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More dividends or less dividends? I'd guess that the vast majority of income investors would prefer “more”.
I would also bet that most income investors want more dividends now. They buy investments with high current yields, with little thought to tomorrow’s yield.
But that’s the wrong approach. And I’ll explain why.
You see, “cost basis yield” is far more important than a stock’s current yield. Over time, cost-basis yield is much more important, because cost-basis yield most accurately reflects your income and wealth position.
This isn't to say you should avoid investing in high yield stocks. But if your choice is between a 6% yield and a 2% yield, the 6% yield isn’t always the best choice. You should be much more concerned on where your yield will be over time.
If a stock yields 6% and pays the same dividend year after year, your cost basis will remain 6%. But a stock that yields 2% today and hikes the dividend payout annually, your cost-basis yield will eventually far exceed the 2% current yield – and even the 6% dividend stock.
McDonald's Corp (NYSE: MCD) and Superior Uniform Group (NASDAQ: SGC) serve as insightful contrasts.
During 2001, you could have bought McDonald's for $25 a share. That stock would have provided a yield of less than 1% at the time. Alternatively, you could have bought a share of a Superior Uniform for $9. Superior's $0.54 annual dividend provided a 6% yield.
Through 2013, Superior has continually paid its dividend at the annual rate of $0.54 a share. So the cost-basis yield would have remained 6% over the last dozen years. Superior Uniform is a consistent dividend payer, but it's not a dividend grower.
McDonald's, on the other hand, is a prodigious dividend grower.
Today McDonald's pays a $3.12 dividend. Continual year-over-year dividend increases would have lifted the cost-basis yield up to 12.5% – more than doubled Superior Uniform's yield.
A $1,000 investment would have bought 40 McDonald's shares. The same investment in Superior Uniform would have bought 111 shares. From 2002 through this year, a $1,000 investment in McDonald’s resulted in $752 of dividend payments. Meanwhile, the same investment in Superior Uniform delivered dividends of $719.
That difference appears negligible. But as the years pass, the annual cash-flow difference has become more pronounced. For example, that hypothetical investment in McDonalds will pay $124 in dividends this year compared with $60 from Superior Uniform. And the dividend spread between the two will continue to grow as time passes.
The difference in wealth effect is even more pronounced.
A share of Superior Uniform traded for $9 in 2001. Today that same share trades for $12.60. As for that $25 McDonald's share, that's worth $97 today.
I'm not just speaking theory here. I've experienced this dividend-growth phenomenon firsthand. We added McDonald's to the High Yield Wealth portfolio in January 2011. The current yield and our cost basis yield at the time were 3% – nothing exciting – based on our $75.17 per-share recommendation price.
Thanks to annual dividend increases, our cost-basis yield has risen to 4.3%. Our investment is now worth $97 a share. Keep in mind, McDonald's current yield consistently holds near 3%.
In the October 2013 edition of High Yield Wealth, I’m introducing a new investment with the potential to grow dividends at an even greater rate than McDonald's. A couple years from now, this investment should have a cost-basis yield that far exceeds today's current yield. What's more, investors should expect this investment to mimic McDonald's wealth-producing price-appreciation effect.