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The Power of Dividends

The Power of Dividends

| October 14, 2020

First of all, I hope that this note finds you keeping well and staying safe. 

We're in the midst of the season when we talk of elections and their impact on the markets.  (Hint: Over time it hasn't mattered which party is in power.)   And yes, the economy is in a recession and volatility remains relatively high.  But, I'd like to bring things down to the ground level, for a moment.

One problem I see is that investors, as a group, are becoming conditioned (perhaps by the media) to worry even more about the market’s ups and downs, about whether or not they are outperforming some benchmark, and if they are going to miss the great fill-in-the-blank opportunity (or need to hide). 

All of this sells ads, but most of it doesn't help the investor meet their goals.  In reality, we really just need to remember that we are putting the power of compounding to work. 

Here’s what I mean by this statement:  Dividends are what we can spend now, but dividend growth is where the fun is.  An investment that can steadily grow its dividends will compound growth over time.

As the chart above shows, the results can be pretty dramatic after a while.  The red bars are the annual income from the S&P500 and the blue bars are the annual interest from the Aggregate Bond Index (which represents most of the domestic taxable bonds.)   

This clearly isn’t a get rich quick idea.  Sometimes the dividends decline a bit. But, importantly, for someone who would eventually live on this income, the growth in the red bars greatly outpaced inflation.  The blue bars were stagnant -- or worse.

Needless to say, this graphic doesn’t show the growth in portfolio value or the ups and downs of its returns.  But it does show a more stable reflection of value:  The portfolio's income generation, which is far more stable and predictable

Whether we admit it or not, stocks are essentially valued on their future cash flow generation.  The “Dividend Discount Model”, one of the oldest valuation methods, computes the intrinsic value of a company’s shares as the present value of all their future cash flows.   

Or, looked at from the other (less geeky) side: 

Question: What is the value of an investment that never will pay you anything? 

Scott's Answer: It’s not worth anything to me…  Eventually, I want to share in the profits...

While this note might be focused on cash flow, don’t think for a minute that this graphic is meant to imply that the S&P500 should be an investor’s only position.  That would be a very risky portfolio, indeed.  But when evaluating components of a portfolio, it is important to look at the future income generation potential from one’s investments, as well as the current income. 

You’re probably thinking that both stocks and bonds lack much yield these days.  And you’re right. But, as the graphic shows, the patient stock market investor is likely to be rewarded with a handsome income stream in future years -- when they need it most.