When I first started writing finance articles, I noticed that my author peers would often include income investing rules like “I only consider a security if it is yielding at least 3%.” That is a rule that has some rationality if you are near retirement or have some plans to collect the cash produced by your investments and do something with it in the near term. But still, I had some type of intuition that this rule was suboptimal, as I noticed that many of the firms with the highest earnings and dividend growth rates tended to have market prices that would only give you an initial yield of 1% or 2%.
The question I seek to answer through case studies is this: What happens if you actively choose to forego current income today, and instead opt to own something that doesn’t give you much income now, but has a strong rate of growth? How do you quantify that “reward” for delaying immediate income gratification? And what becomes of those meagre initial dividend payouts that are invested into a security that has a high growth rate?
The firm I’d like to use for the case study is Nike (NKE) mostly because of its universally acknowledged “moat” characteristics, extremely strong balance sheet, and long-term track record of giving shareholders total returns in the 16% to 20% range (this compounding rate has enabled Nike founder Phil Knight to donate over $300 million to the athletic program at the University of Oregon over his lifetime). It’s a household name that has the type of business characteristics that almost self-evidently make it obvious as a great investment.
My speculation is that the biggest reason why investors (that are aware of Nike’s business model) nevertheless declined to purchase the stock is due to the deterrent effect of the low initial dividend yield that has historically hovered in the 1.0% to 1.8% range. Well, what becomes of that low initial yield?
Let’s assume that someone bought $10,000 worth of Nike stock at a split-adjusted price of $10 per share in 2004, for a total of 1,000 shares. The initial annual income on that stock was only $0.09 per share, or $90 in annual dividend on a $10,000 investment. Although it may not have seemed like much at the time, those $90 in dividends purchased 9 shares of additional Nike stock through dividend reinvestment.
With reinvestment, those 9 shares cumulatively produced $34.92 in dividend income that got reinvested at an average price of $21.34 per share between 2004 and the end of 2015. That means the reinvestment of those shares produced an additional 1.63 shares of Nike stock (and this speaks only to the power of reinvesting Nike’s dividend in 2004).
Nike currently trades at nearly $63 per share. Just by checking the dividend reinvest box in 2004, you got 9 shares issued to you that, and then those 9 shares also created 1.63 new shares over the following decade. The economic value, then, of reinvesting Nike dividends in 2004 turned out to be $659 in market value. This evaluation may seem weird because I am assuming that you only reinvested your entire Nike stock position over the course of 2004, and then I traced those nearly created Nike shares on their own reinvestment journey from 2005 through 2015.
The reason I did this is because I wanted to isolate the variables and show what can happen when you reinvest the dividends from a stock that is only yielding 1% but is so growing earnings rapidly and delivering substantial capital gains. In the case of Nike, the power of reinvesting that 0.9% dividend in 2004 gave you 9 new shares that would go on to produce 1.63 shares so that the decision to reinvest in 2004 gave you a 7.32x increase in the market value of the shares that you chose to reinvest.
When you look at your low-yield, faster growing stocks, and see that the particular reinvestment doesn’t do much to increase the share count, you can take solace knowing that the share count addition may be small but the magnitude of capital appreciation awaiting that addition to the share count may be great.
I frequently see people complain about the low share count addition that occurs when you buy a low yield but fast growing stock like Nike. If you buy 100 shares for $6,300 today, you are going to collect $64. Assuming a generally steady market price, you will end up with 101 shares at the end of the year. That addition of 1 share may not seem like much, but if Nike does from 2016-2027 what it did from 2004 through 2015, the market value of that additional share will increase from $63 to $461 in 2027. The reinvestment over 2016 will show one additional share on paper, but boy, is the magnitude of that share’s value substantially increase by the time 2027 arrives.
Now, that prediction likely won’t happen since the 2004-2015 period saw Nike’s stock increase its P/E multiple from 19 to 29, and then 2016-2027 comparison period may very well see the P/E ratio of Nike revert to normalcy and shrink from 29 to 19. Under this most probable scenario, the $63 would only grow to about $253 instead of $461. A substantial derogation, yet still illustrative of the principle that a modest share count increase can still turn into something significant due to the magnitude of the market value increase for each additional share.
I’ve noticed an uptick in readers on this site from wealthy areas in California, and I can imagine that most of you roll your eyes when you see investment articles that make the assumption of 0% state income taxes when calculating the net after-tax value of an investment, either due to an assumption that the investment is within the confines of a tax shelter or the investor is domiciled in a state without income tax.
You high earners in California have to laugh at that assumption. If you’re earning a high income, and making taxable account investments, you have to be savvier in your investment selections because you will be less interested in stocks require substantial tax payments each year (e.g. most of the return comes in the form of dividends each year) and instead focus on the kinds of companies that deliver most of their value through capital appreciation (gains that can go unrealized for as long as you refrain from selling).
For these types of investors, Nike is a nearly perfect stock selection because it offers an opportunity to build significant wealth for those that aren’t really interested in high income now but would like to own something that would give you passive income later without selling the asset. If you’re in California, you don’t want to go through life paying 13.3% in state taxes on high dividend payments for decades.
The Nike wraparound allows you to only pay 13.3% in California state taxes on $90 in 2004 compared to a $10,000 investment, or $11.97 to the state of California in year one of your $10,000 Nike investment. At the twenty-year mark in 2024, the Nike dividend will have grown to $1.24 per share, or a 12.4% yield assuming no dividend reinvestment (the yield would be around 18% assuming full dividend reinvestment and the payment of California state taxes along the way). Most of the wealth would still be “locked up” in the form of unrealized capital gains as the market value of Nike stock tends to increase 11-fold over rolling twenty-year periods, but you could also be collecting $1,800 annually in 2024 income on your $10,000 Nike investment in 2004.
The bulk of the wealth would remain indefinitely beyond the reach of the tax man because you would have an unrealized capital gain associated with the market valuation of Nike stock increasing from $10,000 in 2004 to somewhere in the low six figures by 2024, but you’d also have $1,800 coming your way in passive income that was allowed to develop by the time you wanted it without having the state of California reach into your pocket and grab too much during the execution of this strategy.
If you have a long-term horizon, and don’t plan on using the income from an investment for a while, it can be a mistake to overlook those stocks with low initial yields. The Rule of 72 can be helpful in making guesses about to do expect. The Rule of 72 states that you take the expected growth rate of stock, use the number 72 to divide it, and then you’ll know how long it takes the yield or market value to double.
Contemplating a stock that has a 2% dividend and 11% growth will double in value every six and a half years, suggesting that the 2% yield will become an 8% yield-on-cost thirteen years later. Likewise, each “share” acquired through dividend reinvest should see its value double every 6.5 years. It is an imprecise art because the slightest changes to the inputs can create dramatically different results if you are trying to calculate the effects over a fifteen to twenty year time frame, but is nevertheless is worth the effort because those 1% yielding stocks can often come with understated benefits if you are interested in the capital gains and eventual yield-on-cost that can result over a decade later.
Originally posted 2016-03-19 23:55:15.