Illustrating the DRIP

I have chosen to use the dividend reinvestment plan through my discount broker to reinvest dividends in my retirement plan holdings. I choose to do so for simplicity and because I am making my performance bet on the entire portfolio, rather than on discerning the "best value" component on a quarter to quarter basis.

From an income growth perspective, it's not immediately apparent which holdings produce the most robust dividend growth if one is watching what the broker delivers in the monthly investment report, which is primarily about the value of the overall portfolio and of each position.

I have tabulated the actual dividend payments over time from a few of my holdings to illustrate the amount of actual dividend growth that I have experienced over the holding period.


WMT

In 2011 I purchased 200 shares of WMT for $10,884.30
Over the next 4 quarters I received $323.11 in dividends with which I purchased 5.424 shares
Over the next 4 quarters I received $360.26 in dividends with which I purcahsed 4.908 shares
Over the next 4 quarters I received $403.44 in dividends with which I purchased 5.322 shares

My cost per share increased from $55.05 to  $75.74 per share in that interval. Dividends received in the last year were 24.9% higher than the first year. Examining the actual payments shows that each yearly payment was a bit over 10% higher than the prior year.  Dividend reinvestment accounts for just under 3% of the yearly dividend growth, and dividend increases account for the remainder.  My share count increased by 7.8% over 3 years.

MCD

In November 2010,  I purchased 150 shares of MCD for $10,723.90.

Over the next 4 quarters I received $374.14 in dividends with which I purchased 4.674 shares.
Over the next 4 quarters, I received $442.23 in dividends with which I purchased 4.76 shares.
Over the next 4 quarters, I received $501.92 in dividends with which I purchased 5.23 shares.
Over the next 4 quarters I received $545.25 in dividends with which I purchased 5.633 shares.

My cost per share increased from $67.95 to a high of $100.65 during that interval.
The number of shares purchased each year increased and the last year's dividends were 45.3% higher than the first year, demonstrating dividend growth of about 11% per year. Dividend reinvestment accounts for about 3% annual increase in dividends and dividend increases account for the remainder.
My share count increased by 13.5% over 4 years.

JNJ

In 2009 I purchased 203 shares of JNJ  for about $11,715.

Over the next 4 quarters I received $431.41 in dividends, with which I purchased 7.035 shares.
Over the next 4 quarters I received $481.26 in dividends, with which I purchased 7.569 shares
Over the next 4 quarters I received $529.93 in dividends, with which I purchased 8.161 shares
Over the next 4 quarters I received $590.75 in dividends, with which I purchased 7.444 shares
Over the next 4 quarters, I received $651.88 in dividends, with which I purchased 6.638 shares

My cost per share increased from $60.90 to $103.96 in that interval. The number of shares purchased varied from year to year, and clearly effected by the rising share price in the latter two years. The last year's dividends were 51.1% higher than the first year, demonstrating a dividend growth of about 10.2% over that interval. Dividend reinvestment accounts for 3% of the annual dividend growth and dividend increases account for the remainder. My share count increased by 18.2% over 5 years.

 I don't have the patience to repeat this for each of my retirement holdings, but these examples demonstrate that investing in blue-chip dividend-paying companies with a history of raising dividends and following a dividend reinvestment plan can result in actual growth in income approaching 10% per year. These examples are not companies with torrid earnings growth OR dividend growth rates, They are mature companies with moderate growth rates and substantial dividend payments. However, with dividend reinvestment, they produce adequate cash income growth within the position that a doubling of that income every 7-10 years is easily within reach.  Given the strong disincentive for companies such as these to cut dividends, the rising income is relatively reliable, even if earnings are more variable and the stock price is volatile. While rising earnings will tend to boost both stock price AND dividends, even stagnant earnings can still yield a rising income as dividends are reinvested, as well as through dividend increases which sometimes happen even in a stagnant earnings environment. When one chooses to take a distribution from the payments, the rate of growth in income will slow, but it should still be possible to see the portfolio keep pace with inflation if inflation stays within reasonable bounds.  I'm hopeful to build a portfolio where a 3% distribution will suffice to meet our maintenance needs. Other writers have demonstrated that this is possible.

It's easy to be preoccupied with issues surrounding the purchase and sale of blocks of stocks, where one must pay close attention to valuation in order to achieve reasonable investment returns over time. Once that purchase is complete however, a DRIP program allows you to average into a larger position over time, adding shares in times of both lower and higher valuation, resulting in an overall favorable entry point over time. Using a DRIP, one adds no more than 2-5% to the position in a given year, so it is unlikely that one will make in imprudent decision to purchase a large block of shares just before a price correction or in an emotional response to changing market.  It seems to me that the interval between the purchase and eventual sale (which could be never) is where most of the action within the position and the portfolio occurs.  It is certainly where the income is generated, unless you enjoy selling stock. For me, buying and selling stock is like buying and selling a house; something to be done carefully and very infrequently. However, I have no problem with adding onto and remodeling the house periodically.

I should reiterate that valuation matters most to the individual who intends to sell some or all of a position to harvest capital gains. Income matters most to the individual who intends to build a cash-producing conglomerate that will continue to spit out increasing cash over time. Rising value is  not the income-seeking investor's friend. Increases in valuation are an inevitable consequence of rising earnings and dividends, but not the opposite.  Rising value blunts the power of compounding for the income seeking investor. 

In order to assure that a dividend growth strategy performs similarly to an equally diligent capital-gains oriented strategy, it's important to take advantage of tax-deferred and tax-exempt vehicles such as the 401k, Roth 401k, IRA and Roth IRA accounts that limit the tax exposure of the investment proceeds over time. The critics of dividend-payments in general have their strongest argument with investments held in after-tax accounts. Fortunately, most of us working stiffs will accumulate the majority of our assets within the bounds of company or individual retirement accounts, blunting the arguments against this strategy.

The examples above demonstrate the potential for one to receive a substantial raise EVERY year with a carefully selected diversified portfolio of dividend-paying stocks. I can assure you that I don't have this opportunity in my daily work, in spite of substantial control over the rate at which I work. If you haven't taken a hard look at the actual growth of cash payments within your DGI portfolio, doing so may give you some comfort about the power of compounding contained within a dividend reinvestment program.

Taking a hard look at the dividend growth motive

I read about and follow the dividend-growth school of retirement investing. This school of investing espouses purchasing equities with a long history of dividend growth. Devotees of dividend growth investing state their primary interest in creating a portfolio that will produce an ever-increasing stream of income, with which they can pay expenses or re-invest, or both.  They claim to be less interested in total return or in capital gains. My problem is that I can't rest completely easily in the new orthodoxy of the dividend growth strategy.

In my heart of hearts, I worry that my dividend-growth strategy won't take me to the place I want to be. In order to have that stream of income, I need a pretty big pot of value.  The best performance I can see from folks who post their performance indicates a steady 4% off of the portfolio is possible. I worry that my strategy won't create the big pot of value that I need in the time that need it. At the moment, my portfolio yields about 40k in dividends yearly. At a 10% total return, it will yield 80k in cash when I'm 62 years of age and it will yield 160k when I'm 69 years of age. That doesn't include future investments. If I maximize my pre-tax deferrals for another 10 years, I'll have another $600k in some kind of retirement asset by then, yielding another $24,000 per year at age 65, and another $48,000 at age 72. I guess that should be enough. The government says I should work until I'm 67, so I could put away close to 750k. Actually, I don't see myself working like I do now for another 12 years.  If the combined current retirement portfolio assets of my wife and I were to double twice and we could harvest 4% off of it with a high-dividend strategy, there would be about $5 million in assets and $200,000 in yearly income. That's an optimistic estimate, as two doublings before we retire may not happen. Once we start to draw income from the portfolio, the net rate of appreciation will decline substantially. However, we'll contribute another $500k to the effort between now and then, so maybe that target isn't so unreasonable.

So...do I really believe in that strategy?  What if I can't earn 10% every year? What if my average is more like 7% per year. that means doubling in 10 years. What if there's a big recession and my portfolio takes a hit like 2008?  The best dividend growth companies marched through 2008-9 and never missed a beat with their dividends. Their value plummeted along with the rest of the market, only not so severely. The investor who didn't panic and sell out saw values rebound within a couple of years. I've been doing this long enough now that I'm pretty sure I won't panic and sell out. My biggest risk is simply not getting the investment performance I'm expecting from my dividend growth strategy.

There are still some big expenses ahead of us. My child's private school education is frighteningly expensive. We'll live under a bridge before my wife would sacrifice that experience for him. We'll be on the hook for college between ages 63-67 or so. It may be that inheritance will cover that expense, but no counting chickens...

I'm not counting on SSI, but if it's there when I'm ready to lay down the scalpel, I'll be happy to take it. According to a wise contributor to an investment site I read, SSI should be looked at as the fixed income-portion of one's retirement portfolio; yields about 3-4%, indexes up with inflation, a modest contributor to the whole.

One should ask, what will a couple of old people do with all that money anyway?  I'll be surprised if we're hopping around the world at that point. We'll be fortunate to have our health. We'll be fortunate if our son has established himself independently. We'll be lucky if the world is a hospitable place in which to wander around. One thing to acknowledge is that we won't quit working altogether in that interval. I can't imagine taking a traditional retirement. What we'll need to do is cover our expenses.

I'm pretty certain I couldn't capitulate and go back to fund, or fund of funds, or capital-gains investing. I fret enough as it is about capital value of my holdings, even knowing the dividend reinvestment is at work. I haven't completely abandoned the old me. So, I'll trudge along with this strategy and hope that eventually the hyper-vigilance will go away and I'll trust more fully in the process.

So, I guess I'm committed, since I can more easily see 3-4% dividends reinvested, along with 5-7% capital appreciation leading to a 10% total return on investment over the long haul, than hoping for higher capital gains and eventually converting to a "harvesting" regimen. If it only makes 7% per year, I can still get to a comfortable place where most or all of my wages are replaced by investment earnings.