Yield, yield, yield – and more yield… That’s what most of the world wants from dividend stocks. Big, fat yields.
But it’s a trap.
Nine times out of ten, plus-sized yields are a sucker’s bet. Because they’re unsustainable.
Often a sign of an ailing business, they’re used to dupe investors into holding problem stocks. (See Pitney Bowes’ (PBI) yield of 12.35%, for a shining example. Louis Basenese outs it as the most dangerous stock in the S&P 500.)
Remember, we want income and safety. We want to do better than Treasuries. We want to do better than inflation. We want to achieve wealth. What we don’t want is to start gambling.
The good news is, you don’t have to play dice to get a steady and increasing stream of cash into your account. And you don’t have to fall victim to the yield trap, because there’s a far, far more important number out there.
And for income investors, this number puts everything else to shame. It’s called yield on cost (YOC).
Think of it as the smarter man’s yield…
Big Things in Small Packages
It’s dead simple. Take a stock’s dividend payout at any given point in time – say, three years after your purchase – and compare it to how much you paid initially (and not whatever the current share price is). That’s your yield on cost.
Here’s the reason YOC is so important…
If you find a stock that grows its dividend aggressively over time, it barely matters what the initial yield is. As the dividends grow over time, so will your yield on the initial cost of those shares.
Let’s take Wal-Mart (WMT), for example. Many dividend investors would take one look at its 2.3% yield and never give it a second thought.
And they’d be missing out on a great long-term income opportunity because of it.
Why? For one simple reason: Wal-Mart’s five-year annual dividend growth rate clocks in at 16.87%.
Forget that its initial yield is just over the S&P 500 average. The dividend growth means your yield on cost is going to skyrocket.
If you bought 1,000 shares of WMT at yesterday’s closing price of $69, given a 2.3% yield, you’d net $1,587 in income for the first year.
Yeah, yeah, big deal, right? Chump change.
Wrong. Don’t miss the forest for the trees.
The huge amount of growth that Wal-Mart puts into its dividends means that in five years, the yield on the initial cost of your investment hits a healthy 4.29%, and your annual income clocks in at $2,960. In 10 years, you’ll be sitting even prettier with an enormous YOC of 9.36% and an income of $6,455.
And if you’re able to reinvest those dividends back into the stock, the story gets even better. Then you’re looking at a YOC of 14.06% and an income of $9,701 at the 10-year mark.
All that from a measly 2.30% yield.
Bottom line: There’s absolutely no good reason to go chasing yield. Fill your portfolio with stable companies that are committed to growing their dividends in the long term.
Remember, if you have patience and discipline, you’ll be reaping the benefits while the yield-chasers sit around wondering why their incomes went up in smoke.