How Reinvested Dividends Can Double Your Return in Stocks


By Greg Canavan and Dan Denning

Last week in The Daily Reckoning, Greg Canavan and Dan Denning wrote about how owning shares that pay you to own them will be key to your investment success in the coming years. With the big four banks – traditionally high dividend players – being downgraded by Standard and Poor’s overnight, we thought it was a great time to revisit why dividends are important and how to safely buy the companies that issue them.

We’ve ‘mashed-up’ the best bits of Dan and Greg’s essays below. Enjoy… And if you want to find out which five Aussie dividend payers Greg has buy recommendations on right now, go How Reinvested Dividends Can Double Your Return in Stocks over Time

Source: Triumph of the Optimists

You’ll note the chart ends in 2000. It includes the Internet boom in the markets, but not the bust. And of course, in the 11 years since then, markets have been heavily influenced by lower interest rates, central bank intervention, and quantitative easing. Globally low interest rates also made it less imperative for companies to pay dividends to shareholders. Companies could borrow cheaply and lever up to grow earnings. It was a market for chasing capital gains in a global boom.

But in the scheme of things, it’s the last 10 years of debt binging that are anomalous, not the previous 100.

Managing Your Dividends

That means we’re returning to a market where dividends will be far more important to your total return than they have been in the last 10 years. As financial analyst Robert Arnott wrote in 2003, “Unless corporate managers can provide sharply higher real growth in earnings, dividends are the main source of the real return we expect from stocks.”

Return Of The Prudent Manager

This is encouraging news. It means the return of genuine security analysis is now on the horizon – after the great deleveraging. Investors will again have to assess which corporate managers do the most with your money. In technical terms, you’re looking for managers who generate consistently high returns on equity.

Ever since executive compensation has been tied to quarterly earnings performance in the US, US corporate managers have borrowed heavily to lever up the balance sheet and deliver quarter-over-quarter earnings growth. They were more interested in delivering earnings surprises to push the share price higher because that directly influenced their yearly pay packet.

You could make a pretty hefty argument that this mis-aligned the incentives of shareholders and corporate managers. The capital management of US firms became short-sighted, short-term, and dominated by growing quarterly earnings by any means necessary. This was particularly true, for example, for firms like Fannie Mae and Freddie Mac.

Return of the Dividend

Shareholders, to the extent, they cared at all, decided to chase capital gains and leave the valuation game to the dinosaurs like Buffett. But we may now be swinging back to a market where capital management matters again to investment returns. And retuning those returns on investment to the investors via dividends. That’s what happens when you take away the balance-sheet boosting powers of easy money and credit. Growth takes a back seat to cash flow earnings. Suddenly divvies start to look enticing.

This is a return to cyclical norms. The good folks at Keep Your Capital Intact And Get Ready To Have
A Swing When The Next Cycle Gets Underway.