There are lots of things I look at when I review my portfolio. One of my favourite things is the yield at cost of my holdings. As a dividend investor I find that it keeps me grounded and focused on what matters over the long-term. Is this a silly mental trick? Perhaps. Do silly mental tricks change our behaviour over time? I believe they do.

Before delving into my convoluted mind we can start with a definition. The dividend yield is a measure of how much an investor can expect to receive in dividends at the current price if the dividend is maintained. We calculate a dividend yield by dividing the dividend paid over the last year by the current share price. If a share is trading at $20 and paid a $1 dividend the yield is 5%.

The yield at cost ignores the current price and instead looks at the cost basis. If you purchased the same share at $10 that paid a dividend of $1 the yield at cost is 10%. Why does this matter? That is a good question. Many people will argue it doesn’t. They will say that what matters is the current yield because that can be compared to other investment options.

What really matters is what you are trying to achieve. My goal is to create an income stream from my portfolio that grows over time. The beauty and the risk of a dividend is that it is not static. Dividends can grow over time. Dividends can also be cut or eliminated. To achieve my goal I need to find companies that grow their dividends over time. If I decided to invest $1000 dollars in a share I want that initial investment to generate a larger and larger cash flow as time passes.

One more nuance which may also be controversial to many of the people that scoff at the notion of looking at the yield of cost. In practical terms the cost basis of a share goes down over time as dividends are reinvested. If I originally spent $1000 buying 100 shares my cost basis is $10. However, if I’ve reinvested dividends over time and I now own 150 shares my cost basis is now $6.66.

There is one important point to add. My theory that the cost basis of a share goes down over time has no impact on taxes. The cost basis of the originally purchased shares remains the same and each newly purchased share has a new cost basis. If I sold the 150 shares the first 100 shares would have a cost basis of $10. The cost basis of each of the extra 50 shares is based on the price the dividend was reinvested. Fair enough. As I said I use this as a mental trick.

How I apply this to my portfolio

In a previous article I published my top 10 holdings. This time I included the yield at cost which includes the impact of dividend increases and the increase in the shares I hold through dividend reinvestment.

First some caveats. Naturally the positions that have grown into my largest holdings have performed well. This certainly isn’t the case for everything I’ve purchased. This is a reminder that not every investment will be successful. I’ve also turned off the dividend reinvestment for all the positions on this chart over the last 5 years as I have started to spend the dividends.

Yield at cost

I’ve described the yield at cost as a mental trick. Looking at the yield at cost reminds me of a couple things that I believe are important to keep myself grounded as investor.

Don’t chase yield

It can be tempting as a dividend investor to simply pick shares with the highest current yields. If the goal is to achieve a high level of passive income it makes intuitive sense to get the biggest bang for the buck from each new share purchase. This approach can be a trap for investors.

A high dividend yield can be an indication that a share is undervalued. As share prices fall the dividend yield goes up. And sometimes investors can become overly pessimistic about the prospects for a company. Buying high yielding shares can be portrayed as a contrarian approach to investing. This is the premise behind strategies such as “Dogs of the Dow” which calls for purchasing the highest yielding shares of the Dow Jones Industrial average.

However, a blanket assumption that the market is wrong can be a dangerous approach. Dividend paying shares are often mature, large companies. These are the same companies that are heavily followed by investors. Investors can be collectively pessimistic at certain times but in many instances the market is rationally and accurately assessing future prospects.

A high dividend yield could be an indication that investors think the dividend is in danger. It could be a result of investor expectations that future growth prospects are weak which will impact the ability of the company to raise the dividend in the future. These expectations could be correct.

One secret to achieving successful investing outcomes is to assess market expectations and conclude they are wrong. This can be the case when investor expectations are extremely positive or extremely negative. Falling to meet high expectations will likely result in poor outcomes. Exceeding negative expectations can lead to positive outcomes.

As a long-term income investor dividend growth matters. At a certain point a lower yielding share will produce a larger income stream in the future if the growth of the dividend is higher. One example from my portfolio is Microsoft (NAS: MSFT). I bought the shares back in 2013 when the dividend was $0.97 a share with a yield of around 3%.

Since the time I purchased Microsoft the dividend has grown to $3 a share. That is a compound annual growth rate (“CAGR”) of close to 9%. My yield at cost is just under 10%. And while nobody considers Microsoft a dividend behemoth the strong growth over more than a decade matters.

If I purchased a share that had twice the yield as Microsoft in 2012 the dividend growth would have to be more than 4% a year to match the current income I am getting from my position. That is not unheard of but it likely means that investor expectations were exceeded for a share that was yielding 6% in 2012.

Time matters

Patience is in short supply in the investor community. Most investors want what they want, and they want it now. This is not a unique observation. And it is often used as a precursor for climbing on a soapbox and proselytising. But I like that investors are inpatient. It means that to be successful I don’t have to outsmart anyone. I just need to do what most people won’t or can’t.

Professional investors are easy to beat this way. They are smarter than me. They have more resources. However, they are saddled with constraints that I don’t have. I have purchased American Tower and Vanguard High Yield ETF relatively recently. The rest of my top 10 have an average holding period well beyond any holding in most professionally managed portfolios.

If you remove the outlier of ADP which was purchased for my wife by my father-in-law when she was two years old the remaining 9 positions have an average purchase year of 2011.

During these long-holding periods there were plenty of times a rational and compelling case could have been made to sell. Share prices don’t move straight up. Companies face challenges that take time to overcome. Headwinds develop when a company or sector falls out of favour.

A professional investor can be punished by falling behind their benchmark for even short periods of time. Investors pull money out of funds and ETFs that underperform. This lack of patience from end investors is a constraint on professional fund managers - it isn't a constraint on me. And while I can sympathise that they deal with fickle investors it undeniably changes their behaviour.

Many professional investors sell shares that have fallen temporarily out of favour in search of shares with near term catalysts. This further drives down prices and leads more investors to sell those same positions.

Patience may be a virtue but I’m not trying to plant myself on a moralistic high ground. I’m trying to achieve my investment goals. During these periods when an otherwise great company has fallen out of favour it gives me the opportunity to add to my position at a higher yield. This could be new money that I invest or simply the impact of reinvesting dividends at more attractive prices. That drives my yield at cost up.

We can use the recent struggles of Diageo (LON: DEO) as an example. The share price has dropped around 19% over the previous year. The global liquor, wine and beer giant is facing difficult conditions in Europe and Latin America. Our analyst forecasts a tough 2024 and expects a decline in sales next year.

Fair enough. I don’t personally see a near term catalyst for the share price to start climbing until these negative trends reverse. Yet my thesis is still intact. The company still has a wide moat based on the intangible assets stemming from a strong stable of brands including Guiness, Johnnie Walker, Smirnoff, and Tanqueray. They also have a cost advantage over competitors which further strengthens the moat.

The business risk is low given the global footprint, diversity of offerings and non-cyclical nature of the industry. The company is in a strong financial position and has a payout rate of 50% which bodes well for the sustainability of the dividend. I still think it is attractive over the long-term and it aligns with my goals and investment strategy.

In 2021 when shares surged the dividend yield was 1.80%. Currently the yield is 2.70% which means that I will acquire more shares with reinvested dividends. That will further increase my yield at cost. If I were to sell now it would mean I would have to pay a significant amount of capital gains taxes. That tax payment would mean I have less to invest in another opportunity. I would also be selling at a price that our analyst believes represents a discount to fair value which has the share in 4-star territory.

I could of course be wrong. But I could also be wrong about the merits of another opportunity for the funds.

The impact on my behaviour

I am a firm believer that most investors are their own worst enemy. Nobody is actively trying to sabotage their finances. There are countless challenges all investors face when trying to make good decisions. To acknowledge how difficult it is to overcome these challenges means it would be naïve if I didn’t devise a way to try to address them.

As previously mentioned, yield at cost keeps me grounded. It gives me a metric that focuses on the advantage of long holding periods which limits my trading. It lessens the temptation to chase the next shiny investment opportunity with the compelling sounding narrative. It helps me balance an income portfolio between higher yields and dividend growth opportunities by reinforcing the impact of that growth over the long-term.

Being an income investor also provides a counter cyclical ballast to the emotional pull to follow the herd. When shares are up and greed spreads through the investor community low yields are less tempting for an income investor. As markets plunge and the proverbial blood runs in the street yields rise which makes investing more attractive. Income investing remains a firebreak for my emotions.

Warren Buffett famously said that investing is “simple, but not easy.” Understanding the techniques and behaviours that led to investing success is only the first step. Turning them into habits and consistently applying them is the key. For me, looking at yield at cost makes investing a little easier.

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