When it comes to the equity portion of a retiree's portfolio, I believe that the most prudent course of action is a long-term buy-and-hold, invest-in-the-business philosophy. From my point of view, strategies based on trading stocks, or playing the market seem too risky for most retirees to participate in when so much is at stake. Future stock price movements can be very volatile and insidiously unpredictable. In contrast, the predictability of the earnings and dividends from a blue-chip business are significantly less volatile and more predictable.
Moreover, once in retirement, the investment objective of the equity portion of the retiree's portfolio logically shifts from a focus on how big the portfolio's value can become, to how much annual income it can produce. In other words, investing for total return becomes secondary to investing for total annual dividend income. Additionally, the retired investor's tolerance for risk is typically greatly reduced, but the ravages of inflation remain a concern.
Investing in a Business in Contrast to Trading (Active or Day)
Before I delve too deeply into the main thesis of this article, a few words about the difference between speculating versus investing are in order. Speculating in common stocks is a price-driven endeavor. In other words, active traders are not only focused on price movement, they are essentially attempting to guess or "speculate" on precisely where the price might go, typically in the short run. This is entirely different behavior than what a true value-oriented investor engages in.
However, I want to be clear that I am not offering a value judgment here. Instead, I am simply attempting to point out that there are significant differences between speculating and investing. On the other hand, I will offer one value judgment of sorts. I personally believe that investing is more appropriate for people in retirement, at least for what is often called their "serious money." This is the money that is required to support them during the years when they are no longer working.
Many retirees are fortunate enough to have monies available beyond those needed to provide their basic needs. Speculating with that "extra" money might be appropriate and even fun. However, their serious money should be invested as conservatively as possible, but not so conservatively that it fails to produce the income that they need to support themselves and their families. Therefore, I contend that positioning themselves as owner/partners of strong businesses makes the most sense for the serious money equity portion of their retirement portfolios. Moreover, business perspective investing is primarily oriented to a focus on the underlying fundamentals of the business.
In the preface to the 6 edition of Benjamin Graham and David L. Dodd's seminal book "Security Analysis" Seth A. Klarman succinctly summarized what I wrote above as follows:
"Value investors regard securities not as speculative instruments but as fractional ownership in the underlying businesses. This orientation is key to value investing. When a small slice of the business is offered at a bargain price, it is helpful to evaluate it as if the whole business were offered for sell there."
Value Investing Implies Fundamental Analysis
If you buy into the notion that value investing is synonymous with fundamental investing, as I do, then it only logically follows that you simultaneously recognize the value of all fundamental metrics and/or concepts. In truth, certain fundamental metrics may be more important or even more relevant than others, but that does not simultaneously indicate that fundamental metrics outside the most important ones are not beneficial or even valuable analytical tools.
"Yield On Cost" Does Not Get the Respect It Deserves
There is one fundamental metric that is often maligned and even denigrated by certain individuals that I consider an essential consideration for retired investors needing income to support themselves. This metric is commonly referred to as yield on cost (YOC). I consider this an essential fundamental metric for retired income-seeking investors. Yield on cost is simply the dividend yield you are earning based on your original investment (COST), and including any dividend increases (or decreases).
The metric "Yield on Cost" is different than the "Current Yield" that a given stock or portfolio offers. Those purists that like to malign the yield on cost calculation are quick to point out that only current yield matters. They take this position because (and they are correct on this point) this is the actual yield that the stock or portfolio provides today. To their way of thinking, today's yield (the current yield) is the only yield that truly matters, and therefore the only yield worth considering. However, I believe they are missing several salient features and benefits of yield on cost that I will be elaborating on throughout the remainder of this article.
But before I go on I respectfully submit that I believe much of the criticism of yield on cost stems from the term itself. As previously stated, the antagonists are correct; yield on cost is not representative of the yield that the current dividend represents. Therefore, I personally utilize a different term when I am considering this fundamental metric that I consider essential for retirees to consider. Instead of yield on cost, I call this metric "Growth Yield." As I will soon elaborate on, when thought of this way, the true benefits and utility of this important metric to retirees become evident.
A clue to rationally appreciating, and appropriately respecting growth yield (yield on cost) relates to the most important investment objective of the retired investor. The prudent retired investor is not merely interested in how much dividend income their equity portfolio currently provides, they are equally interested in their dividend income growing and by how much. This is why I like the term growth yield over yield on cost. The prudent retired investor recognizes that in order to keep up with future inflation, the dividend income component of their portfolio needs to increase faster than inflation.
Presenting the Benefits and Utility of "Yield on Cost" Based on a True Story
Following the lead often offered in the movie industry, I intend to present the salient features, benefits and utility of growth yield (yield on cost) based on the true story of an actual retired investor's portfolio. Just as it is often done in the movie industry, what follows is based on an actual retiree's portfolio, but not exactly so. For simplicity, I have standardized some of the facts such as actual date of purchase and the exact amount of money originally invested.
However, what follows is close enough to what actually occurred in a real-life portfolio, and with real human beings, to effectively present my thesis. Thus, simultaneously allowing me to elaborate on and clearly illustrate the many benefits that the careful consideration of growth yield (yield on cost) truly provides.
A Successful Retirement Plan Courtesy of Growth Yield (Yield on Cost)
Approximately 10 years ago, a long-standing client of mine came to me with the announcement that he had set his retirement date 3 years hence. Consequently, he and his wife had rationally concluded that their investment objectives should change commensurate with their forthcoming change in status. I agreed, and at their request began formulating a plan based on their inputs, concerns and stated needs.
Up to this point in time, this family (in the accumulation phase), was primarily focused on maximum total return consistent with their tolerances for risk. As a result, their equity portfolio was balanced and comprised of a foundation of above-average growing dividend growth stocks coupled with fast-growing non-dividend paying pure growth stocks. Since up to now total return was their primary objective, all dividends were reinvested and contributions routinely added.
These long-standing clients, who had also become dear friends, laid out their new objectives and future needs. Through careful planning, disciplined savings and investment practices, and hopefully they would acknowledge sound investment management, they had accumulated a portfolio of approximately $3 million. They calculated that this portfolio would need to generate $100,000 per year of income during retirement for them to maintain the standard of living they had become accustomed to. For perspective, the client is a doctor now long retired.
My contribution to their stated goals and objectives was first to assure them that their income objective of $100,000 of annual dividend income upon retirement was both realistic and achievable. Using round numbers, it mathematically required a current yield on cost of approximately 3.33% per annum by year-end 2008, their retirement target date.
However, I also informed them that given the current market circumstances and their conservative tolerance for risk, a yield of 3.33% would be a stretch at this time (the beginning of 2006). On the other hand, this presented my first opportunity to introduce them to the important concept I call growth yield (yield on cost) and how it could get them to the yield they needed when retirement finally came. A quick calculation indicated that a practical and realistic current yield of approximately 2.8% was current market realistic.
This calculated to approximately $85,000 of dividend income in year one, or approximately $15,000 short of their retirement income needs. However, I also pointed out that they also needed to consider the possibility of future inflation and the desirability for a cash cushion above their indicated income need. To accomplish these goals, I explained how expected dividend increases over the first 3 years prior to retirement could get them to the $100,000 level of dividend income they needed by the time they retired.
But most importantly, I introduced the concept of growth yield (yield on cost) with the recommendation that it become their primary focus when evaluating the success or failure of their portfolio's ability to meet their income needs over time. As I will soon show, encouraging them to focus on growth yield over stock price volatility ended up making all the difference.
The Growth Yield Portfolio Established 3 Years Prior to Retirement
The following portfolio was established at the beginning of 2006, approximately 3 years prior to the doctor's retirement at the beginning of 2009. As we will soon see, the unfortunate timing of their specific retirement date is where the concept of growth yield (yield on cost) really proved its value.
But first let's look at the portfolio that was created on their behalf in early 2006. However, the reader should note that all of the data presented in the following Portfolio Review is based on the portfolio as it sits today, and not what it was in the beginning of 2006 when it was first created. For example, the dividend yield shown on the following report is today's current yield and not the yield on cost established in 2006. On the other hand, I will present that data on a year-by-year basis later. Stated more directly, the following is a current portfolio that was originally established at the beginning of 2006.
For simplicity, I recommended a diversified portfolio of 20 companies comprised mostly of blue-chip dividend growth stocks with legacies of increasing their dividend each year. However, in order to reach the required dividend yield, I sprinkled in a couple of higher-yielding equities to include a few select utilities, one MLP and one REIT. The goal was to create a balanced portfolio with a blend of high current yield and low growth, coupled with average yielding but above-average growing blue-chip dividend growth stocks. For illustration purposes, $150,000 was invested in each selection.
The following $3 million portfolio was created at the beginning of 2006, what follows are the results that it achieved by year-end of each subsequent year. The reader should remember that prior to the establishment of this portfolio these people were totally focused on investing for total return, but were now asked to change their focus to dividend income and growth yield (yield on cost):
Still accustomed to focusing on total return the client was pleased with the portfolio value, but concerned that dividend income was short of their goal.
Portfolio value: $3,381,695
Dividend income: $88,845 (approximately $15,000 short of the goal)
Although the focus on total-return-habit continued, the increase in their portfolio value was reassuring, and the client was also very pleased that dividend income had already reached their retirement need level.
Portfolio value: $3,710,991
Dividend income: $105,108 (stated income goal reached)
Year-End 2008 (Retirement Begins)
The client was now entering retirement, just in time for the Great Recession, and they were shocked that the portfolio value had fallen below what they started with. The total-return-habit reared its ugly head, and gripped with fear they wanted to liquidate the entire portfolio.
Here is where the concept of growth yield (yield on cost) proved its metal. Reminded that they built the portfolio with an objective of dividend income of $100,000 per annum, 2008's dividend income of over $116,000 was settling. Even more soothing was the realization that their blue-chip portfolio holdings were strong enough to raise their dividends even during the recession.
Portfolio value: $2,882,671
Dividend income: $116,076
Although the focus on dividend income had settled them a bit, the fact that their portfolio value had fallen below what they started with was still a concern. This brought to mind one of the best definitions I ever heard for an excellent investment advisor stated by financial writer and commentator Bob Veres as follows:
"The excellent investment advisor is one who has the courage and integrity to insist that his clients do what they ought to do, rather than what they want to do."
However, these worried retirees still needed some convincing, therefore, I turned to the earnings and price correlated F.A.S.T. Graphs research tool for support. I started by showing them Johnson & Johnson (NYSE:JNJ), one of the bluest of all blue-chip stocks that they owned, and asked them to focus on the company's earnings and dividends by showing them the following graph plotting earnings and dividends, but no price to distract them:
Next, I re-drew the graph with price included to illustrate that the market was now undervaluing Johnson & Johnson. Here I stressed that all that was really occurring was that Johnson & Johnson had become temporarily illiquid. Earnings and dividends had continued to grow, which is why we invested in this company in the first place.
Most importantly, I reminded them that the portfolio was built to produce a growing dividend income stream with no intention of selling at this time. Since they had no intention of selling any of their holdings, why would they consider selling a perfectly valuable asset for less than its true worth? Fortunately for them, as I will soon illustrate, they agreed.
Next, in the spirit of fairness I presented several companies in the portfolio that were experiencing earnings weakness during the Great Recession. However, I pointed out that these companies remained profitable enough to continue to increase their dividends.
Stanley Black & Decker (NYSE:SWK) was one example. I wanted to remind them that growing dividends was the primary objective of our portfolio's plan. Therefore, I expanded the graph as far back as I could go to illustrate that this was not the first time that Stanley Black & Decker had experienced moderate earnings stress and stock price volatility. By doing this I was able to simultaneously illustrate that a steadily-increasing dividend was the one constant they could rely upon.
Then I proceeded to utilize the F.A.S.T. Graphs™ research tool to go over the dividend growth record of each company in their portfolio. Once these retired investors had something other than price volatility to focus upon, their attitude about the future was significantly more serene.
By year-end 2009 the portfolio value had recovered above its original cost, and the dividend income was now significantly in excess of their stated objective simultaneously providing the cushion I had originally recommended. The plan was working, and the concept of growth yield (yield on cost) was coming into sharper focus. Capital appreciation was a bonus, but spendable income was what mattered most.
Portfolio value: $3,370,644
Dividend income: $124,513
Even though the Great Recession had not yet been totally forgotten, the portfolio's continuing progress in capital appreciation was building confidence. But the greatest assurance was produced by the concept of growth yield (yield on cost). These retired clients now had a comfortable excess dividend income cushion and worries about inflation and sustaining a comfortable lifestyle in retirement were waning.
Portfolio value: $3,921,058
Dividend income: $134,035
By year-end 2011 the primary question became how much total dividend income did we earn this year? The drop in portfolio value during the Great Recession was becoming a distant memory. Income was what they needed, and the portfolio was producing it in spades thanks to growth yield.
Portfolio value: $4,367,720
Dividend income: $147,111
By the end of 2012, the conversation had turned to luxuries such as we are considering an extended vacation in Europe this year. Worry was replaced with confidence based on the power of a growing dividend income stream.
Portfolio value: $4,539,210
Dividend income: $161,281
By the end of 2013, they started asking what they should do with all the excess income they now had. For me personally, an added bonus was a comment made by the wife. It's comforting to me, she said, that I should not ever have to liquidate assets to meet my current living needs. Growth yield (yield on cost) had accomplished its purpose.
Portfolio value: $5,542,057
Dividend income: $174,271
Current Year 2014 (Not yet Complete)
I am anxious and fascinated to see what this year's attitude might bring. However, I suspect that even if we enter another bear market, the clients' heightened focus on their dividend income and their awareness of the important metric growth yield (yield on cost) will carry us through.
Yield On Cost Summary
An Important Sidebar
Because I felt it would interfere with the flow of the portfolio results with a focus on growing dividends presented above, I left out a few important facts. All of the dividend income generated prior to retirement in the example above was reinvested. Consequently, the real-life portfolio added approximately 10% more to their principal prior to harvesting the dividend income. Consequently, the annual dividend income available to these retired investors was moderately understated.
Summary and Conclusions
As I pointed out in the introduction to this article, I believe that retired investors are best served by taking a business perspective when investing their retirement portfolios. Business perspective investing primarily deals with evaluating the fundamental strength and value of the business behind the stock. In this regard, all fundamental metrics are important to measure and consider. Since a growing income stream becomes of paramount importance to people in retirement, a focus on the dividend record of the company they are partnering with seems only logical.
Although often rebuffed by many purists, the concept of growth yield (yield on cost) may be one of the most important and beneficial concepts for retired investors to consider and understand. As I illustrated with this article, there are many benefits to be gleaned from a focus on growth yield. Its ability to empower investors to navigate troubled waters may be one of its most salient features. Its ability to facilitate the implementation of a sound and potentially-growing income-producing investment plan is another.
Perhaps somewhat ironically, focusing on a company with a history of increasing their dividends will most often simultaneously lead to a portfolio capable of generating high total returns. Dividends are paid out of earnings, and therefore, growing dividends typically come from companies that are growing their earnings. In the long run, earnings growth delivers commensurate capital appreciation and a growing dividend income stream.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.
Disclosure: Long SWK and JNJ at the time of writing. The author is long JNJ, SWK.