I will not sell XYZ, as my yield on cost is now 8%.
I'm sure you have heard (or even said) this line a few times, haven't you? Funny enough, I've also used this line to justify some of my holdings. For example, I've considered the yield on cost for my low dividend-paying stocks. The idea is to show how a 1-2% dividend yield stocks could become a 3%+ yielder in a few years - there are examples of companies like Disney (NYSE:DIS), which pay around 1-1.5% yield but provide shareholders with a strong pay raise each year. I have held DIS in my portfolio for about 5 years now, and it is currently paying 3% yield on my cost.
What Does Yield on Cost Mean?
The yield on cost, or YOC, refers to the dividend yield you receive based on the price you initially paid to acquire a share. For example, you purchased shares of Disney (DIS) a while ago at $80 when it was paying an annual dividend of $0.78. Your yield at that time was ($0.78/$80 * 100) 0.975%. Not even 1%. Most dividend growth investors would disregard such poor yield and search for a better distribution rate.
The point I used to convince those investors to buy low-yielding stocks was based on the yield on cost. Let's assume you bought DIS at $80 with a dividend of $0.78. Five years later, the stock has jumped to $132, and the dividend is now $1.31. What is your dividend yield? You can answer this question with two different numbers. The first one would be to use the yield on cost, and therefore, using the current dividend paid ($1.31) divided by the price you paid to acquired those shares ($80). Suddenly, you have DIS shares paying a 1.64% yield instead of 0.975%. This is what we call the yield on cost.
However, many investors would disagree with you and claim that the DIS yield has barely changed over the past 5 years and is currently 0.992%. This is because those investors use the current dividend paid ($1.31) divided by the current price ($132).
What the YOC Hides
Using the yield on cost could become dangerous for your portfolio. I realised this when I wrote a controversial article about General Electric (NYSE:GE). While my thesis was that GE should not be part of a dividend growth portfolio, as the company will continue to struggle to increase its payouts, many investors claimed they would never sell it. What was their main argument? Their yield on cost was over 10%.
These investors caught a falling knife back in 2008-2009 when GE ran into severe financial problems due to the credit collapse (no wonder the company sold GE Capital recently!). At that time, GE even cut its dividend payouts. Many investors saw an opportunity to grab shares of a giant blue chip for about $10. 8 years later, their investment value has tripled and their yield on cost has reached double digits.
I can appreciate the rationale of holding a stock paying 8-10% dividend yield. However, what the yield on cost hides in such situations is the present state of affairs. By using the YOC to justify your holding, you use their past performance. Kudos to you if you made a great move, but this doesn't foresee what will happen next.
What if you get rid of the YOC and start looking at the current yield instead?
Imagine you bought for $10,000 shares of GE during the credit crisis. Let's say your investment now worth $30,000 and your YOC is 10%. This means your GE shares pay $1,000 annually in dividend. This also means GE's current dividend yield is 3.33%.
If you were to sell your shares today, you would receive $30,000, not $10,000. Therefore, you would dispose of $30,000 to generate a payout of $1,000. While finding a company paying a 10% dividend yield is highly difficult, finding one paying 3.33% is far from mission impossible. Even better, chances are you will find a company that has better growth perspective than GE in the next 10 years. For one, I would gladly swap my GE shares for any of the five Canadian banks (RY, BNS, CM, BMO, TD), as they all pay over 3.50% and show better growth prospects.
What Really Matters (and It's Not the YOC)
In the end, what really matters for me at the moment is my dividend growth rate. Since I will not use my dividend payout for at least another 30 years, I don't really mind how much I'm generating with my portfolio today. However, the growth rate tells me how fast I am running in front of inflation each year.
If I was about to retire, the dollar amount generated by my portfolio would become a lot more important. I would then agree that buying new shares of DIS at 1% yield is not very appealing. What would matter to me at this point is how much I receive from my portfolio each month. If the yield isn't high enough, I would have to compensate by selling part of my holdings to generate enough income.
In both cases, the yield on cost remains irrelevant. At best, I would feel good by looking at my DIS shares paying a 6% yield in 30 years from now, but chances are the company’s current yield will remain around 1%. The YOC shows if you were smart (or lucky) enough to make strong investments in the past. However, it doesn’t tell you anything about what your future yield will look like. I don't think it should be used to justify any of the holdings in your portfolio. What do you think?
Disclaimer: I hold shares of DIS, RY, BNS, TD, not GE.