfolio's purchasing power or my income. Since I am only 48, retirement is still quite a way off for me. While I don't need the dividend cash for living expenses now, I might need it to augment my retirement benefits (i.e., IRA, pension, and Social Security). The compounding interest provided by DRIP means that the size of my position grows quarter over quarter. If the stock price drops yet the yield remains constant, my holding becomes even larger because I now purchase more shares at a cheaper price. DRIP also offers the secondary benefit of hedging against an equity's potential downturn.
I currently own a small position in Ford (F). I bought it in February of 2022 when I thought the worst days for the stock price were behind at $18.04/share. I was wrong. I have been underwater in the position since I opened it. As I had always planned to do, I elected to reinvest the dividends. In the seven quarters I have qualified (record date), DRIP has added 161.1778 shares to my position. I believe in Ford and will continue to hold it for the foreseeable future, but it is still a loss for me, currently trading at $11.46 (01/15/24). A -36.47% loss, IF you go by the original purchase price, but you can't anymore. With the additional shares from DRIP, my average cost per share has now become $17.03, meaning a -32.67% loss. Next quarter's disbursement will bring it down to roughly $16.81 and only a -31.83% loss (based on current pricing). The more shares I acquire without using my own funds, the more I dilute that original purchase price amongst the now larger holding. DRIP's compound interest can increase your gains and minimize your losses over time.
In How Tuesdays, we sometimes use fake companies to illustrate a point. Good Co (GDCO) for positive qualities, Bad Co (BDCO) for negative, and I Don't Know Co (IDK) for those grey areas in between. For today, let's use GDCO to illustrate the value of reinvesting your dividends.
In January of 2024, you buy 5000 shares of GDCO at $10/share. The very generous board of directors at GDCO has set aside a $4/share annual dividend. Priced over the four quarters, that is a $1/share quarterly dividend.
You have spent $50K and your position (5000 shares at $10/share) is worth $50K.
With the close of Q1FY24, you are eligible for that quarter's dividend and have opted to reinvest. GDCO's stock price has been rock steady at $10. Your $5000 dividend purchases 500 more shares to add to your position.
You have still only spent $50K, but your position (5500 shares at $10/share) is worth $55K.
Q2FY24 closes, and GDCO has only moved sideways, staying at $10. Your now $5500 dividend (because of the additional 500 shares from Q1) purchases 550 more shares.
You have still only spent $50K, but your position (6050 shares at $10/share) is worth $60.5K.
Q3FY24 has been a rough one for GDCO. The stock price has slid to $8/share. The dividend remains intact, and your $6050 dividend purchases 756.25 more shares (because of the now $8 price).
You have still only spent $50K, and your position (6806.25 shares at $8/share) is only worth $54,450. *Here, the stock price has dropped the overall value of the position. Still, the additional shares, particularly those purchased at the $8 price, have made your average cost per share $7.35 as opposed to the $10 you originally paid.
Q4FY24 GDCO surges to a strong finish, trading at $12/share. The dividend remains unchanged, and the $6806.25 disbursement purchases only 567.19 shares at this new price point of $12.
You have still only spent $50K, but your position (7373.44 shares at $12/share) is worth $88,481.28.
Obviously, that is another utopian scenario where everything went well, but I wanted to show the compound interest effect of DRIP over time. In the end, the GDCO position was +$38, 481.28. Had you cashed out each quarter, the total would have been +$10K on the position and an additional +$20K cash. The decision ultimately comes down to what you need and when you need it. As Phil will point out, managing dividends doesn't have to be an all-or-nothing strategy.
Phil's Reasoning for Receiving Payment from Dividends:
I want to make a basic point on DRIPs. There isn't a wrong answer to the question of whether or not you should enroll. There is a mathematically correct answer, but those answers are highly specific to each individual investor and each individual stock. The compounding value that Clint talked about is a fantastic way to build wealth without having to invest any more funds. It's why I have 12 of my 14 dividend-paying securities enrolled in a dividend reinvestment program. It allows me to put a portion of my portfolio in long-term storage. I don't have to manage it actively; I don't have to invest time conducting research. I have started placing more value on low-maintenance stocks in my increasingly busy life.
Yet, for my two biggest holdings, Procter & Gamble (PG) and Lowe's (LOW), I don't reinvest. Why? I think I can get a better return if I put that money elsewhere. I treat these dividends like any other deposit I make into my brokerage account. I am trying to get the best return on investment. I can get a better return for certain stocks that may not have an exceptionally high dividend if I move that dividend money elsewhere.
Take PG as an example. PG pays an annual dividend yield of 2.5%. If PG pays me $1000 in dividends each quarter and I reinvest those dividends, I get roughly 26 new shares yearly ($4000/$150 per share). Those new shares in turn pay me another $100 in new dividends ($4000 x 2.5% annual yield).
PG DRIP = Value of New Stocks Purchased ($4000) + Future Dividends ($100)
Now, the value of those new stocks purchased won't always stay at $1000. Depending on how PG performs, that number can go in either direction. But let's put that aside for a second and assume that I take that $4000 and use it to buy into our fictional company GDCO instead:
GDCO = Value of New Stock ($4000) + Future dividends ($160)
Moving my money from PG to GDCO made an additional $60 in dividends. Why? GDCO pays a better rate (4% to PG's 2.5%). If I'm going to invest $4000 in dividends, I want to invest it in the stock with a higher annual yield. This simplifies the process significantly because the value of the underlying security can also change. All it would take is for PG to outperform GDCO by more than 1.5%, and it would retake the lead. But that's where research comes in. DRIP programs are fantastic because they allow me to build wealth passively, but if I am confident in my research, then putting that dividend money elsewhere sometimes makes more sense.
The other reason I do not enroll some of my investments is timing. One of the drawbacks of DRIP is that you do not get to decide when you reinvest. The dividend is distributed on a set date. You buy that stock on a set date. Each company can calculate their DRIP price differently (including a potential discount), but you still don't have any flexibility. If the stock then drops the next day, then that's just bad timing. The reality is that taking the dividend doesn't stop me from buying the stock at a later date. If you look at Clint's example above, had you cashed out the dividends in the first three quarters for $15K, you could have used it to buy 1875 shares of GDCO on the $8 dip. That would then spread the average cost per share out even further and make for a more considerable gain when it hit $12. With my smaller positions, I'm not as worried about the timing because the difference is smaller. But the bigger the investment, the more valuable the timing becomes.
Let's take GDCO again. Assume I own 5000 shares, and those shares pay a quarterly dividend. Each quarter, I get $500 to reinvest. For every percentage point the price drops, I can use that $500 to buy an additional half-share. If GDCO stock drops to $9, I can purchase an additional six shares. That's six more shares worth of growing value, six more shares worth of dividends. Again, this is where research comes into play. The right play at the right time can provide better value than the DRIP program would. You just have to be willing to do some research and some math.
Thanks for reading! We hope it was helpful and shed a little light on dividends and portfolio income for you. We'd love to hear from you with any questions, comments, or useful tips you have to share in the discussion below.
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