Source: GaveKal Capital
The reason dividends are so crucial to long-term investing is the simple fact that dividends allow your money to work for you. Reinvested dividend distributions allow one to acquire more shares and those additional shares increase one’s future dividend distribution. This enables one to acquire more shares, which increases the future dividend distribution and so on and so on. The exponential power of compounding is the key to wealth accumulation, and dividends unlock this power for stock investors.
Let’s study this power with a simulation. As with all simulations, the inputs are critical to the formation of conclusions. Thus, we do our best to place our assumptions in a historical context. We have three main assumptions in this example: EPS growth rate, dividend yield, and dividend growth rate. For the EPS growth rate we use a 4 percent growth rate that is in line with long-term nominal GDP growth expectations. For the dividend yield we use a 2% yield since this is approximately the dividend yield for the S&P 500 currently. The average dividend yield for the US stock market over the past 142 years is closer to 4.5 percent.
Finally, for the dividend growth rate we assume a 6 percent annual growth rate. We base this assumption on a mean reversion for the corporate payout ratio (dividends/earnings) over the next several decades back to its long-term average. As charts 2 and 3 show, the payout ratio in the United States is at a very low level relative to where it has been for the last 142 years. This could be due to corporations’ focus on using cash flow to buy back stock rather than distributing it to shareholders. This is ultimately detrimental to long-term equity investors because share buybacks are a return of capital not a return on capital. Without the return on capital, investors are unable to accumulate more shares and take advantage of the power of compounding. We assume that this will correct over the long-term and a 6% dividend growth rate would gently move the market back to a historically normal payout ratio of around 60% over the next three decades.
In our example, we assume we are living in a binary world where one year from now we either have a doubling in valuations or valuations fall by 65 percent. We also assume that the new valuation levels prevail for the next 30 years. In chart 4, we illustrate these two valuation changes within the historical context of the past 142 years.
Source: GaveKal Capital
First, let’s take a look at the total return for an investor if he or she is fully invested. On the left, we have modeled the one-time doubling of valuations in 2015 in light blue. On the right, we have modeled the one-time crash in valuations by 65 percent in 2015, also in the light blue. In each situation, the beginning market value of the portfolio is $1,000,000.
The annualized total rate of return over 30-years is actually 40 basis points higher when valuations dramatically decline. The reason for this can be found in the shares column. The number of shares owned at the end of the simulation period when valuations double is 817 compared to 3,002 shares when valuations crash. The quantity of shares that can be purchased when dividends are reinvested is much larger after valuations have dropped. This allows investors to accumulate more shares, which increases their compounding capacity, and leads to greater wealth accumulation over the long-term. A doubling in price actually has the opposite effect. The quantity of shares that can be purchased is much lower so the power of compounding is reduced. Higher prices don’t compound but the reinvestment of dividends does.
Source: GaveKal Capital
Next let’s further the illustration and take a look at an investor that is 70 percent invested in equities and 30 percent invested in cash prior to the valuation adjustment. Let’s assume that after the market either doubles or drops by about two-thirds the investor becomes fully invested. As you can see below, the annual return between the two scenarios diverge quite a bit. When the market doubles, an investor’s annual return drops by 59 basis points to 7.21 percent. Meanwhile in the crash scenario, an investor’s annual return increases by 157 basis points to 9.77 percent. If the investor assumes that each scenario has a 50 percent chance of occurring then the investor actually increases his or her expected annual return by 49 basis points by holding 30 percent cash prior to the valuation adjustment versus being fully invested. In fact, even if the investor believes there is a 72 percent chance of a doubling scenario in price and only a 28 percent chance of the crash scenario, it would still slightly be in his or her interest to hold 30 percent cash. Or put another way this is the approximate breakeven probability level.
Source: GaveKal Capital
Tapping into the exponential power of compounding over long periods of time is without a doubt the surest way to reach one’s long-term financial goals. For equity investors, dividends are the key to unlocking this power and with that understanding, a sustained fall in equity valuations should be looked upon as an opportunity. Holding onto some cash can increase one’s long-term rate of return, even if one believes a doubling scenario is much more likely, because the benefit of the option to deploy cash at an opportune time outweighs the risk of buying at a future higher price.
Steven Vannelli, CFA, is managing director at GaveKal Capital and portfolio manager of the GaveKal Knowledge Leaders Strategy. He and his team blog daily about the markets at http://gavekal.blogspot.com/. Follow them on Twitter @GaveKalCapital.