This article written in response to an earlier article: The Yield on Cost Trap.
As a dividend growth investor, when I read the above article I had an immediate reaction that this was wrong. However, I read through and carefully analyzed the points that the author was making, and the arguments presented do have some validity. Although there may be some validity to the arguments I feel their is a shortsightedness to the perspective adopted by the author of the article, and I felt I should counter the arguments of the article's author from the perspective of a dividend growth investor.
For those unfamiliar with the idea of Yield On Cost (YOC) it is a common metric used by dividend growth investors to track the development of a DGI portfolio, and the increases of dividends paid each year. With dividend growth investing, yield on cost should rise each year as the dividends being paid are increased by the companies invested in. Yield on cost is a relatively simple concept, and is very easy to calculate. YOC is simply annual dividend/cost basis per share (Cost basis per share= Total cost basis/# of shares held).
The author mentions that he currently holds 200 shares of McDonald's (NYSE:MCD) stock in his portfolio, with a yield on cost 9.5%. That is a great accomplishment, and deserves to be recognized as so. The author contests however, that since the effective yield on MCD shares is only 3.2% he would be better off selling out of his current position to buy into a higher yielding stock, in this case Johnson & Johnson (NYSE:JNJ) with an effective yield of 3.6%.
On a purely superficial level, the author is correct. If he were to take the $18,000 in MCD stock and sell it, only to buy $18,000 worth of JNJ he would increase his annual income at this time. At this time $18,000 of MCD stock at current yield would provide an annual dividend stream of $576 versus a dividend stream of $648 for Johnson & Johnson.
However, what the author neglects to consider is future dividend growth and capital appreciation for a stock. Both stocks have similar projected EPS growth for next year at approximately 10%. Additionally an investor must consider the dividend growth rate as the primary goal for DGI investors is to develop a reliable and growing income stream.
Since earnings per share growth is roughly equivalent for the two stocks we will ignore share price growth and assume that P/E ratios will remain roughly the same for the companies, so prices will grow at an equivalent rate.
However, MCD has a 5 year dividend growth rate (DGR) twice that of JNJ. (MCD 5-yr DGR =20% versus JNJ 5-yr DGR=10%).
The chart below shows how an investor could expect the income stream to grow given the assumption that the companies will maintain their 5-year dividend growth rates. The dividend payment amounts for year 2011 were taken directly from the original authors article. Each successive year shows the previous years dividend payment increased by the company's 5 year dividend growth rate. So in the chart below each year the value of dividends paid by MCD increases by 20% and dividends paid by JNJ increase by 10%.
As you all know, past performance is no guarantee of future results, but based upon the growth of MCD and JNJ in the past we can estimate how potential growth may look. As you can see in the chart above, within 2 years the annual dividend stream for MCD stock would exceed that of JNJ, and after 10 years the dividend stream from the MCD stock would be roughly twice that of JNJ. Based on these estimated numbers MCD would now have a yield on cost of 56%, more than half of the investor's initial investment ($5300). So for every dollar in the initial investment, the investor is now receiving $0.56 in annual dividends which will likely continue to grow. That investment in JNJ made after selling MCD stock, YOC is just 8.4%, the investor is getting back less than a dime from each dollar invested.
I love JNJ stock, and I'm in fact a shareholder. I believe they provide solid and reliable returns for investors, but JNJ is not going to grow its dividend as fast as some stocks with higher growth rates, and for DGI investors, dividend growth is the goal. Although I respect the opinions of the author of the original article investing only in high yielding stocks is a shortsighted approach to dividend growth investing. Dividend growth investors must take a complete look at a company and the future prospects of that company, and given that the greatest asset available to a dividend growth investor is time, it is often pertinent to look for stocks that will be able to increase dividends at a high rate for years to come in order to maximize their income stream.
While the argument of the author could be applicable to those folks in or approaching retirement, where swapping out low yielding stocks for those with higher yields can provide a meaningful boost to income at that time, it is not appropriate for all dividend growth investors. For investors with time on their sides dividend growth rates and yield on cost are important measures to consider when building a sound DGI portfolio.
Disclosure: I am long JNJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.