Part Two in a series on investment strategies used in the diversified portfolio of corporate leaders with concentrated holdings in the companies they manage.
Story clients generally dislike speculative and complex investment strategies in their diversified investment portfolio because their core investment portfolio is dominated by as much as an 85% concentration in the stock and equity awards of their employer. Concentration, while laden with risk, is not a bad thing, but combining concentration risk with complex strategies magnifies investment risk well beyond most clients’ preference. What then would be a sound and simple strategy for use in the core of one’s diversified portfolio that might also tie directly into creating future, tax advantaged retirement income? Reflecting on this question is the purpose of this blog series.
Compounding something negative begets something worse. Taking a continuous level distribution from an equity portfolio which has decreased in value is a fine example of negative compounding. Compounding something positive begets an amazing result, over time. It is attributed to Albert Einstein as saying that "compound interest is the 8th wonder of the world!” In the context of this blog, consistently compounding a stock’s dividend is powerful; yet compounding is supercharged when one holds stocks that not only pay consistent dividends over time, but which routinely grow the amount of dividend they pay per share. Imagine for a moment how powerful this concept might be when the rate of growth on the dividend exceeds the ongoing rate of inflation. When one’s focus turns to consistently growing tax-advantaged cash flow, the underlying volatility of the investment itself diminishes in the context of our fears. In fact, future blogs will demonstrate that negative stock pressure can enhance the already supercharged nature of a well-managed dividend growth investment strategy.
When the corporate paycheck ends, most clients desire income: cash flow, not dependent upon stock market conditions in this case, via dividend income. Developing a portfolio of Dividend Growth stocks is a powerful component, among others, of creating stable, long-term financial security within one’s family. Here is our favorite formula for diversified portfolio investment success. To illustrate, we will reflect on Warren Buffet’s well documented purchase of Coke in the late 1980’: a simple and transparent strategy *
High Quality + High Dividends + High Growth Rate of Dividends + Time = Superb Results**
High Quality Company: In this case, Coke. Exquisite management aligned with shareholder interests. A high demand, branded product. Outstanding financial metrics. Berkshire purchased roughly 400 million shares, a billion dollars of Coca-Cola in 1987/88 at approximately $2.50/share adjusted for splits.
High Dividend: Coke had long, unbroken decades of dividend payments when Berkshire made the investment. Coke traditionally pays in the vicinity of a 3% yield on its current stock price which is an above average dividend yield. In 1988, Coke paid a split-adjusted, annual dividend of approximately $.08/share or 3.2% of its $2.50 share price.
High Growth of Dividends: Coke’s $.08 per share dividend in 1988 has grown to $1.60 per share in 2019. This charts a growth rate on dividend declarations of about 10%/year.
- The current, rolling 25-year average rate of inflation is approximately 3.74%/per year. Coke’s average annual dividend growth rate has outpaced the rate of inflation by about 2.7 times.
- Coke’s February 2019 annual dividend per share of $1.60, is still approximately 3.0% of Coke’s current $55.00 share price but 20 times it’s 1988 dividend rate!
Time: It is easy to be patient when markets are robust. The opportunity of using compounding, however, depends upon an investor’s ability to remain patient when markets are crashing. Time is a vital and perhaps virtuous component of success. The magic of compounding’s impact is realized at the speed of a sloth, not at our human desire to see things happen at the speed of light.
- Over the 31 intervening years between 1988’s dividend of $.08/share and 2019’s $1.60/share, Coke’s annual dividend (not its stock price) grew at the compound rate of approximately 10.15%/year.
- Coke’s underlying stock price movement from 1988’s $2.50/share, to 2019’s $55.00/share has grown at a comparable, compound rate of 10.49%/year.
Now there is something to ponder. The dividend grew slightly in excess of 10% per year and so did the underlying price of the stock. Is that a coincidence, an outlier, a freak of the markets? Stay tuned to future Blogs.
Some of us can remember where we were 31 years ago. Had we purchased just 10,000 shares split adjusted or $25,000 of Coke and spent the dividends every year, our current holding would be worth about $550,000. But here’s the clincher: the annual dividend on our original $25,000 investment would be about $16,000 or 64% of our original investment per year. This is an awesome example of putting the power of compounding to work in one’s life and this is a real-life example of yield on original investment ($16,000/year divided by an original investment of $25,000). Imagine, with future growth of the Coke dividend at its historic rate, one might anticipate reaching an annual dividend flow of 100% per year of one’s original investment of $25,000 within about 5-7 years, or roughly 2025 by which time the value of one’s holding might be approximately $833,333 (assuming the dividend to stock value remains in the historical realm of 3%).
The above result is illustrated absent reinvestment of Coke’s annual dividend back into Coke shares each year, a practice known as dividend reinvestment. Berkshire has reinvested Coke dividends into other investments within Berkshire. Imagine what the annual dividend cash flow yield percentage (yield on original investment) might be had Coke dividends been reinvested in Coke shares? This question will be further examined in future blogs.
As this example illustrates, seeking growing stock dividends does not imply that one must sacrifice steady growth of an equity’s underlying stock price. There are core similarities between how rising cash flow yield (dividends, commodity price, or rent) impacts the underlying value of a stock, or the price per acre of farmland, or of a rental property.