We have the pleasure of interacting with DIY dividend investors everyday. We talk about individual stocks, investment strategy, portfolio theory, yield, income, etc. You know, all the things that dividend investors love to talk about. That said, there is one concept that comes up from time to time in our conversations that makes us cringe a little bit...yield-on-cost!
This article discusses our discontent with the concept of yield-on-cost and why we think it is a false sense of security for income investors.
Yield is Important
There is no question that yield is important to income investors. Yield quantifies how much income an investor is generating from each dollar invested. However, there are different ways to calculate and analyze yield.
The most commonly stated yield figure is current yield:
Current Yield = Annual Dividends per Share / Current Price per Share
For example, if a stock has annual dividend payout of $1.50 per share and the stock is currently trading at $60.00 per share, the current yield is 2.5%:
$1.50 / $60.00 = 2.5%
Another yield calculation that investors sometimes look at is yield-on-cost:
Yield-On-Cost = Annual Dividends per Share / Cost per Share
Let's say that you originally paid $30.00 for the stock above that is currently trading for $60.00. Your yield-on-cost is 5.0%:
$1.50 / $30.00 = 5.0%
Clearly, this is two drastically different ways to calculate yield on the same stock.
Why Do Investors Like Yield-On-Cost?
Honestly, we believe that investors primarily like yield-on-cost because it makes them feel good. In the example above, doesn't 5.0% sound a lot better than 2.5%? In reality though, the investment is generating the same income today in dollar terms regardless of how you choose to calculate yield. Whether you bought 100 shares at $30.00 or $60.00...your 100 shares are currently generating $150 of annual income.
Yield-on-cost advocates will say that yield-on cost helps them track dividend growth over time. It's true that if you take the percentage difference between your yield-on-cost over time, you will get a sense for how much your dividend has grown.
For example, if the annual payout of the stock above was $1.00 per share when you made your initial investment at $30.00, the original yield-on-cost was 3.33% ($1.00/$30.00 = 3.33%). The percentage change between the current yield-on-cost (5.0%) and the original yield-on-cost (3.33%) is 50% (5.0%/3.33% = 50%)
We agree that dividend growth is critical for an income investor to stay ahead of inflation, but why not just look at the income generated from your investment in dollar terms to track dividend growth?
If you bought 100 shares when the annual payout was $1.00 per share, your initial annual income from that investment was $100. Today, that same 100 shares is generating $1.50 per share annually (or $150 of income). If you look at your income growth in dollar terms, you still get the same 50% growth rate ($150/$100 = 50%).
In other words, you get to the same growth rate...but you aren't being mislead by a higher yield calculation.
A False Sense of Security
Our biggest issue with yield-on-cost is the mind games that it plays with investors. We are all human and all else being equal...2 is always better than 1 (or 5.0% is always better than 2.5%).
As shown in the example above, its true that you are earning a yield-on-cost of 5.0% on your original investment...but in reality, you are only earning 2.5% on your current investment. When an investor focuses on yield-on-cost, they get a false sense for how much income the investment is actually generating.
In addition, it makes rebalancing decisions harder because you are forced to make an apples to oranges comparison with other investments (yield-on-cost vs. current yield). We hear about these dilemmas all the time from investors. For example, lets say that an investor owns PepsiCo (NASDAQ:PEP), but is potentially interested in swapping it out for Coca-Cola (NYSE:KO) due to Coke's higher yield and better relative valuation. While this may be a wise decision for their portfolio, the investor may decide against it if he/she gets too fixated on their current yield-on-cost of PepsiCo.
We actually talked to an investor last week about this exact situation and his response to us suggesting that he consider swapping out Pepsi for Coke was: "I can't sell Pepsi, my yield-on-cost is 5.7%."
In reality, however, Coke is currently yielding 3.2% vs. Pepsi's 2.9%. In addition, Coke's Parsimony Value Rating is currently 67 vs. Pepsi's Value Rating of 40 (suggesting better relative valuation).
Focus on Income Growth in Dollar Terms
We advocate that investors focus more on maximizing income in dollar terms and forget about percentages.
Our investment strategy for our DIY Dividend Portfolio newsletter is to buy great stocks at good prices while maximizing risk-adjusted income. When managing a portfolio of dividend stocks sometimes that means swapping one stock out for another. When making a purchase (or swap) decision, we always want to adhere to our portfolio management rules. Each purchase or swap must:
- Maintain (or improve) our target sector allocation weightings (i.e., we don't want to add a stock to a sector that we are already overweight on - unless we are swapping out one stock for another)
- Maintain (or improve) annual income in dollar terms
A recent example of a stock swap that makes sense is swapping out Bristol-Myers Squibb (NYSE:BMY) for Johnson & Johnson (NYSE:JNJ). From a portfolio management standpoint, it would maintain our target sector weightings as both stocks are in the healthcare sector. Now let's look at the income comparison.
We originally recommended buying BMY in Sept. 2012 around $32.00 per share. At the time, we felt that BMY was trading at an attractive valuation and the stock was yielding 4.25%. Shares are up over 100% since then and the yield-on-cost today would be around 4.6%.
For this simple example though, let's just assume that you bought BMY about a year ago at $48.00 per share.
In July 2014, BMY's annual payout was $1.44 and the stock was yielding 3.0%. If you invested $10,000 at $48.00, you would have purchased 208 shares and your original annual income would have been $299.52.
The stock is up 35% since July 2014 (even despite the big sell-off last week) and those 208 shares would now be worth $13,437. In addition, the annual payout is now up to $1.48 equating to annual income of $307.84.
While your yield-on-cost would currently be 3.1%, the actual current yield on your BMY investment would be 2.3%.
Now lets look at how swapping out BMY for JNJ would affect annual income.
JNJ is currently trading at $100.14, with a annual payout of $3.00 per share and a yield of 3.0%.
If an investor were to sell the BMY position and invest the proceeds of $13,437 in JNJ, you could purchase 134 shares of JNJ.
With an annual payout of $3.00 per share, the new JNJ position would generate $402.00 of annual income...a 30.6% increase over the annual income generated by the BMY position!
In addition, JNJ has an above average Parsimony Value Rating of 54 compared to BMY's Value Rating of 1 (suggesting a much better relative valuation for JNJ).
This is just one simple example of how yield-on-cost could potentially cloud the portfolio decision making ability of an income investor. If you only looked at BMY's yield-on-cost of 3.1%, you may have been indifferent to swapping it out for JNJ's current 3.0% yield. However, the result of the swap would be significantly higher income and a better risk-adjusted capital position.
We advocate that investors always analyze their income stream in dollar terms and to always look for ways to grow that income stream while maintaining or improving the risk-adjusted capital position of their portfolio (i.e., buying stocks with better relative valuations).
This isn't to suggest that you should constantly be looking to trade stocks in and out of your portfolio (especially stocks that are currently growing their dividends at a healthy clip), but it is a good technique to add to your portfolio management strategy.
Note that investors should also be aware of tax consequences of a swap or sale decision (which will vary by investor).
Disclosure: The author is long JNJ, KO. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.