One of the advantages of holding a stock for a long time and reinvesting the dividends into the same company that paid out the dividends is that you become very receptive to the idea of falling stock prices. In fact, sometimes I think that only affluent or aspiring affluent private investors that are reinvesting the dividends are the only ones who truly appreciate how falling dividends can aid the income production process.
I want to use GlaxoSmithKline as an example because they are in the news today. The management has a long history of being honest and candid with investors, and actually, they usually get punished for it (that’s why it’s hard for me to get mad at management teams that speak in corporate jargon and describe all bad news as one-time events, because when investors actually hear negative news from corporative executives, they pout and lower the price of the stock 6%, like you saw with GlaxoSmithKline today).
After announcing that sales wouldn’t be increasing and the $1.7 billion buyback would be halted, the stock fell from $54 to $50. On Seeking Alpha, I saw some GlaxoSmithKline investors say they were selling the stock, and I’m not happy to see stuff like that because it shows a lack of regard for truly long-term thinking. Somewhere along the line, a bunch of investors got the idea in their head that ownership positions should grow profits by 10% every year without fail, and the price of the stock should smoothly sail up 10% each year with it. If you want to own specific for long periods of time as part of your strategy, you’re going to have to bury that notion because business life doesn’t move with that kind of linear smoothness.
I’m not saying you should be excited that sales aren’t growing rapidly this year (you should always root for rapidly growing business fundamentals and a stock price that lags this growth so you can buy more, and benefit from reinvested dividends), but you should have the perspective to recognize that GlaxoSmithKline is a $120 billion company with a very, very diverse portfolio of products that throw off lots and lots of cash.
If you study the company in depth, you will be amazed at the entire collection of diverse products that come together to produce profits on behalf of shareholders. I’m not sure that anyone who truly understands the vastness of its diverse profitable income streams would ever relinquish the stock, unless the price got so expensive that the earnings yield was less than half the rate offered by ten-year Treasury bills.
Usually, they declare a dividend right about this time every year (my guess is that you’ll hear what GlaxoSmithKline is going to pay shareholders either tomorrow or Friday—it might even be declared by the time you get around to reading this year!), but let’s assume that it is $0.57 per share.
Five years from now, no one is going to be talking about GlaxoSmithKline’s quarterly earnings report that came out in July 2014. It won’t even be something you’ll mentally register when you look back on the stock. But if you review your history of financial statements, you will see what happened you reinvested your shares.
Let’s stick with our investor who owns 1,000 shares. When the stock was trading at $54 like it was yesterday, a dividend that would get reinvested would only buy 10.55 shares. You’d have 1,010 shares paying out $2,393.70 in cash distributions (I’m using the 2013 payout rate as a reference point, which is lower than what 2014 shareholders will actually receive).
Because the price is now $50 per share, the same dividend payment will instead create 11.4 shares. Because of this teeny, tiny price fluctuation in the scheme of things, you now have one more share that will be working on your behalf until you die if you choose so—that GlaxoSmithKline share will be paying out dividends in 2015, 2016, 2017, 2018, and so on. No one hardly talks about it because it is such a small difference. But over a twenty-year investment time frame, you’re talking about that one share collecting eighty different dividend payouts of its own, and its effect grows more pronounced with time.
Almost everyone you will encounter in the financial universe is going to focus on that ephemeral net worth swing from $54,000 to $50,000, not really caring about those 1,011 shares paying out $2,396.07 as the baseline going forward. This is why income investing as part of a buy-and-hold strategy becomes extremely countercultural: people will think you’re psychotic from trumpeting a $3 permanent increase in annual income while disregarding the $4,000 “paper” loss.
It takes recognition that swings in stock prices are illusory in the short term and the price will ultimately reflect GlaxoSmithKline’s eventual growth over the long term, and the knowledge that the freebie shares created by a lower price will amount to something as they start to throw off dividends of their own over the decades, to enjoy this kind of income strategy.
In a way, I’m kind of glad for the opportunity this moment presented—I’ve only been writing in a bull market period of economic expansion in which it’s been non-stop earnings growth and dividend growth. It’s nice to have a moment to catch one’s breathe, and say, “Wait a minute, this is what income investing is about, and healthy megacap enterprises experiencing downticks in stock price is a little turbo-charger that is going to add to the total amount of annual income that long-term business stakes generate.”
The people who truly would appreciate the spirit of what I’m getting at here are those who hold on to an income-rich stock throughout the financial crisis. Imagine seeing the shares created by Chevron when you were reinvesting at $64 per share. I bet you like having those extra shares on the balance sheet, which generate dividend income of their own and eventually can be sold in their own right (e.g. if the depressed share prices of Chevron netted you 10 more shares than what you would have achieved with reinvestment had the price stayed high, they can now be sold for $133 each).
No, GlaxoSmithKline going from $54 to $50 does not have the same income growth effect as you saw from the reinvestment of dividends during the lows of the financial crisis. But it’s the same principle that applies, just a smaller dosage.