How to read an Annual Report part 2: Dividend

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This is part of my series on The Annual Report. Please read the other posts for other perspectives on the matter:

How to read an Annual Report part 1: Management
How to read an Annual Report part 2: Dividend

Introduction

So, we have had a look at the management teams of the companies and what to look at there. The question is still, how do we differentiate long term, solid companies from junk companies in an easy way that doesn't require a lot of time. The answer might be dividends. Lets look at the details.

Companies that don't pay divided

The are numerous reasons for a company not to pay out any dividends, maybe they are in an expansion phase, researching a new product, acquiring businesses etc.  This is all well and good, the question we should ask as long term investors is:

Is the management team creating more value for us by keeping the cash in the books instead of paying it out in dividends?

For me, to answer this question would take too long to analyse and research. I.e. going back in reports and looking at the returns over a longer period of time. And that is basically the one reason why I don't invest in them.
Other reasons why I keep away is because when my money making machine build phase is over, I would like to be able to live on the returns. If the companies I own don't pay out dividends I would have to sell my shares, bit by bit to be able to make a living and that just feels wrong.

Companies that pay dividend

So, we have now filtered out a big chunk of companies that don't pay dividends. Lets look at the ones that do.
For a company to be able to pay a dividend it requires that it must have a revenue stream that is higher than the cost of operations. The management team must be confident that they will be able to continue with operations even after the dividend is paid. To be able to pay dividends, year after year the companies must adapt to all sorts of challenges that the world throws at them, from financial crisis to acquisitions. Everything the company does, must pay itself. The company can't afford to throw away money.

So, companies that pay dividend are good. How do we know that they will continue to do so? As with mutual funds, we can't predict the future by looking at past performance. There is always a risk. But dividend companies have one thing that stands out: Shareholders don't tend to like them if they mess with the dividend policy.
And that is why so many companies make an extraordinary effort to pay the dividend. If they don't do it one year, it sends out strong signals that things are not in order and many larger institutional owners tend to sell when it happens, making the share drop.

If the company has paid dividends for a decade, we should be interested.

Companies that raise dividend

So dividend payers are great companies, but what makes companies stand out even more from the competition? Companies that raise their dividend year after year. To be able to raise a dividend year after year, the operations must be optimized. And just like with the dividend payout itself, shareholders tend to not like it if a company changes its dividend payout plan and doesn't raise it for one year.
There is even a name for companies that have raised their dividends for 25 consecutive years, they are called Dividend Aristocrats.  Its a thing, it is part of the company's image. The company is a dividend raiser and most of them are quite proud of that and it takes something out of the ordinary to change that. For example the financial crisis in 2009, the list of S&P500 Aristocrats dropped 10 companies. From 52 to 42. Keep in mind that the whole financial sector was on the edge of collapse and still 42 companies managed to raise their payouts to shareholders. If you reinvested that cash during that year, you got a lot of shares for a bargain as the markets plummeted at the same time. I feel that I can trust a dividend raiser, they go the extra mile.

Conclusions

Of course there are companies that for various reasons stop or change their dividend payouts. Maybe that should be the signal for you to go somewhere else instead of the quarterly noise with missed expectations. If the company is still able to raise its dividend even after a 'failure', it is still a great company to own and most likely things will sort themselves out.

I'm not that into numbers as you might have noticed on this blog, I'm happy to leave them out most of the time. But one thing that should be kept in mind when looking at companies that pay dividend is that if you re-invest the dividend payout, and the payout is higher each year. You will get some awesome compounding effects on your investment. The numbers go crazy after some years. I'll let you find the numbers on google yourself. :)

A great place to start searching for dividend paying companies: The DRiP Investing Resource Center
They have lists for various markets, US, Canada, UK and Sweden to name a few.


Disclaimer. I am in no way an expert on capital management or investing. On this blog I only wish to share my findings, ideas and comments on current events and fields that interest me. I hope that my thoughts can entertain you. I expect that everyone reading take their time and do their own research before acting on anything read on this blog. Investing is not for everyone. E&OE.

The power of compounding

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I tend to keep away from actual numbers on this blog, mostly as they are not my strong suite and that I want to the readers to do their own homework.
So lets see how that goes when we will cover the subject of compounding.

Introduction

Compounding is the idea that when you receive interest on your investment and reinvest it you will start to receive interest on that interest as well. And next year, you will add another round of interest and so on. After some years, the snowball starts to build itself faster and faster.
This is the reason why you should reinvest your returns, be it interest rate or dividend payouts. The numbers go crazy after a few years.

One time investment: Savings account vs. reinvesting

A very simplified scenario. Say you invest 100000. And each year, you will receive 6%. The following table shows the growth with and without reinvestment, i.e. compounding for the first 25 years. I.e. plain is your savings account with 0% interest.

year	savings account	reinvested
1	100000	100000
2	100000	106000
3	100000	112360
4	100000	119101
5	100000	126247
6	100000	133822
7	100000	141851
8	100000	150363
9	100000	159384
10	100000	168947
11	100000	179084
12	100000	189829
13	100000	201219
14	100000	213292
15	100000	226090
16	100000	239655
17	100000	254035
18	100000	269277
19	100000	285433
20	100000	302559
21	100000	320713
22	100000	339956
23	100000	360353
24	100000	381974
25	100000	404893

The difference is a whooping 304893. Just by locking in your money and reinvesting each year the original investment has grown 4 times!
OK, the example is a little biased against the savings account. So lets look at a more realistic calculation.

Continuous investment: savings vs reinvestment strategy

In a more realistic scenario you would continue to invest new money each year, say 30000 per year the numbers would be the following:

year	savings account + additional savings	reinvested + additional investment
1	100000	100000
2	130000	136000
3	160000	174160
4	190000	214610
5	220000	257486
6	250000	302935
7	280000	351111
8	310000	402178
9	340000	456309
10	370000	513687
11	400000	574509
12	430000	638979
13	460000	707318
14	490000	779757
15	520000	856542
16	550000	937935
17	580000	1024211
18	610000	1115664
19	640000	1212603
20	670000	1315360
21	700000	1424281
22	730000	1539738
23	760000	1662122
24	790000	1791850
25	820000	1929361

The difference now would be 1109361. That's a lot of money.

Living on the yearly returns

If you, like me, plan to live on the returns from your investment, given the above numbers the following would be paid out per year if you stop reinvesting.

years	savings account	savings account  + additional investment	reinvested	reinvested  + additional investment
10	0	30000 for 10 years	10137	30821
15	0	30000 for 15 years	13565	51393
20	0	30000 for 20 years	18154	78922
25	0	30000 for 25 years	24294	115762
30	0	30000 for 30 years	32510	165062

Savings accounts: you would need to do withdrawals to get any money as most accounts have 0% interest rates.
After 10 years, the reinvesting plus additional investing will generate an extra investment unit of 30000 per year by itself. And after 25 years, it adds the initial investment each year!
And going from 25 to 30 years adds another ~50000 per year.

Conclusion

I know my plan. Continuously invest and reinvest all dividends! Event if the 6% per year rate is just fake and in reality it would be different depending on a number of variables, taxes, costs, market fluctuations etc. But the effect of interest on interest on interest over and over again is just something that must be leveraged in any long term investment plan.

Hope this helped a little bit in showing how this effect works :)

Disclaimer. I am in no way an expert on capital management or investing. On this blog I only wish to share my findings, ideas and comments on current events and fields that interest me. I hope that my thoughts can entertain you. I expect that everyone reading take their time and do their own research before acting on anything read on this blog. Investing is not for everyone. E&OE.