In the 1930s, a youngish man named Alfred Cowles III founded the Cowles Commission for Economic Research. One of Mr. Cowles’ first projects involved back-testing stock market performance from 1871 through the Great Depression, paying special attention to the effect of reinvested dividends during this time frame.
This was a purely academic exercise—back then, dividends weren’t something that you reinvested because the technology and affordability didn’t exist for it to make sense. It wasn’t a thing. If you owned $40,000 worth of AT&T, you collected your $800 in the mail every three months and used the dividends to help you support your lifestyle. Wanted to make a house payment and take care of the utilities? That’s what the AT&T dividends were for. Wanted to reinvest? You’d have to make a special buy order to purchase 100 shares. If AT&T was trading at $30 per share, you’d have to come up with the other $2,200 on your own. And you’d have to spend a couple hundred dollars on the new buy order. It was just…a different world.
The barriers to entry for making an investment were incredibly high—you couldn’t effectively start investing with $50 in your hand like you can today through Loyal3, Computershare, Sharebuilder, or what have you—and this made it difficult for someone to achieve significant social mobility without a rapidly increasing salary. The welcome effect is that people took it as a matter of course that stocks were real businesses bought for ownership, although stock buyers had the reputation of being slick and wily because their ownership positions were based on the current and future profitability of companies rather than secured bonds which had been the hallmark of traditional conservative investing accounts because property could be sold to return part of your principal in the event that the business failed.
Anyway, the importance of Alfred Cowles III’s research is that he pointed out what happened when investors reinvested their dividends (which, due to trading costs, was nothing more than a theoretical exercise at the time). Even if you bought at the high before the Great Depression happened, you were still back to even within four and a half years if you had taken the slashed dividends and put them into new shares that had become even more undervalued. What was a theoretical exercise during the worst economic crisis endured in the United States is something that investors are able to actually do in real life now.
I call this the “Four Year Rule” in which it becomes very difficult for profitable enterprises that pay dividends to deliver a loss of principal because you have the advantage effects of dividend reinvestment to help your returns. I think a lot of heartache and worry in the investing world could be avoided if you could just shake people out of the fear of worrying about stock prices in the next twelve months and instead demonstrate that it only takes a few years of dividend reinvestment for everything to be fine. Sticking with the AT&T example, you would have collected the following annual dividends between 2010 and 2014 ($1.68+$1.72+$1.76+$1.80+$1.84). That is $8.80 in dividends; the highest price you could have paid for AT&T stock in 2010 was $29.60. You’ve collected over 29% of your purchase price in cash dividends alone. The price of the stock would have to fall below $20.80 for you to take a paper loss on your investment in 2010 assuming you bought it at the absolute highest price during that year.
There is a reason why I have taken such a liking towards GlaxoSmithKline of late—the company pays out $2.66 per share in dividends. At a minimum, shareholders will collect at least $10 per share in dividends over the next four full years of dividend payments. You would need the company to shed more than a fifth of its market value for you to have a paper loss four years from now.
Obviously, these rules don’t apply as much for companies with dividend yields in the 1% to 2% range. But once the dividend yield crosses the 3.5% point or so, it becomes very difficult to take a paper loss once you’ve been reinvesting dividends for at least four years.
Coca-Cola has paid out over $5 in dividends on every share purchased for $30 in 2010. You would need the price to fall below $25 per share for you to take a paper loss—based on current profits, that’s a valuation of 12x profits on Coca-Cola stock for you to take a paper loss (as a reference point, Coca-Cola only fell to 15x profits during The Great Recession).
The research of the late Alfred Cowles III provided some perspective on how dividends interact with falling stock prices during a recession—and hinted at the fact that profitable enterprises tend to recover within four years under most worst case scenarios. This isn’t a principle that applies to low-yielding stocks like Disney, Visa, and Nike (in the case of those companies, you rely on the regular growth in earnings per share to carry the prices forward) but does apply to companies with stable profits and dividends that give you a decent starting yield point. Just sitting on your rear for four years and clicking the reinvest button takes most of the potential losses out of blue-chip investing, and the lessons from Mr. Cowles’ research would be nice to keep in mind next time investors get caught up by a 15%, 20%, or 30% loss in the marketplace.
Originally posted 2015-02-23 10:20:32.