To Reinvest or Not Reinvest: That Is the Question

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Feb 19, 2015

Many readers have written and asked about whether Nintai reinvests dividends and if so how this impacts our long-term returns. The answer to this is yes in almost all cases. Before we get into reasons in more detail, it’s important to discuss the impact of dividend reinvestments in general and the distinction between equity rate of return (ERR) versus capital accumulation rate (CAR) in particular.

ERR versus CAR: It Really Matters

Michael Mauboussin wrote a great article about dividend reinvestment in a January, 2011 piece titled “The Real Role of Dividends in Building Wealth”. In the article he points out that price appreciation is the only source of investment returns that accumulates capital over the long term. This is in direct conflict with the broad acceptance that dividend reinvestment produced the vast majority of returns over the past century. Mauboussin demonstrates that many financial historians are failing to take into account the difference between the equity rate of return and the capital accumulation rate. The difference between these two can be quite confusing. When you hear that 90% of all returns since 1900 can be associated with dividends you’re not getting the whole story. Let’s take a look at both calculations as well as Mauboussin’s brilliant introduction of the idea of a capital accumulation rate formula.

To obtain the equity rate of return you simply add price appreciation with the dividend rate. If your holding price increased by 11% and the dividend yield was 2.5%, then your equity rate of return was 13.5%. The capital accumulation rate is calculated differently. Here we use a formula of looks like this:

Price Appreciation Rate + (1+ Price Appreciation Rate) * Dividend %

Utilizing the same corporate numbers the capital accumulation rate is 13.8%. This formula reflects that all dividends were reinvested and can make a dramatic difference in capital balances over the long term. It is critical to point out that the CAR can be significantly below ERR because investors may reinvest only some or none of the dividends. Because very few funds or investors reinvest 100% of dividends it is critical we create a formula that reflects this in capital accumulation.

Mauboussin discusses the capital accumulation rate formula and why it’s critical to include the dividend reinvestment rate. The formula looks like this

Price Appreciation Rate + (1 + Appreciation Rate) * Dividend % * Reinvestment Rate

Utilizing this formula it becomes clear how important 100% dividend investment is in capital accumulation. Seen below is the difference between no reinvestment and full reinvestment in accumulating capital. By 25 years out you would have double the capital if you had reinvested all your dividends.

Ă‚ Year 5 Year 10 Year 15 Year 20 Year 25
No Reinvestment $140.3 $196.8 $275.9 $387.0 $542.7
Total Reinvestment $162.6 $264.4 $429.8 $698.9 $1,136.4

In summary, Mauboussin rightly points out that dividends provide no excess return for investors but rather dividend reinvestment and their price appreciation provide the added return.

Why We Reinvest: An Additional Reason

With all that said, our goal is to accumulate capital for our investors. We have discussed how 100% dividend reinvestment leads to the highest capital accumulation over the long term. But we reinvest for an additional reason. Nintai invests in companies that achieve extremely high returns on invested capital. These companies can utilize capital to produce returns far in excess of our possible investment returns.

ROIC and Portfolio Holdings

Nintai’s portfolio investment criteria (discussed in far more detail here) focuses on high rates of free cash flow and return on invested capital. On average the portfolio achieves a 38.7% return on capital. As seen below rates range from a low of 14.2% to a high of 82.2%. In every case we believe management has created a situation where reinvesting excess cash in either dividend reinvestment or retained earnings makes the most business sense. In these instances we would rather see management redeploy its capital in growing the business versus returning it to shareholders.

Portfolio Holding ROIC Dividend Rate
Baxter (BAX, Financial) 23.2% 2.9%
Coach (COH, Financial) 33.7% 3.4%
T Rowe Price (TROW, Financial) 24.1% 2.1%
Qualcomm (QCOM, Financial) 21.3% 2.3%
Novo Nordisk (NVO, Financial) 67.7% 1.9%
Fastenal (FAST, Financial) 25.6% 2.4%
Expeditors International (EXPD, Financial) 17.7% 1.4%
Blackrock (BLK, Financial) 20.6% 2.0%
Mastercard (MA, Financial) 42.3% 0.6%
Cognizant Technology (CTSH, Financial) 21.5% N/A
Waters (WAT, Financial) 15.8% N/A
Ansys (ANSS) 29.3% N/A
Factset Research (FDS) 41.1% 1.0%
Computer Programs & Systems (CPSI) 50.1% 5.2%
Dolby Labs (DLB) 29.5% 0.5%
New Oriental Education (EDU) 22.7% N/A
Morningstar (MORN) 28.2% 0.9%
Hermès (HESAY) 28.8% 1.1%
Manhattan Associates (MANH) 45.1% N/A
Synaptics (SYNA) 14.2% N/A
Terra Nitrogen (TNH) 82.2% 8.0%

Conclusions

We believe our investment criteria provide our investors with the chance to achieve above average returns in the long term. This is achieved in two ways – price appreciation of initial invested capital and price appreciation of reinvested dividends. Over time the reinvestment of 100% of our portfolio dividends leads to the highest rate of capital accumulation. We believe finding companies with high returns on equity, assets, and capital, little to no debt, high free cash flow rates, and trading at a significant discount to intrinsic value can lead to significant price appreciation and – over time – capital accumulation. By reinvesting our dividends in our portfolio holdings we can simply accelerate this accumulation and increase our returns to shareholders.

We hope this answers the several questions we received about dividends. As always we look forward to your thoughts and comments.