New Label For An Old Concept?

Includes: JNJ, KODK, PFE, PG, XLV
by: Roger Nusbaum

Over the weekend there were a couple of articles at Seeking Alpha (here and here) that very favorably discussed the concept of yield on cost investing. Here is the Investopedia definition which seems to differ slightly from what the Seeking Alpha articles were about.

The two SA articles seemed to focus on similar examples whereby holding a stock for many years and reinvesting the dividends lead to a much larger share position which then results in a much larger dividend payout when it comes time to start living off the portfolio. Part of the equation here is that the stocks selected grow their dividends reliably over time.

Taking an example from the first article on Procter & Gamble (NYSE:PG) as follows:

If you'd purchased $10,000 worth of the stock back in 1982, three decades ago, and reinvested dividends, you'd have 8,964 shares of stock today. Each pays $2.25 per share, so your income would be more than $20,000 per year.

That means every single year, you're collecting twice what you originally put into the stock - a yield to cost basis of 200%+. Oh, and your shares are worth more than $500,000, which is an extra bonus.

The second article had an example with client holding Johnson & Johnson (NYSE:JNJ) that somehow ends up with a $53,000 annual dividend on a $275,000 position. You may have better luck understanding that example than I did.

Anyone feel free to correct me if I am wrong but all that seems to be happening here is assigning a statistical measure to the compounding benefit that goes with reinvesting dividends into companies that survive. Surviving is an important word, as one reader commented on the survivorship bias embedded in the stocks chosen to make the point. This reader noted Eastman Kodak (EKDKQ.PK) as an example of a former dividend grower gone bust. The author replied in the comments that he did the work on Kodak and despite what the stock has done, the 30 year result isn't a disaster.

The second article also devotes a lot of space to why the financial services industry doesn't like this strategy because it leads to fewer commissions generated. Commissions at the wire houses have been on the way out for many years. I left Morgan Stanley nine years ago and most of the office and products available were fee based not commission based back then. There may be plenty of reasons to question where any financial advisor is coming from but generating transactional commissions stopped being one of them in the mid 1990s.

As a quick side note, the business of financial advice is not much different than most other professions. Some are crooks, some are incompetent and the vast majority moderately proficient or better. For what it is worth an advisor who stays reasonably close to the market (even if they never beat the market) and prevents their clients from doing anything truly stupid is at least moderately proficient.

No strategy is without drawbacks. If you don't understand the drawbacks of your favored strategy then you don't understand your strategy as well as you should and you're making an uninformed decision. Yield on Cost might be as great as the two articles assert but it has drawbacks. It relies on stock picking with the drawback there being choosing the wrong stocks. Also there is a certain amount of work that must go into following a stock holding and being correct about whether a decline is just a normal pullback or when something has changed permanently like many of the US banks in 2008.

There also needs to be ongoing forward looking analysis of the holdings. Not that anyone can be correct 100% of the time of course but taking an example from a reader comment on one of the YOC articles was Pfizer (NYSE:PFE). This was a darling stock for a long time. Over the last eight years it is down 36% on a price basis compared to a 20% gain in price for the Healthcare Sector SPDR (NYSEARCA:XLV). The dividend kept being increased as the stock was going down until 2009. Then the dividend was cut in half and has been on the way up since.

If this article makes its way to Seeking Alpha someone might say that they had a chance to buy PFE at cheap prices although the 50% lag versus the sector is very meaningful IMO. All the more so when factoring in that XLV does have some yield of its own. I wrote a bearish piece on PFE for Motley Fool in May 2004 which is why I targeted the eight year time period.

The other issue is record keeping for taxable accounts. The dividend is paid which is a taxable event of course and then used to buy some number of shares at some price. This occurs every three months (for a domestic stock) and these records must be maintained for the occasion that the stock must be sold. Presumably the gain or loss must be calculated for each reinvestment that has occurred (I'm not a CPA, if there is an out for this somehow please leave a comment).

The intention might be to never sell but if something you've held in this strategy for 20 years becomes Kodak and you recognize it early you're probably going to want to sell. The record keeping issue is not necessarily a reason by itself to avoid the strategy but it is a drawback.

And again, all strategies have drawbacks.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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