Six steps to solid long-term returns

Are you constantly checking the prices of your shares and calculating your profit or loss? If you're a day trader, fair enough. But if you are hoping to build your wealth over the long term, take a step back from the screen you need to consider more effective and less stressful strategies. By buying shares in solid companies, reinvesting the dividends and using the power of compounding over a long period of time, rather than checking your portfolio every five minutes, you are returning to the basic principles of sound investment and stand a far better chance of achieving your financial goals.

The wonders of compounding

Compounding is a simple concept it's the interest earned on interest already received but it can make a big difference to your future wealth. The same principle works for dividend payments. By reinvesting the dividends of sound companies with good long-term prospects, you can create your own dividend-compounding machine. If left for long enough, this can allow you to build significant wealth and future income. To show the power of this approach, I've taken the example of utility provider SSE over a ten-year period from October 2000 to October 2010. The total return to the investor is determined by three main factors:

The initial dividend yield

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Dividend growth

The effect of compounding.

A thousand shares are bought at 532p per share in October 2000 at a cost of £5,320 (excluding transaction costs for the sake of simplicity). During 2001, SSE pays a dividend of 30p per share giving income of £300 to buy more shares in October 2001 at a price of 607p per share. During the next nine years, SSE increases its annual dividend to 70p per share with extra shares purchased at prices ranging from 637p to 1,403p.

In October 2010, the investor has 1,620 shares with a market value of £17,957 (a gain of 238% over cost) and an annual income stream of £1,134 (21.3% yield on initial cost), assuming reinvested dividends. If the investor had not reinvested any dividends, the total gain (value of shares and cumulative dividends received) would have been £10,516 (198%) and the income return on the initial investment would have been 13.2%.

Let's say we extrapolate this for another ten years, but assume no further dividend growth or share-price appreciation. Here the effect of compounding is to increase the total gain to 523% (£27,816) and give a yield on initial cost of 37%. Without dividend reinvestment, the total gain would be 329% (£17,516) and the yield on initial investment still 13.2% a significant difference.

What you need to do

1. Buy good businesses with leading positions in growing markets. Look for hallmarks of quality, such as a high return on capital employed (ROCE defined on page 44) and strong cash generation. See below for two potential candidates.

2. Focus on total return, not just the dividend yield. A firm's ability to grow its dividend is a major contributor to the compounding process.

3. Only buy firms with a strong financial position low levels of debt and high levels of interest cover (this may be relaxed for utilities with regulated monopolies).

4. Ensure that dividends are well covered by profits and the firm generates sufficient cash flow to pay them.

5. Most on-line broking accounts have a facility automatically to re-invest dividends, or holders of shares in certificated form can join company dividend re-investment plans (DRIPs).

6. Don't forget, dividends represent taxable income, so use an Individual Savings Account (Isa) where possible.

Two dividend-compounding candidates

Morrisons (LSE: MRW) has the highest ROCE of all the major UK food retailers with a respectable 13.2%. It consistently generates surplus cash flow, has financial strength (interest cover which measures how many times profits cover net interest payable of 21 times) and a very well-funded pension fund. The fact that it makes a lot of its own food products also gives it competitive strength that others cannot match. During the last ten years it has grown its dividend at an average annual rate of 15.9%. At 270p and paying a 9.6p dividend, its shares yield 3.6%. The company has targeted double-digit dividend growth for the next three years, while spending £1bn on buying back its own shares. Given Morrisons' scope to grow andexpand into online sales, it could be a good long-term dividend-compounding candidate.

Cigarette maker British American Tobacco (LSE: BATS) is very profitable, with a ROCE of 26.4%, and it's an impressive generator of surplus cash flow. Interest cover is 9.8 times, based on 2010 operating profits of nearly £5bn. During the last decade, BATS has grown its dividend at an annual average of 14.7%. At 2,407p and paying a 2010 dividend of 114.2p, the shares yield 4.7%. Its dividend policy is to pay out 65% of sustainable earnings. Based on City forecasts, it's expected to grow its dividends by 8%-10% for the next two years.