CHUCK CLOSE IS A WIDELY-LAUDED ARTIST whose last name is well-suited for one of his most famous techniques: in the 1960s and 70s, he created jumbo-sized, photorealistic portraits built up from tiny dots of color that could be seen only when one was quite close to the painting. This approach helped inspire the development of today’s ink-jet printers.
Close’s portraits make little sense from a vantage point very near the canvas; the isolated color globs seem random and chaotic. Seeing the whole picture requires stepping back and taking in all the details as a unified work. In a similar manner, we believe investors are well advised to “step back” and approach dividend-oriented portfolios from an integrated, total return perspective considering both income and capital gains over the long-term. We believe many investors have become overly focused on the “tiny dots” of today’s current yield. Current Yield: The Basics Current yield is a snapshot in time of a company’s annual dividends per share divided by its current stock price per share. The resulting data from multiple securities can then be averaged to arrive at the overall current yield of a portfolio. While we view current yield as an important variable to consider, we believe it has become far too common to rely on it as a primary or even sole measure of a dividend-oriented portfolio. Part of this trend may be driven by simplicity; current yield is a data point that is readily available among the information tools used today. As is so often the situation, however, this simplicity can come at a cost—in this case, potentially lower long-term total return.
The key danger in overly focusing on current yield, in our view, is that investors can be led to overlook companies that have enjoyed such success that they have been rewarded with stock price increases that equal or outstrip the growth of their rising dividend. That is to say, if the denominator of a company’s stock price appreciates at an equivalent or faster rate than the numerator of its dividend, such a situation may put downward pressure on that company’s current dividend yield, even if the dividend is growing respectably. We find it detrimental to eliminate positions from a portfolio or exclude companies from research coverage merely due to low current yield. By placing too much emphasis on current yield, we feel total return over the long-term could be compromised due to comparatively weak capital gains.
Yield-at-Cost: Providing Some Perspective
Given our long-term approach to investing and our partiality to companies with consistent dividend growth, we believe a more effective way to analyze yield is not by utilizing the current yield but rather the “yield-at-cost” of a portfolio. Yield-at-cost divides a company’s current annual dividends per share by the original cost per share basis at which the company was brought into a portfolio. This calculation takes a company’s dividend growth into account and doesn’t “penalize” a company for stock price appreciation. From our perspective, one of the key insights of a yield-at-cost analysis is that healthy dividend growth may accompany or even lead to stock price appreciation.
A Real-World Company Example
Exhibit 1 chronicles an example of a dividend growth company and a high-yielding company. Company A shows a relatively low-yielding, but strong dividend growth company. Company B shows a high-yielding, flat dividend payer.
An investor focused solely on yield will likely prefer company B for its very high yield. While the company may provide an attractive level of current income on an annual basis, the dividends paid out by the company remain static, coinciding with relatively little capital appreciation. An investor in company B may receive bond-like returns but experience equity-like risk. Company A would likely be overlooked by that yield-seeking investor, because its current dividend yield never once surpasses 2%. However, this is not the result of a static dividend payment – in fact, the company increased its dividend by 36% annually over the 5 year period. Its consistently low yield can be attributed to the similarly strong capital appreciation in the company’s stock price, which grew by 27% annually over the same 5 year period. We believe this example accentuates the limitations of focusing on a company’s yield as a means of security selection and as an analytical device. A company with a low yet growing dividend may offer an investor greater total return potential due to the strong relationship between dividend growth and price appreciation.
A Sector Example
Reviewing the results of securities across different sectors may also demonstrate the usefulness of a yield-at-cost perspective. We believe examining the history of these stocks can illustrate how the dual components of total return affect a company’s current yield over time in ways that require nuanced analysis.
As shown in Exhibit 2, the Utility Co. stock price appreciated at a significantly faster rate than its dividend growth, resulting in a lower current yield than at initial purchase. But despite the yield decreasing during the period the stock has been held, investors were rewarded with a strong total return experience due to the stock price appreciating simultaneously with the increasing dividend. The Energy Co. also helps demonstrate the interplay between price and dividend growth. The company experienced both strong stock price appreciation and dividend growth over the period, but in this case, the dividend has grown notably faster than the stock price. This led to a higher current dividend yield than when the company was originally purchased, and once again, yieldat-cost helps to quickly and informatively capture these dynamics.
Santa Barbara’s Approach to Applying Yield-at-Cost
We believe a yield-at-cost perspective can help add value for our clients by providing us with tools to retroactively evaluate companies in the portfolio that may be growing dividends while simultaneously appreciating in value. The chart in Exhibit 3 shows a generally widening gap over time between the current portfolio yield and the portfolio yield-at-cost of the Santa Barbara Asset Management Dividend Growth portfolio. We believe this example illustrates a portfolio that has benefitted over time from both dividend growth and capital appreciation. We find the portfolio’s yield remained competitive throughout this period, but by avoiding what we would view as overreaching for yield, we were able to maintain exposure to select companies that benefited from stock price gains.
Ultimately, we believe the increase or decrease in a security’s current yield shouldn’t be of chief importance; rather, we believe emphasis should be placed on the total return that has been produced as a result of owning high-quality companies that possess the financial flexibility to increase dividends while also appreciating in value with time. We view a yield-at-cost perspective as a much more helpful framework for determining portfolio success than simply looking at current yield. In our view, “seeing the whole picture” in this manner is likely to provide real value for clients over the long-term.
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