In November of 2007, after five years of phenomenal growth, the Commonwealth Bank of Australia touched a new record high of $62.16. Of course since then the bank, which was the very definition of a solid blue chip company, has since dropped over 60%, last week returning to levels not seen since early 2003.
Many of my friends, who I often struggle to convince of the merits of long term investing, have used this as an example of why even a conservative buy and hold approach is flawed and indeed have in some cases taken it as evidence that the share market is a poor investment option. Well, allow me to respond.
Consider this. Let’s say that at the start of 1999 you purchased $10,000 worth of CBA shares and elected to reinvest your dividends along the way. On top of this you resolve to save $2000 each year (that’s less than $40 per week) and buy more CBA shares at the end of each year. How would you have gone?
At the start of 2009 you would have been sitting on around $42,000 worth of shares. Considering that you would have invested only $28,000 of your own funds over the previous 10 years, that’s a healthy 50% capital gain. Moreover, your holding would be generating more than $3,800 annually in dividends; an annual return of almost 14% on your invested capital.
Figure 1. The value of holding CBA shares between January 1999 and January 2009. $10,000 initial investment, with all dividends reinvested, and $2000 added at the start of each year.
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But how can these figures be correct considering the massive decline in share price? It’s largely due to the power of dividend reinvestment and the resulting compounding return. Reinvestment gives you more shares, which pay you more dividends, which buys you more shares, which pay you more dividends…. You get the point. Combined with regular contributions the size of your holding grows very quickly indeed.
Now can you see why I’m not worried? Remember that this is after the worst market crash in 30 years, and you would still be receiving a yield that would make any term deposit or bond look ridiculously inadequate. Furthermore you would have received massive tax advantages through all the franking credits, and be enjoying a massive 50% capital gain.
Some skeptics will point out that the bank is likely to scale back its dividend payments this year, and they may well be right. But that doesn’t derail the bigger picture at all.
Figure 2. CBA annual dividend payments since 1992. From 2009 onwards estimates are used.
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Let’s Assume that in 2009, CBA scales back its dividends to 2006 levels, and takes 3 years to recover (Figure 2). Does this really represent any significant set-back? As long as dividend payments increase on average over the long term, I am as happy as can be. Besides, given the current share price the yield would still remain extremely attractive and well above the long term average.
Hopefully you can now see why I am such a strong believer in long term investment into income stocks. Sure it’s nothing to get excited about in the first few years, but before long you find yourself in the situation of having a large capital base that generates a lovely and tax effective passive income. That’s an income you get for doing absolutely nothing!
If you would like to learn more about the benefits of income investing and how to establish a portfolio of quality income stocks, visit www.dividendkey.com.
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