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Wednesday, August 12, 2009

* Dividend Stocks Secret Ingredient

When people learn that I am an income investor it is not uncommon for them to ask why I invest in stocks instead of high yield money market accounts [MMA] or certificates of deposits [CD]. I generally start with my short answer of, "Dividend stocks have a secret ingredient that makes them a much more desirable investment."

Needless to say this usually piques their interest and normally the response is something like, "Secret ingredient? What secret ingredient?" Then I explain.

Dividend Stocks Hidden Power

To the casual observer, a CD may be earning a similar rate as the dividend stock and it is federally insured, thus protecting the purchaser from loss. So it must be better, right?

What separates good dividend stocks from MMAs and CDs is a hidden power not readily recognizable to the uninitiated - dividend growth. While a CD will pay a market interest rate for its term, its only growth is movement in the market rate at renewal, which can go either up or down. Contrast that with a good dividend stock with decades of consecutive annual dividend increases.

Dividend Stocks Yield On Cost

One way to compare the earning power of two investments or an investment and a CD is to look at their Yield On Cost [YOC] over time. YOC is a simple concept where you divide annual earnings over the investment's cost. Consider this simple example of a stock with a 2.75% yield and a dividend growth rate of 7%, compared a 5-year CD paying 3.00%, where earnings in both are withdrawn when paid:
Div. Stock CD
Investment $ 10,000 10,000
Initial Yield 2.75% 3.00%
Div. Growth 7.0% 0.0%
Earnings Yr. 1 275 300
YOC Yr. 1 2.8% 3.0%
Earnings Yr. 2 294 300
YOC Yr. 2 2.9% 3.0%
Earnings Yr. 3 315 300
YOC Yr. 3 3.1% 3.0%
Earnings Yr. 4 337 300
YOC Yr. 4 3.4% 3.0%
Earnings Yr. 5 360 300
YOC Yr. 5 3.6% 3.0%
Earnings Total 1,581 1,500
YOC Final 3.6% 3.0%
Though the dividend stock started with a lower yield of 2.75%, its final YOC after 5 years was 3.6% compared to the constant 3.0% of the CD. The key here is to find dividend stocks that are growing their dividends and will continue to do so. Since these numbers are contrived, the obvious question is how does this translate to the real world?

Dividend Stocks The Last 10 Years

Below are some bellwether dividend growth stocks and their performance over the last 10 years, assuming $10,000 was spent to buy shares at the stocks 1998 high:
Procter & Gamble Co. (PG) - Analysis
1998 Dividend per Share: $0.51
1998 High Share Price: $47.41
1998 Yield on High Price: 1.1%
1998 Shares Purchased: 210 (cost: $9,956)
2008 Dividend per Share: $1.45
2008 Yield On Cost: 3.1%
Current Yield: 3.1%

Johnson & Johnson (JNJ) - Analysis
1998 Dividend per Share: $0.49
1998 High Share Price: $44.88
1998 Yield on High Price: 1.1%
1998 Shares Purchased: 222 (cost: $9,963)
2008 Dividend per Share: $1.80
2008 Yield On Cost: 4.0%
Current Yield: 3.22%

3M Co. (MMM) - Analysis
1998 Dividend per Share: $1.10
1998 High Share Price: $48.94
1998 Yield on High Price: 2.2%
1998 Shares Purchased: 204 (cost: $9,984)
2008 Dividend per Share: $2.00
2008 Yield On Cost: 4.1%
Current Yield: 2.80%

McDonald's Corp. (MCD) - Analysis
1998 Dividend per Share: $0.18
1998 High Share Price: $39.75
1998 Yield on High Price: 0.5%
1998 Shares Purchased: 251 (cost: $9,977)
2008 Dividend per Share: $1.63
2008 Yield On Cost: 4.1%
Current Yield: 3.62%

Sysco Corp. (SYY) - Analysis
1998 Dividend per Share: $0.16
1998 High Share Price: $14.34
1998 Yield on High Price: 1.1%
1998 Shares Purchased: 697 (cost: $9,995)
2008 Dividend per Share: $0.82
2008 Yield On Cost: 5.7%
Current Yield: 3.70%
The above data also demonstrates another important concept - your starting point is very important. Ten years ago the stock market was higher in relative terms than now, thus the yields for most companies were lower than now. After 10 years of growth, the YOC is not much higher than the stocks current yield. However, similar growth over the next 10 years will produce a dramatically higher YOC.

(Photo Credit)

Full Disclosure: Long PG, JNJ, MMM, MCD, SYY. See a list of all my income holdings here.

Tags: [JNJ] [MCD] [MMM] [PG] [SYY]

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