by Marc Lichtenfeld, Investment U Senior Analyst
Wednesday, September 14, 2011: Issue #1600
You hear that beeping sound?
That’s the sound of my truck backing up to load it with dividend stocks.
This may well be a historic time for some investors. One in which they’ll look back on fondly. While others were panicking, they created the building blocks of their fortunes.
Rates are at historic lows. The 10-year bond is at 1.98 percent. The 30-year is barely above 3.25 percent.
And rates, particularly short-term ones, could go even lower in the near future.
Next week, the Federal Open Market Committee (FOMC) meets to decide what to do about the sputtering economy. One of the options being discussed is QE3 – a third round of quantitative easing.
Quantitative easing is when a country buys its government bonds. It serves two purposes. It drives down interest rates, making it less of a burden for consumers and businesses to borrow.
As a result of lower rates on savings, money markets and bonds, investors put their money into more speculative assets, increasing the prices for those assets, putting more money in the pockets (or portfolios) of investors, which then hopefully sparks growth.
Now, if you’re scared, you can lend the U.S. government your money for 10 years and receive 1.98 percent. Your capital is guaranteed. If you lend Uncle Sam $10,000, at the end of 10 years you’ll have $11,980 ($10,000 capital plus $1,980 in interest).
Chances are, 10 years from now, the cost of food, gas, medicine and other vitals will be more than 19.8 percent higher than it is today. And 19.8 percent is all you’ll have earned on your money over the 10 years.
Over the past 10 years, the rate of inflation change was 27.5 percent, or a compound annual growth rate of 2.31 percent. So if the inflation figures of the past decade repeat themselves over the next, every year, your treasury investment would be falling behind the inflation rate by nearly half a percentage point.
In order to beat a 1.98 percent rate, you need to accept some risk. The stock market is certainly riskier than investing in a treasury. But with a 10-year horizon, it may not be as risky as you think.
Since 1937, including reinvested dividends, the S&P 500 has returned an average of 130 percent over 10 years, or a compound annual growth rate of 8.7 percent.
Even if you think the stock market is going nowhere over the next decade, dividend stocks have the potential to create significant wealth.
Let’s use insurer AFLAC (NYSE: AFL) as an example. Most consumers know AFLAC because of the annoying duck commercials. But shrewd investors know AFLAC as a dividend aristocrat – a member of the S&P 500 that’s increased its dividend every year for at least 25 years.
In AFLAC’s case, it’s been 28 years in a row of dividend hikes.
The stock yields 3.5 percent. Solid in today’s low interest rate environment, but nothing special by any means. Over the past five and 10 years, the dividend has increased an average of 21 percent each year.
Over the last three years, dividend growth has slowed to an average of 12 percent per year.
Let’s be conservative and assume that dividend growth is cut in half over the next 10 years and only averages 6-percent growth.
If you buy 100 shares at $34.50 and reinvest the dividend that grows by 6 percent per year, even if the stock goes absolutely nowhere in 10 years, your $3,450 investment would be worth $5,442.
If you reinvest the dividend, the power of compounding would really be kicking in and generating wealth or income at this point. Your 100 shares would now be 157 shares. And your dividend would be up to $2.02 per share. So your yield on your original investment would now be an extremely attractive 9.2 percent.
To get 9.2 percent today, you need to take significant risk. To get 9.2 percent in 10 years, you only need to take a little bit of risk in a stable company that’s been raising its dividend for nearly three decades.
Again, this is assuming the stock doesn’t move for 10 years. If the market returns to close to historical averages and the stock goes up just 6 percent each year, your $3,450 investment becomes $8,240 for a 139-percent return or a compound annual growth rate of 9.1 percent.
There are a lot of great dividend stocks with healthy yields and years of consecutive dividend increases. This is a great time to load up on quality stocks that will build wealth for tomorrow with below average risk.
If you need some good dividend ideas, take a look at our Perpetual Income Portfolio.
I don’t know if stocks will be higher next month or next year. But I’m relatively certain that if you invest in a stock that pays dividends and increases its dividend every year — in 10 years, it will outperform nearly every other asset class.