Wednesday, May 18, 2011

How To Build A Sustainable High Yield Portfolio

Every investor wants to earn more. It is how we define "more" and how we go about earning it that defines the type of investor we are. Income investors want more income. Yield is a significant determinate of income. There are two ways to own a high yield portfolio. They are:

I. Buy The High Yield

If you want a high yield portfolio today, the only way to get it is to buy high-yield stocks. The problem with this approach is that companies with high-yield stocks are not run by nicer, more generous, shareholder-friendly executives. Instead, companies with high-yield stocks usually carry more risk.

This path to high-yield often ends with dividend cuts or significantly declining share prices. That leads us to option II, a better way to earn high yield for the more conservative income investor.

II. Build The High Yield

Instead of buying a current high-yield stock, investors in dividend growth stocks prefer to build their own. Granted, the current yield may never be classified as high-yield, but over time the yield-on-cost (YOC) can reach epic heights. YOC is simply Current Annual Dividend dividend by Original Cost Per Share.

YOC is not a substitute for calculating an internal rate of return (IRR). The IRR calculation takes into account both capital appreciation and the timing of cash flows (purchases, sells and dividends). YOC does illustrate the power of a growing dividend when compared to fixed rate investments suxh as bonds and CDs.

So how does YOC grow over time? Here are several real-world examples from my income portfolio:

a. Dividend Growing Faster Than The Share Price

To create a large gap between current yield and YOC all you need is a dividend growing faster than the stock price and some time to pass. This can be a very powerful combination if you are fortunate enough to purchase a low yielding stock before several significant dividend increases.

Consider Wal-Mart (WMT). In July 2007, I purchased WMT at $48.83/share at a time when its quarterly dividend was only $0.22/share. The initial yield was a lowly 1.8% ($0.22*4/48.83). Four dividend increases later, WMT is now paying a quarterly dividend of $0.37/share which gives me a respectable YOC of 3.0% ($0.37*4/48.83).

That is a 68% increase in the stock's dividend, while its share price only grew 12.6% to around $55 for a current yield of 2.7%. If the two growth rate were to remain constant the difference between YOC and current yield will grow exponentially.

b. Dividend Growing With No Share Price Growth

If the share price remains flat for several years, but the dividend continues to grow, YOC will track the current yield.

In March 2008 I purchased Sysco Corp. (SYY) at $28.34/share at a time when its quarterly dividend was only $0.22/share. This gave me an initial yield of 3.1% ($0.22*4/28.34). Three dividend increases later, SYY is now paying a quarterly dividend of $0.26/share which gives me a YOC of 3.7% ($0.26*4/28.34).

While the dividend increased 18% the stock was virtually flat (prior to its latest earning announcement). With SYY, current yield and YOC are the same - but both are higher than the original 3.1% yield.

c. Dividend Growing Slower Than Share Price

The largest disparity between current yield and YOC comes when the share price grows significantly faster than the dividend growth rate.

In March 2009 I purchased 3M Co. (MMM) at $47.88/share at a time when its quarterly dividend was $0.51/share. This gave me an initial yield of 4.3% ($0.51*4/47.88). Two dividend increases later, MMM is now paying a quarterly dividend of $0.55/share which gives me a YOC of 4.6% ($0.55*4/47.88).

While the dividend only increased 7.8% the stock is up 98% to around $95/share. At that price the current yield of 2.3% is about half the YOC.

Other YOC scenarios to consider:

Clorox Co. (CLX) | Yield: 3.2%
Purchased Dec/2008
Initial Yield: 3.5% | YOC: 4.2% (+0.7)

Canadian National Railway (CNI) | Yield: 1.8%
Purchased: Nov/2007
Initial Yield: 1.8% | YOC: 2.8% (+1.0)

Chevron Corporation (CVX) | Yield: 3.0%
Purchased: Dec/2008
Initial Yield: 3.6% | YOC: 4.0% (+0.4)

Genuine Parts Co. (GPC) | Yield: 3.4%
Purchased: May/2009
Initial Yield: 4.9% | YOC: 5.5% (+0.6)

Kimberly-Clark Corporation (KMB) | Yield: 4.2%
Purchased: Dec/2008
Initial Yield: 4.5% | YOC: 5.3% (+0.8)

The Coca-Cola Company (KO) | Yield: 2.8%
Purchased: Nov/2008
Initial Yield: 3.3% | YOC: 4.0% (+0.7)

McDonald's Corp. (MCD) | Yield: 3.1%
Purchased: Oct/2007
Initial Yield: 2.6% | YOC: 4.3% (+1.7)

The above stocks illustrate two important concepts, 1.) dividend growth is powerful over time and 2.) your initial price matters. Even a low-yielding stock like CNI can provide a decent YOC given some time to grow and a respectable growth rate. If you are fortunate enough to start with a higher yield, such as GPC the results can be dramatic as the YOC grows and the current yield declines through share price appreciation. It pays to have a value slant when selecting which dividend growth stocks to buy.

Full Disclosure: Long WMT, SYY, MMM, CLX, CNI, CVX, GPC, KMB, KO, MCD. See a list of all my income holdings here.

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