## Dividend Yield vs. Yield on Cost

When approaching retirement, a common strategy is to convert a substantial portion of one’s investment portfolio to income producing securities, whether this be bonds, dividend paying stocks, or even something ultra-conservative such as CDs. If the intention is to live solely off of this income, the most obvious question is: What size must the portfolio be to sustain your desired lifestyle?

The S&P 500 index yields 2.12% at the time of this writing, although individual stocks within the index comprise the full range from those that don’t pay a dividend at all, to those in the double digits. But for argument sake, let’s say that you plan your retirement based on a 2.12% yield. With a \$1 million portfolio, you will have an income of just over \$21,000 per year – before tax! It’s possible to live off this amount (many people do) but it’s possible to do much better, particularly if implementing your investment strategy early.

Specifically I am going to look at how a Dividend Growth Investment strategy can turn that 2% dividend yield into a much more substantial yield on cost. For those new to these terms, dividend growth investing is a method whereby stocks are purchased of companies who have a history of increasing their dividend year after year – essentially the equivalent of an annual raise for those relying on dividends as their primary source of income.

Dividend yields are calculated by simply taking the company’s annual dividend and dividing it into the current share price. For example, if a company is currently trading at \$100 / share and pays a \$5.00 dividend annually, it’s current yield is 5% (\$5 / \$100). Yield on cost however is quite different. YoC is calculated by taking the current annual dividend and dividing into the average cost per share that you paid for the stock. YoC can be much higher than the current dividend yield if the company raises it’s dividend on a frequent basis.

Let’s look at an example using actual numbers. In 2003, Chevron (CVX) was trading at \$43.50 and paid a \$1.43 annual dividend. This works out to a yield of 3.29%. Let’s say you purchased 100 shares back then for a total investment of \$4,350. CVX has increased it’s dividend every year since 2003 (actually for the past 25 years), and is now paying a \$3.60 / share dividend. Assuming you haven’t bought any additional shares in the past 10 years, your total cost is still the same \$4,350, or \$43.50 / share. Therefore your yield on cost is much higher: \$3.60 / \$43.50 = 8.3%

This is the power of starting investing in dividend growth stocks early, and I don’t often see this point emphasized enough. In addition to the stability that dividend growth stocks provide, the additional income arising from the higher yield on cost can be quite substantial.

Let’s look at one more example, this time assuming that \$5,000 is invested in CVX every year for the past 10 years:

At the end of 10 years, we will have invested a total of \$50,000 and will have purchased 701 shares. Our average cost per share is therefore \$71.36 and based on the 2012 dividend of \$3.51, our yield on cost was 4.92%, a whole 1.67% higher than the stock’s current yield. One or two percent may not sound like that much, but that’s actually over 50% higher than the 3.25% current yield!

I hope this helps to explain the power of one of the misunderstood aspects of dividend growth investing. Be sure to try out my free yield on cost spreadsheet to play around with the numbers yourself!

## Combining Dividend Growth Investing with Value Strategies

Due to the relatively aggressive nature of my stock selection methods, I often tend to end up with my portfolio more heavily weighted towards small-cap, high-growth stocks. While the riskiness inherent to this class of securities is more often than not offset by above average share price appreciation (if bought at good value), it’s good to also have a portion of your portfolio allocated towards stocks that will exhibit less volatility and provide steady growth over the long term.

One way to accomplish this is to select a number of Dividend Growth stocks for inclusion in your portfolio. Dividend Growth stocks are those typically of older, large-cap, well-established companies that not only pay a dividend, but have also had a history of increasing the dividend annually over the past 10+ years. These stocks attract a different sort of audience from the investment community and provide the benefits of reduced volatility and an income stream even during times when the market is in a lull. More importantly however is the idea that because the company’s dividend increases every year, your yield-on-cost goes up every year as well. This means that buying a stock that yield’s just 2% today, might yield 10% on your cost to purchase the stock in the future. For this reason, dividend growth stocks are usually considered to be very long term investments, so that this benefit is maximized.

One of the best sources of information for dividend growth stocks is David Fish, who updates his list of Dividend Champions monthly. The list consists of all those stocks that have increased their dividend payments every year for the past 25 years or more. It also includes lists of those companies that have increase dividends between 10 – 25 years and also 5 – 9 years. The spreadsheet can be found on David’s DRiP Investing Resources website.

My goal is to identify those dividend growth stocks that meet the following criteria:

• Current dividend yield of at least 2%
• History of increasing dividends for at least the past 10 years
• Payout ratio less than 50%
• Positive EPS growth rate
• Attractive valuation
• Market capitalization of at least \$5B

With these criteria in mind, I’ve selected ten stocks to add to the Stockodo watch list.

1. ACE Limited (ACE) – An insurance holding company currently yielding 2.2% with a track record of increasing dividends annually for the past 20 years. With a payout ratio of just 25%, positive earnings growth, and a compounded dividend growth rate of 13% over the past 5 years, it meets our criteria. Despite trading at near 10-year highs, it’s currently trading at a PE ratio of 11.
2. Chevron (CVX) – An oil & gas company worth \$230B sporting a current dividend yield of 3%. Chevron has increased dividends for each of the last 25 years, yet has a payout ratio of just 27%. The company has grown dividends at a rate of 9% over the last 5 years, and CVX trades at a PE multiple of just 8.9 today.
3. C.H. Robinson Worldwide (CHRW) – A \$10B logistics company with a current dividend yield of 2.35% and a history of dividend increases over the past 16 years. Payout ratio is currently 38% and dividend growth has been 13% over the past 5 years. CHRW is currently trading at a PE ratio of 16.
4. Cardinal Health (CAH) – A \$16B healthcare services company with a current dividend yield of 2.6%. CAH has increased dividends for each of the past 17 years and has a current payout ratio of 33%. Dividends have grown at a rate of 24% over the past five years, but has slowed down to just 10% last year. Cardinal Health currently trades at a PE of 12.
5. Caterpillar (CAT) – A manufacturer of heavy mining/construction equipment with a market cap of \$57B and dividend increases in each of the last 19 years. CAT currently yields 2.4% and has a payout ratio of 25%. Dividends have grown at 8% over the past 5 years and CAT currently trades at a PE multiple of just 10.
6. Deere & Company (DE) – Manufacturer of John Deere farm equipment, currently valued at \$33B and yielding 2.4%. Deere has increased dividends for the past 10 years and has a payout ratio of 26%. Dividends are growing at a rate of 8% per year and DE trades at a PE ratio of 15 currently.
7. 3M (MMM) – A conglomerate currently valued at \$73B and yielding 2.4%. 3M has increased dividends for the past 55 years and has a payout ratio of 40%. Dividends are growing at a rate of only 5-7% per year and 3M trades at a PE multiple of 17.
8. Praxair (PX) – A specialty chemical company with a market capitalization of \$33B and a dividend yield of 2.1%. PX has increased dividends for the past 20 years and achieves a dividend growth rate of 12% per year. Praxair’s payout and PE ratios are currently 43% and 20 respectively.
9. Teva Pharmaceutical (TEVA) – An Israeli pharmaceutical manufacturing company with a focus on generic drugs. TEVA is currently valued at \$34B, yields 2.6%, and has increased dividends for the past 13 years. Dividend growth rate has ranged between 15% and 22% over the past five years and TEVA trades at a PE multiple of 18 currently.
10. Walgreen Company (WAG) – A retail drugstore chain with a market capitalization of \$45B and a dividend yield of 2.3%. Walgreen has been growing dividends for the past 37 years and at a high rate in the recent past. Dividends have been growing at a 23% rate compounded over the last 5 years. WAG currently trades at a PE ratio of 21.

## The Structural Flaw in Data-Driven Quantitative Analysis

People who lean more towards fundamental analysis tend to think differently than others using alternate methods. There is a distinction between those people that rely on news and statements by management and fundamental analysts who rely solely on numerical analysis, which are probably more like technical analysts in their thought processes. Those who take a qualitative approach tend to question their assumptions more, because they rely on opinions and obviously everybody who engages in any kind of analysis should always question the underlying assumptions and learn the limitations of their systems.

I want to make it clear that I am not deriding technical analysis as a foolhardy approach. Even the most rigorous fundamental analysis is subject to the issues I discuss here. However, the severity and prevalence of the issues for fundamental analysis is lower. Technical analysis by its very nature exposes itself to the flaws of forecasting.

## The Security Blanket of Numbers

Fundamental analysts using a numerical approach are not ultra-reliant on historical analysis to the extent that they limit exposure to assumptions regarding the future, however they share their faith in numbers with technical analysts. Rarely is the world so black and white, and often you might find yourself using a mixed approach. Something about the way we are wired makes us more comfortable trusting calculated numbers than the statements of individuals. I might not be exposed to a representative sample of people, but I see this worship of numbers far too often. It could be due to the fact that most people I know are science and engineering types. If you are surrounded by people more attuned to the philosophical theory of knowledge it might be different. Continue reading

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## Value Investing Workflow: The basic concepts

A workflow is a series of specific tasks or criteria that must be fulfilled in the course of reaching a larger goal. Our goal as value investors is to find, evaluate, purchase, and ultimately sell for a profit, the stock of publicly traded companies. There’s a series of steps required to be successful in this endeavor and the easiest way to approach the problem is by following a step-by-step approach. Following is the basic concept of a value investing workflow. Continue reading

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