New Label for an Old Concept?

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 Proctor & Gamble (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 (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 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 (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 (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.

8 Comments

  1. Correct me if I’m wrong or please comment at least. I understand in an IRA or Roth, the record keeping for tax purposes is not a requirement.

    Second,W.Buffett frequently has written on the concept of return on invested capital. It seems to me at least to be head and shoulders a best way to experience investment success. Over the long haul, it works! Other strategies are gambling. IMHO.

    Reply
  2. The first sentence of the record keeping paragraph says for taxable accounts.

    You’re saying that every other strategy besides the one you seem to like is gambling?

    Reply
  3. I started investing in the 80’s using dividend reinvestment plans (DRiP’s) offered by corporations: In many cases you could buy your initial shares directly at no transaction cost and the corporate investor relations dept would handle all subsequent re-investments and record keeping, also at no transaction cost.

    Not too many companies deal directly with investors in that way now, using servicing organizations instead (Wells Fargo is big in this space I believe), but it’s still not a bad way for a youngish investor to go; steady dividend growers (independent of how high the dividend is) tend to be stable, long-lived companies on average.

    I used to own about a half dozen DRiP’s but the number has been reduced to 4 over the years as a couple companies stumbled. I haven’t put any new money in those accounts in decades and those remaining have been in my portfolio over 20 years (JCI for 30) and are significant positions with nearly 5% yield and semi-huge capital gains on top (they’ll be donated to charity when I kick the can).

    Reply
  4. 5:43 here.

    I raised the question on non taxable record keeping hoping to get some input from the CPA types not to raise an issue with you Roger. It seems too simple especially with foreign holdings and foreign taxes. Just hoping for some insightful stuff.

    Second,It really isn’t a question about what I like. It just seems to be a strategy that is sound and it works with your caveats a given.
    I do own one investment that returns all my invested capital and then some each and every year.

    And yes, my feelings are that other stragegies are more toward gambling-some more than others. thanks for the blog.

    Reply
  5. Early in my marriage, my mother in law was giving my wife $25 in Pepsi stock on a quarterly basis. I asked my wife to please say “thanks but no thanks,” as I could see the record keeping trajectory…not worth the couple of hundred dollars accumulated when it came time to unwind it all.

    I’m OK at math, but I try to keep my life simple. All of my DRIPs are in non-taxable accounts.

    Reply
  6. I have owned and sold mutual funds that reinvested dividends, some as freauently as monthly. If you are reasonably proficient with Excel, its not that difficult; you will generally have 1 long-term sale with various purchase dates and 1 short-term sale with various purchase dates (and, before someone comments, I know that mutual funds also provide an average cost that simplifies the process, but I prefer the old fashioned way; that’s just me). It takes a half-hour to an hour per sale at tax time to run the numbers.

    Reply
  7. If you were able to pick the survivors, this would be “low risk”. As you pointed out, a historical analysis suffers from survivorship bias. The DZ posse at SA does not care about impairment of capital, temporary or permanent. It’s a part of the belief structure of YOC that gets reinforced in their articles. Those are smart folks, so I don’t understand their blind spot to capital losses.

    Every sector has had a cute puppy that turned into a dog, sometimes with no warning at all. Earthquakes, tsunamis, bad management, and disruptive technological advancement have taken a toll on many companies over the years. Your 3% rule and healthy/ unhealthy market monitoring system will help mitigate top down and individual blowups from permanent impairment of capital.

    Reply

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New Label for an Old Concept?

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 Proctor & Gamble (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 (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 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 (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 (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.

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