There is a huge difference between understanding compounding and actually understanding the numbers behind it. As a blanket term, compounding is thrown around in the investment arena often, yet few investors are actually patient enough to experience its full potential. Creating real wealth takes time, discipline, and strategy.
In this episode, Greg uses our model portfolio to look at a couple of examples that expose just how significant your portfolio income can be when you have the discipline to let it grow. Moreover, he makes the case that income growth, rather than price growth, has a larger impact on the long-term value of your portfolio. Later, he likens the mindset of dividend growth investing to Odesseyus's voyage.
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This is Greg Denewiler and you're listening to another episode of The Dividend Mailbox, a monthly podcast about dividend growth. Our goal is to stuff your mailbox full of dividend checks and make each year's check larger than the last.
Welcome to episode 29 of the Dividend Mailbox and today we're going to look at what It really takes to be a successful investor. And of course, since we live in the dividend growth space, I really hope that by the time you get done with this episode, you'll realize why it works and why it's a good strategy to consider. It does create wealth. So, one of the things we're going to do is an exercise looking at how returns develop long-term, just how powerful compounding is, and how it's not always easy to see on the front end what is more valuable - whether it's growth, whether it's a higher income. But in this episode, we're really going to get into the numbers and hopefully prove that long-term, consistent, sustainable, dividend growth can really work for you. But, before we get into the episode, just a quick note, last episode we did mention that we intend to get a Union Pacific report out there, well that intention is still there and hopefully we can get it soon.
Today, we're going to look at our model portfolio, and one of the reasons why is because the markets have been fairly volatile in the last two years. I thought this would be a good time to review our basic strategy, Dividend Growth. We use the Model Portfolio, which is a live portfolio, as really kind of a foundation to work from. It's just a great way to give us a guideline of how we're doing. So, as we talk about the Model Portfolio, we have gone into it in more detail in past episodes. If you have not listened to any of the previous episodes, it's probably worth your time to go back and listen to those to get a little better feel of just how this is progressing.
And one of the things that you're going to see... When you look at the S&P 500, a few years ago we were up 29%, last year we were down 18% on the S&P 500, this year, as at the time that we're recording this, we're up 14%. When you've got a market that's that volatile, what it can lead you to do is kind of wonder: “Exactly what strategy should I be following now?” It becomes quite easy to look at your portfolio, specifically as we look at the model portfolio, where you can have some dramatic deviations but longer term it really isn't that much different. It can really test you and make you wonder, “am I doing the right thing?”
So, if you look at the period starting from January 1st,2022, and you carry it through the end of September of this year, the S&P 500 is actually down 7% for that period, even though for this year the market's up, as I said a little earlier, about 14%. If we look at our model portfolio over the year and nine months, it basically is flat. So, if your time horizon is a year and nine months, we're doing well. But if your time horizon is the last nine months, we're not doing so well. But here's where this gets much more interesting. You really have to step back and decide: what does success look like? Because what we've had in that space where the market's been up, down, and it's really ended up sideways or slightly down, our income has grown by 13% two years ago,22% last year, and it will have grown by 18% this year. What that means, at least in my book, is we've really had a huge win, even though the total account value to date for the last 21 months has gone nowhere. And I really hope you get this point here as we dig into this a little deeper.
So, as we get into these examples, one of the things I'm going to do is I'm going to put a zero on our model portfolio, just because I think it makes it more relative for pretty much anybody listening. A lot of people listen to this looking for ways to retire and to create an income that they can live off of. Well, the reality is you can't live off of $58,000, but $580,000 becomes a little more relevant. So, we're just going to add a zero to everything. It doesn't really change anything.
So, as we look at the portfolio, as far as where it was back in January of 2022 to currently, it's around $580,000. It ended in 2021 earning a little over $13,300 of interest and dividends. In 2022, we were up to $16,300, and this year we are on track to earn a little over $19,000. There's about a 95% probability that the number's going to be right around there because the great thing about dividends is they are predictable and if everybody just pays what they've currently announced, then that's where we're going to end up. It's pretty much a done year. We haven't really had any principal growth, but we've had some pretty significant income growth.
But, we now have a dilemma, and I'm going to offer a proposition to you, and that is next year, if you had a choice, you could either pick having your income grow by 18% and the account value stay relatively flat, (like what our model portfolio grew its income by this year), or you could have price appreciation and the entire account goes up by 14% (which is what the S&P 500 has done this year), but you didn't have income growth that was anywhere close to 18%. Which one would you choose? And in reference to our model portfolio, if the income goes up by 18%, that would imply that your income increases by $3,000. But if you take the price option, if it goes up by 14%, that would mean that you would have had a profit of $81,000.
So now what I'm going to do is convince you, to take the $3,000. Focusing on income growth is much more valuable in the long term than looking at just the price going up in the last nine months, even though the numbers are dramatically different.
So, here we go. We talk about the second-decade effect, occasionally. One of the great things about predictable dividend growth is you can start to forecast the future with a little bit more accuracy, although you can never predict what will happen exactly. But now we're going to look at what we've done for the last 10 years and then project out— with what I think are some conservative estimates just based on history— and see what we can expect for the next 10 years.
So, what has our track record actually been? In the last 12 years, we have grown income by 10% a year. What that means is our income has gone from $6,000 to $19,200. Right now with the portfolio at $580,000, that's a yield of 3.3%. Fortunately, or unfortunately, even if you just look at tomorrow, you have to make assumptions, and the farther out you go, the more assumptions you make. But really, one of the keys here, and I hope this is part of the point, the fewer assumptions you make, usually the better off you are. So now, based on the predictability of dividend growth, we're going to look at some conservative estimates of what we can expect in 10 years. We're going to use a few examples here. And $19,200, that's the number we're using as the base for all of these assumptions.
We will start with just 6% dividend growth off of our current number, and the reason I'm using 6% is that's the S&P 500 dividend growth rate long term. If we get income growth, it just grows by 6%, we will end up with income in 2033 of $34,500. Then, we look at a few assumptions here to figure out what the value of the portfolio will be. If we have that same 3.3% yield in 10 years, and we're earning $34,500 of dividends, then our portfolio will have a value of not quite $1,050,000. But then, let's go one step further. A year and a half ago, when the income of the portfolio was only a little over $13,000, but it was still 580,000, the yield was 2.3%. If we have a yield of 2.3% in 10 years, then the portfolio is worth $1.5 million.
But here's where it starts to get really interesting, and it's the whole value of compounding. If we're able to achieve our 10% %-a-year income growth for the next decade, if we are fortunate enough, we will in 10 years have $50,000 of income. At that point, if the portfolio yields 3.3%, it's worth a little over $1.5 million. And if it earns 2.3%, It is almost $2.2 million.
Maybe you're going to say, “Okay, that just sounds too good and too easy.” Well, the first thing I would tell you is that income growth can drive the bus. Another way to look at this is, the income growth puts pressure on the total value of the portfolio to increase. If you're receiving $1 of income, and you pay $20 for that income, that's a 5% yield. So then, if that $1 goes to $2, and you're still getting the same 5%, now, that $2 is worth $40. So, your income has doubled, and the value of your portfolio has doubled. Over time, if the yield stays the same, it by default means that your portfolio has to increase in value.
One of the points that I want to make is: No, these relationships don't play out sometimes immediately, day to day, month to month, but in the long run, they can be amazingly correlated. It's why I'm going to stress it's more important to be focusing on that sustainable income growth than to be worried about what prices are doing. This portfolio that, right now, doesn't show a whole lot happening, underneath there's a lot happening because we've had really nice income growth, and that's where the focus should be. I can tell you that 10% income growth is definitely possible because our income growth could have even been a little better than that. We had some years where we had cash that was earning nothing, and it was between 10-20% of the portfolio.
But, not to belabor this too far, what if you took the $81,000 number? What if you say, “I want growth, and I have the confidence that I'm going to continue to be able to achieve that growth.” So now let's go to the other side and look at what it means when you just focus on stock price growth rather than dividend growth.
If you start with $580,000 and you earn 7% a year, just from the price growth, then your portfolio is going to grow to $1.3 million in 10 years. You may be thinking, why are you using 7%? Well, because that is what the long-term return of the S&P 500 is if you take out the dividend. So, we're just trying to use a relatively realistic or conservative estimate. Going forward, 7% is probably a reasonable expectation.
But, right there, the reality is, the income portfolio is right up there competing with that, and it quite possibly is going to beat it. But there is an advantage to earning an income from your portfolio and being paid every year. In our example of $19,000 growing to $34,000 over the course of 10 years, and we'll just take an average of $26,000 a year, without any compounding of that, in 10 years you've earned 260,000 of income. That has been paid to your account. It doesn't matter what the prices are doing, you have the option of living off of it, reinvesting it, or doing whatever you want with it. If the market has not moved a whole lot and you're in a flat market, that cash flow gives you a lot of options and it potentially allows you to buy things cheaper, which long-term is really to your advantage. But if you take the price option, you're just really at the mercy of whatever those prices do. If the market doesn't do anything for five years or 10 years and you want to buy something else, you have one choice: you have to sell something. If you're totally dependent on price appreciation and you want some income out of your account, you have to figure out which stock you want to sell, and at what time you sell it. The more decisions you make, the more you open yourself up to making a mistake, and all investors make mistakes over time. But when you've earned that income, you're able to either reinvest, if prices are down you can buy more, if prices are up you don't have to do anything, it just gives you options. And if you want to take some income out, you don't have to sell anything and worry whether the price is up, down, or sideways. So it just helps take a little bit of the decision process off the table, which is part of why dividend investing works long-term and why some of the great investors use it.
So to circle all the way back to the question: Should you take the $3,000 or should you take the $81,000? I hope the conclusion that you've come to is this is really a game of mindset. $81,000 of price appreciation is really fun to see on your account statement at the end of the year, but on any given day, the value of our portfolio, or anything you own, can change the next day. It changes over the next year and you don't know what that number is going to be. The $81,000, can be taken back tomorrow. But you know the one number that doesn't change? The $3,000 is paid to you and it's money that they can't take back. In the long run, that 3,000 of income growth over time is going to give you the same results or possibly even better. So the only difference is more options and a little bit more control over how you reinvest your money and how you create value long-term.
Now we're going to go to kind of scenario three because you might be asking: “Well, wait a minute if I get 3.3% from my portfolio right now and we're looking for income growth… Well, guess what? I'm going to give you a 78% increase in your income today. The way we do that is if we just go out and buy a 10-year Treasury, they're roughly around 5%. In fact, on $580,000, you're going to earn $29,000 a year.” At the very minimum, it becomes tempting, “why not just go after 5% and be done with it?”
Well, of course, I wouldn't have brought this up unless I thought I was going to be able to sell you something else. Let's see just how that scenario plays out long term. The treasury interest is extremely predictable, in fact, it's guaranteed. So, if you add 10 years of earning $29,000 of bond interest up, you've earned a total of $290,000. That number does not change. It's not an assumption. It's not a, “we hope for the best.” The only thing that becomes subject is our reinvestment rate, and there we're going to just assume $50,000. That's a number that I think is conservative and we're just pulling it out of the hat, so to speak, but I can tell you that number has a lot of risk to it because if the Fed is successful and interest rates go back down to 3%, you're not going to be reinvesting at 5%. The number is going to be much lower. Now, of course, you could go the other way, but if you add $580,000 and your $290,000 of 10 years of interest from the bonds, and then a little bit of compounding of $50,000, you get to $920,000. Well, do you notice something here? That $920,000 number is on the small side of what all of our other options were from our dividend growth portfolio.
And here's where this gets really interesting. If, let's just say in 10 years... Interest rates are only at 3%. Well, at that point, you're going to reinvest that bond, and you reinvest your $920,000 and get 3%? That's only $27,600. Under all of our other scenarios, if we're successful in growing our dividends, and we just grow them by 6%, which is the S&P 500 rate, we're at a number higher than that– we're up to $34,000. Here's where this gets really dramatic, if we look at the decade after that, we're actually into the third decade because we already have a ten-year track record, (which is why we've got a reasonably high degree of confidence that we can actually pull this off on some level). So, if $34,500 grows by 6% for the next ten years, you end that decade with an income of $61,800. And if you were in the 10-year treasury at that point with your $920,000 because you thought, “Hmm, that was easy. 5%, That was the thing to do 10 years ago. It was much more attractive than what my dividend income was.” Well, again, I'm not the sharpest knife in the drawer, but I think $61,000 is a much bigger number than $27,000. And then, let's go another step further and say that we're fortunate enough because you've been listening to the Dividend Mailbox, and you grow your dividends by 10% a year, that $34,000 is now up to $89,000. And if you've really been a good listener, and not only have you grown it by 10%, but you grow it by 10% for the next decade, and then a decade after that, over 30 years, you're comparing your income to $27,000 versus $129,000. You'll say, “Well, okay, what if, what if rates are still at 5%?” You're going to turn around and take that $920,000 and earn $46,000 for the next 10 years. You're really not even close, and the opportunities that you have by just focusing on growing those dividends... it's a fairly dramatic difference. It just takes time for this to play out.
One of the big problems with the treasury scenario is that once you buy them, that income does not grow. The only thing that grows is the interest that you get off of that each year and what you're able to do with that, but that's a pretty small number. It just doesn't have the same power of compounding that our dividend growth gives us. And that is where you get a lot of value from your portfolio.
If you change from a dividend growth portfolio over to the treasuries, you've really stopped the whole compounding process of your dividend growth, which in the long term can have some pretty profound effects on your total return.
You always have to remember there's never a free lunch out there and I think the message that I want to leave you with is— probably at some point in school, you heard about the voyage of Odysseus. This is a great analogy to where this whole dividend situation is currently. You probably remember that he was sailing his ship, and he had been forewarned that if he listened to the siren songs from the island— all the other ships would be so mesmerized or seduced by those songs that they sailed right into the rocks. So he decides that, “Hey, I want to hear these songs, but I don't want to end up dead.” So, what he does is he has his crew put wax in their ears and they have him tied up to the mast so that he won't be able to do anything. They go cruising on by the island while he practically goes mad listening to those siren songs. But fortunately, because he used discipline and he was looking at the long game, he is still alive. And the point I want to try to make is that it's kind of the same thing with Dividend investing. The problem is the markets can be fairly volatile. It's easy to be drawn off course without really stepping back and looking at how these things play out long term, how the numbers compound. It doesn't take these big outsized returns, it just takes consistent compounding. What you really want to try to do is get as many of the variables out of the equation as you can, and that's part of what the dividends do because the cash flow accumulates and it just gives you so many more options. One thing I will tell you is that to long term being successful at anything, whether it's looking at dividend investing, whether it's looking at capital gain, or potential price appreciation, you really have to know what you're doing. It's the whole compounding thing over time that makes it all work.
I'm also going to leave you with another situation that you've heard, we've hit on this several times. I don't want to go very far into it, but it's a great illustration of how this whole thing plays out. We've spent a fair amount of time on Williams-Sonoma in the past, and I would suggest you go back and listen to one of those past episodes. We said it was a great pick. We thought it was just a great situation. No debt, they're really compounding cashflow, high returns on the business, and the dividend has been growing by 10%. Well, the Williams-Sonoma story, at least so far, is doing well. The stock is up to $150. It's been a little higher and that is basically a 40% gain from where we bought it just a little over a year ago.
Well, if you just stand back and look at it overall, you've had a good gain relatively quick. Your first reaction may be, “why not take a little bit of money off the table? Because, if we run into a recession here, everybody knows, or at least they think they do, stocks go down, retail especially goes down, why not take a little bit of money off the table?” I'd be lying if I said I didn't think about it at least once.
Well, here's the deal. This is where you have to step back, you've got to tie yourself to the mast because you're not in it listening for the siren songs, you're in it for the long-term voyage, and the long-term voyage says those dividends, if they grow by 10%, they're going to be up to over $9. If that stock trades at a yield of where it is right now, it's a $450 stock, and there are very few assumptions that you have to make to get it there. The point that we're really trying to make here is we would rather have a long-term return of 400% rather than a quick 50% profit in the short term. This is how we build wealth, and it's hard to find these good compounding machines. When you do, you buy them, and you just sit on them. You don't overthink it, because if you have a company that's executing well, it just makes it much easier to not have to worry about making another decision and just let that company compound your return over time.
So, in conclusion, as we compare, “Okay, do you want your income to grow by 18% or your price to grow by 14%? The reality is, that both of those numbers are going to fluctuate and the dividend growth is not going to be 18% every year, however, it is much more predictable and the value of receiving that cash flow is much stronger long-term than just watching your account value go up from month to month with no predictability in it at all. As investors, we're just going to be much better off if we tie ourselves to the mast, cash those dividend checks, and watch the compounding grow. You really don't see it grow much from month to month, but there's a lot that's going on underneath. One day you wake up and those numbers have gotten much bigger, and it's to a point that you're actually starting to create real wealth.
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Past performance does not guarantee future results. Every investor should consider whether an investment strategy is right for them and all the risk involved. Stocks, including dividend stocks, are volatile and can lose money. Denewiler Capital Management may or may not have positions in the publicly traded companies mentioned herein.