Settling The Debate: For Dividend Investors, Yield-On-Cost Matters

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 |  Includes: ABT, CL, JNJ, PG, WBA
by: Geordy Wang

I had the pleasure of reading fellow contributor and dividend investing guru David Van Knapp's article yesterday, "5 More Myths About Dividend Growth Investing." While the article itself was a worthwhile read, which is true to form for anything David publishes, the thing I found most interesting was the heated debate in the comments section about the merits of a popular, but controversial metric in the dividend growth community: yield-on-cost. This metric is frequently used by dividend investors, but critics argue that the number itself is useless at best, and harmful at worst. According to these detractors, YOC prevents investors from making sound investment decisions by creating an irrational attachment to previous winners.

They're absolutely right and absolutely wrong. They're right in the sense that a buy/sell decision should never be influenced by YOC. After all, you don't succeed in investing by chasing money that has already been made - the best investments are those that will deliver the best results moving forward. However, YOC is far from useless when you're a dividend investor. It allows you to maintain a running scoreboard for each investment you made, it allows you to measure your overall results as an investor, and it allows you to set future performance targets for yourself. Every single one of these functions is critical for any investor who's serious about making money in the stock market.

We look forwards when we decide which companies to invest in, but we look backwards when we want to analyze our decisions, figure out what worked and what didn't, learn from our mistakes, and hone our investment strategies. There are far too many investors in the market who choose to ignore the composite performance of their portfolio, either willfully or due to ignorance in how to properly track it. Ignoring results doesn't lead to improvement in any endeavor in life, and investment is no different.

Performance tracking is absolutely crucial no matter your walk of life, whether you're a salesman, a professional athlete, or an investor. When we buy companies, we measure them against earnings to make sure they're growing over time. When we entrust our money to a mutual fund manager, we measure them against an index to make sure they're earning their fee. When we take that bold step and make the choice to take our financial destiny into our own hands and manage our own money, we can't afford to hold ourselves to a lesser standard. Otherwise we will, as Warren Buffett has so eloquently put it, "shoot the arrow of performance and paint the bull's eye wherever it lands."

One of the biggest advantages of investing your own money is that you can choose the benchmarks that make the most sense for your own investment goals. Fund managers are judged by their annual total return, because that's what most of their clients care about, but that's not the only metric out there. In order to be useful, a benchmark must be adapted to the individual circumstance. For example, Buffett measures Berkshire Hathaway's (NYSE:BRK.A) (NYSE:BRK.B) returns by growth in book value per share over time. This metric works for Buffett because Berkshire does not currently pay a dividend. It would be completely useless for a company like Altria (NYSE:MO), where the majority of its return comes from the dividend, which is paid out of book value. What's a perfect fit in one situation is useless in another.

Despite the enormous explosion in the popularity of dividend growth investing, the majority of investors still concentrate their attention on capital gains opportunities, and measure the return of their stocks by their price appreciation. However, this metric doesn't make sense for dividend investors, whose investment goals center around the creation of a growing income stream. It would be nonsensical for such investors to benchmark against capital gains, because that's not where the bulk of their return will come from. I personally use overall appreciation in portfolio value, dividends included, but that wouldn't work for any dividend investors who are actually spending the dividend, especially retirees.

That's where yield-on-cost comes in. YOC gives every dividend investor a useful tool in measuring their own performance (which, as we've established previously, is something all investors need to be concerned with). It can be utilized regardless of whether you choose to spend or reinvest the dividend. If Joe McDividend sets a goal of achieving a 10% yield-on-cost in ten years, and ten years later his YOC is only 8%, he knows he didn't meet his performance objective. When he begins analyzing his positions to find his underperformers, he'll start from the bottom up, with the stocks that have the lowest YOC, adjusted for the amount of time he has owned them. Conversely, for the stocks with the highest YOC, he can study them to find out why they performed so well, which will allow Joe to duplicate those results in the future. As such, YOC fulfills for dividend investors the exact same role that price appreciation does for capital gains investors, and portfolio value appreciation does for total return investors.

Still in doubt? I've provided a chart below that shows the price and dividend growth of five well-known dividend champions over the last two decades. For starting price, the data point will be fiscal year 1993. For ending price, it will be Wednesday, 3/14/2012. Starting and ending dividends will be derived from fiscal year 1993 distributions and the latest fiscal year distributions. Both price and dividend appreciation will be expressed in a compounded annual growth rate. The stocks used for this study are Procter & Gamble (NYSE:PG), Walgreen (WAG), Johnson & Johnson (NYSE:JNJ), Abbott Laboratories (NYSE:ABT), and Colgate Palmolive (NYSE:CL).

Click to enlarge
(Click to enlarge)

Take notice: the number in the price appreciation column and the number in the dividend appreciation column are almost the same for every stock. This is no coincidence. This convergence is due to the fact that both price and dividend appreciation come from the same source: growth of the underlying business. In almost every case, the dividend growth rate is slightly higher than the price growth rate due to increasing payout ratios, which is an expected occurrence as companies become more mature. Over a long enough time period, growth of a company's market value should be the same as the growth of its dividend when adjusted for payout ratio.

In the end, the ultimate goal of the dividend investor is the same as any other long term, value-oriented investor: to buy quality businesses at attractive prices. Yield-on-cost isn't irrelevant - on the contrary, it is absolutely vital, because it provides the dividend investor with a valuable benchmarking device by which to evaluate the holdings in his portfolio. Without such a metric, the dividend investor would be unable to gauge the performance of his positions, and he'll essentially be moving in the dark when it come to self-appraisal. However, armed with such a metric, the dividend investor can keep a running tally of his successes and failures, which will allow him to analyze his decisions, learn from them, and ultimately, become a better investor over time.

Disclosure: I am long BRK.A, BRK.B.