Dividends Really Are Like Snowballs

snowballOur entire investing future is a product of three things:

(1) The amount of money we invest.

(2) The growth rate of our investment.

(3) The amount of time we allow an investment to grow.

The higher we can get each of those three elements, the more we will have (note: I am not claiming that amassing the largest fortune should be your goal. It is all about utility. Warren Buffett used to joke that even a seemingly unassailable virtue like delayed gratification has its limits because, hey, you cannot save sex for old age. A $100,000 in the hands of a twenty-five year old could be much more valuable than $300,000 in the hands of an eighty year-old. The key to investing, and life in general, is finding the right calibration between satisfying your current and future self to the best of your ability).

Having mentioned that, you presumably have a desire to build long-term wealth or else you would not be reading this website. And today I wanted to discuss the third element mentioned in the equation above: the time we allow an investment to grow.

The reason why this globe isn’t stuffed with six billion dividend growth investors is because, among other reasons, the dividend checks generated from your holdings are relatively small in the beginning years. If you buy $1,000 worth of Coca-Cola stock, you are not even going to be generating $30 worth of passive income right off the bat.

At that point, you need help from three friends which I refer to as the “Holy Trinity of Wealth Creation.” They are the combination of: current dividends, the growth rate of the dividends, and the reinvestment of the dividends. When you take a cash payment that you receive four times per year, plow it back into additional ownership units, and combine it with a growing dividend that you will reinvest as well, you are putting yourself in a position to take advantage of the power of compounding that Einstein discussed.

Plus, there is a huge psychological advantage in knowing that each dividend reinvested leads to a higher dividend check next time around. Let’s say you are sitting on 200 shares of Johnson & Johnson that you have accumulated sedulously over the past couple years. At the current dividend rate, you are receiving a $0.66 check every ninety days as your share of the company’s profits. That means you are initially slated to receive $132 in dividend income from your first check.

But here is where things get fun. When you reinvest those dividends at, say, $85 per share, you pick up an additional 1.55 shares of stock. That means that, when it comes time to receive your next dividend payment, you will have 201.55 shares working for you instead of 200. Even though the $0.66 check remains the same, you will now be collecting $133.02. At first, you might be tempted to laugh: Really Tim, you want me to get excited about a dollar? Yes, yes, I do.

That dollar increase is only one cog in the wheel—one dividend payment. You get three more dividend payments over the course of a year, and if Johnson & Johnson continues to do what it has done for the past half a century, you will get a dividend raise next year.

What are the implications of that? Well, when you take the four dividends at $0.66 and reinvest them, you are looking at adding about 6.25 shares to your account before the next dividend raise takes effect (the exact figure is subject to the purchase price of your reinvestment). If you are able to have 206.25 shares when Johnson & Johnson raises its quarterly dividend to $0.71 or so next year (a 7.5% increase which is a bit below historical norms), you will be instantly making $146 every ninety days. Just by reinvesting your dividends and waiting for a raise, you got a 10.6% growth in income. Considering all you had to do was click a reinvest box and sit back for a year, that ain’t a bad way to go through life getting raises.

And that is just one year’s story. Imagine when you take that action and let it build upon itself for twenty years.

If you bought Colgate-Palmolive twenty years ago, you’d be lucky to be generating $200 in initial income on a $10,000 investment. Today, you’d have a little over 2,456 shares if you reinvested the dividends, and they would currently generate $3,340 in annual income. Whatever amount you would have invested into Colgate in June 1993, you would currently be receiving dividends that are over 16.5x your first dividend check. How can you not love the long-term investment opportunities available in the United States of America? You can get rich on friggin’ dish soap if you give it enough time.

When Alice Schroeder wrote her biography on Warren Buffett, she chose to call the book The Snowball. Long-term dividend investing is exactly like rolling a snowball down a hill. The first $10,000 put into Colgate-Palmolive twenty years ago may not have seemed like much, only generating $200 or so in immediate income. But as the dish soap business grew and you took your share of the profits to plow back into more ownership units in the company, you worked your way towards $3,340 in annual income, or 33.40% of your initial purchase price.

Imagine if you spent a year or two getting a block of stock in a company like Colgate-Palmolive put in a tax shelter like a Roth IRA. It would be entirely reasonable that you’d have $3,000+ in tax-free annual income to deploy elsewhere, just by putting aside some money today for a long-term investment. And Colgate is just one stock. One company. Apply these principles for 20-30 years across two to three dozen companies, and your snowball will grow so big that it will be confused with an avalanche.