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The Simple Math Why Dividend Investing Works

August 18th, 2013 Leave a comment Go to comments

Why I was a younger investor, I was enticed by the hot internet stocks of the day. Who needs a 6% dividend when my stocks just went up 10% today? Although I was great at math, I didn’t understand the math involved to actually getting great consistent returns out of owning stocks. Of course, it’s more than just math, you need to understand stocks and how to determine which ones to buy. Stocks do go up 10% in a day, even today. But if you own stocks or trade them, you need to keep tabs of what your progress is overtime. Short term changes don’t typically lead to long term returns.

It’s a hard lesson to learn, but you are better off tracking earnings and dividend yields instead of stock prices. I’ve gotten to the point in some of my investments that all I need is the dividend to tell me what the state of the business is and whether it’s a good time to buy.

The Market Right Now

There’s a lot of turmoil right now in the market due to the confusion and uncertainty about short and mid term interest rate policy. As much as I like reading about the market and all the things that go on, ultimately you should relate this back to your investments on an individual basis. Right now, it’s good news as far as I’m concerned because the turmoil has caused weak hands to get out of overbought quality dividend stocks.

For example, Realty Income (O) at $55 was way over bought at 22X cash flow. Now at $40, the yield represents a more normal valuation level. It’s the same dividend yield (5.3%) and valuation as it was in 2005 when the interest rate policy wasn’t so accommodative. I will be buying soon for my IRA.

Also, whenever Exxon Mobil gets near a 3% dividend yield, it’s time to get ready to consider buying. The last time XOM hit 3% was in 2010, oddly enough when XOM went lower than it’s 2009 crisis low. Since that time, the stock is up about 45%. How about the dividend? It’s up about the 43%. Who say’s markets aren’t rational?

Dumb Money – Kinder Morgan

Another company I like and own is Kinder Morgan (KMI). When we are in the early innings of a market change or rotation (currently, the market is rotating out of yield), you will find that initially everything is treated the same. So, anything with a yield right now is getting hit.

This is the dumb money.

Not all yield is the same. Kinder’s yield is high but it is growing fast. Eventually, the market has to recognize this. Through earnings increases and share buybacks, the earnings (and dividend yield) is up 11% YTD while the stock is up about only 6%. Last week, I reinvested the quarterly dividend at this lower price. This is a case where the market gives you a gift – getting to buy shares at a lower price.

This is the time to take advantage of the market’s dumbness.

The Simple Math

When I look at my investment in Kinder, I am happy about what it is doing. The key point here is that I am not really that interested in the stock price as a measurement of how well the investment is doing. What I’m interested in is how much my earnings are increasing. Here’s the math:

KMI
Shares Dividend Buyback Price Reinvestment Shares
2012 4th 1000 360
1st qtr 1000 370.00 37.50 9.87
2nd qtr 1009.867 383.75 40.17 9.55
3rd qtr 1019.42 407.77 37.50 10.87
4th qtr 1030.294 412.12 37.50 10.99
1041.283
Total Dividends 1573.63
Total Return 14.48
Dividend Increase 11.11

KMI’s dividend was $0.36 in the 4th quarter of 2012. If I owned 1000 shares, that’s a dividend of $360. If I owned this for all of 2013, my earnings will increase over 14% (I’m assuming a 4th quarter price that same as it is right now – of course it hasn’t happened yet).

The total return is the increase in quarterly dividends – in this case, $412 versus $360, or 14.5%. This is higher than the dividend increase of 11%. This is the math that shows that you can increase your wealth much faster than the actual performance of the company itself – simply by reinvesting the dividends.

If the company keeps performing well the increased earnings will yield higher stocks prices over time. But for now, a lower price gives you an opportunity to buy more for less money.

 

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