2024-01-04 08:22:14 ET
Summary
- True compounding involves considering factors such as dividend yield, dividend growth, dividend growth frequency, and dividend payout frequency.
- Essential companies for capturing true compounding include American Tower Corp., Cogent Communications, Essential Properties Trust, Realty Income, Analog Devices, Microsoft, Enterprise Products Partners, and Altria.
- Over the past 5 years, these companies have outperformed the S&P 500 while also exhibiting a higher yield and much faster dividend growth. Additionally, they are less volatile.
I'm happy to be back writing articles here on Seeking Alpha. Due to some major life changes, I have taken a brief hiatus as of late, but I am looking forward to publishing articles frequently once again. As readers of my past articles may know, my investment philosophy and focus is centered around dividend growth investing ((DGI)) and long-term investments in stable, profitable companies. As I've grown as an investor, I have continued to gain knowledge on responsible and efficient compounding through making mistakes as well as making good decisions. In this article, I'll take a look at some of my portfolio companies and what it means to truly compound.
True Compounding
For the most part, I had always envisioned compounding as a straightforward and simple concept. In my mind, that translated to investing in growing companies that also pay a dividend, so I can set my investments and let them grow without having to purchase shares periodically in order to increase the number of shares I own. However, I've come to realize that there are many more mechanics at play that need to be understood in order to truly capture the full power of compounding. In short, here are the major items I've identified that factor into true compounding:
- Dividend yield
- Dividend growth
- Dividend growth frequency
- Dividend payout frequency
As we will dive into later, a symbiotic relationship between compounding and dollar cost averaging begins to appear. My personal experience and historical performances of the holdings discussed in the next section indicate that balancing these factors can help lead to strong portfolio performance.
The Essential Compounders
Here I will look at companies that I personally hold and that I believe are essential in capturing true compounding.
- American Tower Corp. ( AMT )
- AMT is a cell tower REIT that generates revenue via cell tower lease payments from large telecom companies and now has a growing data center business as well. Due to the high-growth nature of the industry and mission-critical infrastructure that it possesses, American Tower has seen strong growth in the digital age. If you would like a more in-depth analysis, please see this previous article that I have written dedicated solely to AMT.
- American Tower has increased its dividend every quarter for over a decade. Much more frequent than standard DGI companies that raise the dividend once annually.
- Cogent Communications ( CCOI )
- CCOI is a communications services company that acts as the toll booth operator for the majority of the entire world's internet network. With predictable cash flows and the ownership of one of the world's most critical resources, Cogent has witnessed healthy growth with reliable growing dividends. I also have an article dedicated to the operations of CCOI that can be found here which also includes the next company on the list, Cogent Communications.
- Identical to AMT, Cogent has increased its dividend every quarter in recent history.
- Essential Properties Trust ( EPRT )
- EPRT is a net lease REIT that focuses on the middle market of commercial properties. By limiting their real estate investments to tenants that operate necessity-based businesses, they reduce their risks on rental cash flows.
- Not quite as high achieving as the previous two companies, EPRT still impressively increases their dividends twice per year and pays out quarterly.
- Realty Income ( O )
- O is a net lease REIT company that touts itself as the monthly dividend company. With a focus on larger market necessity-based businesses, Realty Income has a business model similar to EPRT but on a much larger scale. This long-time titan of real estate is a Dividend Aristocrat, with over 25 consecutive years of dividend increases.
- Once again, we see a larger than average frequency in dividend increase announcements for the portfolio holding. Realty Income has increased the dividend on average 4 times per year in recent history.
- Unlike most dividend payers, O pays out their dividends monthly.
- Analog Devices ( ADI )
- ADI is a semiconductor behemoth that always seems to sneak under the radar. This company is a personal favorite of mine, as I am an engineer and have worked closely with them in the past. A deep dive into what makes ADI so appealing can be found in a past article of mine here . Operating in a highly profitable industry and with an impressive track record of near-perfect management execution in mergers and acquisitions, I believe the future is bright for Analog Devices.
- ADI increases its dividend once annually and pays out quarterly.
- Microsoft ( MSFT )
- MSFT doesn't require a long explanation. The second-largest company in the world has been hitting on all cylinders for over a decade now. High-margin products, an iron-clad balance sheet, and an unparalleled ability to innovate have propelled Microsoft into one of the greatest-performing stocks in history, and has an arsenal of weapons to choose from to continue its growth into the future. My investment views on MSFT can be found in another one of my articles linked here .
- MSFT increases its dividend once annually and pays out quarterly.
- Enterprise Products Partners ( EPD )
- EPD observes many of the same characteristics as CCOI in the sense that they are the toll booth operator of a precious resource in oil and gas. Predictable cash flows and barriers to entry for new competitors give investors confidence that the extremely healthy balance sheet won't be changing any time in the near future. Enterprise Products Partners is generally a crowd favorite in the dividend investing community, and me included .
- EPD increases its dividend twice annually and pays out quarterly.
- Altria ( MO )
- MO finds its way into the Essentials due to its unprecedented dividend growth streak as well as a juicy yield. Altria has brilliantly navigated the waters of the increasingly smokeless world and executes a business model that rewards investors with large profit margins and healthy cash flows. Miraculously, the shift to e-vapes and oral tobacco appears to actually provide even greater margins than the highly profitable legacy tobacco products.
- MO increases its dividend once annually and pays out quarterly.
To provide a comparison, I have compiled a set of metrics based on recent years to understand how an equally weighted "Essentials" portfolio of the companies detailed above compares to the market-wide benchmark of the S&P 500 ( SPY ).
"Essentials" Portfolio | SPY | |
Yield | 4.66% | 1.40% |
5-yr. Div. Growth | 10.33% | 5.40% |
Total # of Annual Div. Increases | 19 | 4 |
Total # of Annual Div. Payments | 40 | 4 |
Between these 8 companies, all of the major factors previously outlined are well covered and done so by companies with a long history of strong financial performance. To take a more in-depth look at the total returns for each of these holdings I'll compare the portion of total returns that are achieved via stock price returns versus dividend payouts. A healthy balance of these two contributors to total returns allows for greater stability in the long term and can give you options for how you can reconfigure your portfolio or modify portfolio weightings without needing to sell off stock.
5yr | AMT | CCOI | EPRT | O | ADI | MSFT | EPD | MO |
Price Ret. | 36.97% | 67.67% | 87.36% | -3.74% | 119.93% | 266.50% | 8.04% | -16.04% |
Div. Ret. | 16.75% | 46.60% | 48.17% | 24.05% | 21.90% | 19.45% | 50.67% | 40.32% |
Total Ret. | 53.72% | 114.27% | 135.53% | 20.31% | 141.83% | 285.95% | 58.71% | 24.28% |
Now to bring it all together, I back-tested my "Essentials" portfolio versus SPY to see how these companies have performed versus the S&P 500 benchmark using an equally weighted portfolio of the 8 positions. The back test time frame begins in June 2018 when EPRT first became publicly listed and extends through the end of 2023.
Historical Performance (portfoliovisualizer.com)
With a noticeable gap, the Essentials Portfolio has outpaced SPY over the past 5 years, and not only that, but it also possesses a higher dividend yield and a faster dividend growth rate. Another item to note is the reduced volatility, a byproduct of the far more frequent dividend payouts that provide the positive benefits of dollar cost averaging.
Risks
Of course, there are risks for the future performance of the Essentials that range from a large number of factors including competition, obsolescence, and unknown economic disasters in the future. Another item to point out is that it seems rather easy to say these companies are essential for the sake of the article, as most of us already know that these companies have done well historically. However, the overall theme of the article is that the characteristics of these holdings are what are ideal, and they are not the only companies in the public market that possess these qualities. I am confident that another iteration of analysis with a different portfolio composition of similar companies would yield positive results as well. This provides a foundation for how we can look at choosing our holdings for the future.
Summary
Not all compounding is created equal. In order to truly capture the full power of compounding, it is important to take all of the different types into consideration. I also practice what I preach and tailor my personal portfolio to meet this criterion as well. Having diversity as the main driver of total returns also provides greater stability to a portfolio. We cannot predict what will happen in the future, so all we can do is prepare ourselves as best as we can. Lastly, we all have different investing goals, but it is my personal belief that these companies (or others observing similar qualities) have a place in any portfolio.
For further details see:
True Compounding: The Essential Stocks