Back in 1988, the world was a slightly different place.
The Soviet Union was still a country, and it had 46,000 nuclear warheads pointed towards your living room. Ben Johnson was a dirty disgraced cheater, while Carl Lewis apparently wasn’t. People paged other people, and then used pay phones to respond to said pages. We have watches and goofy looking glasses now with more computing power than the biggest and baddest desktop machines on the planet back then. Steve Jobs, Bob Hope and Johnny Cash were all still alive, while now we’re stuck with a stupid internet joke about those three guys I refuse to repeat on account that no, it’s stupid.
But the most important thing that happened in 1988 – at least for the purposes of this blog post – is our boy Warren Buffett was buying a whole bunch of shares in Coca Cola. Thanks to the recent stock split, Buffett owns more than 400 million shares of Coke, and enjoys an annual dividend in the range of $500 million annually.
Because Buffett bought Coke a long time ago, he’s sitting on a pretty substantial capital gain on the stock. Between 1988 and 1998, Coca Cola shares were up more than 1,000%. The company just recently has approached the record high it reached in 1998, meaning it’s been essentially dead money since. Still, the return during that first decade was fantastic.
At this point, Buffett’s Coca Cola shares are up so much that each year he’s getting about 40% of his initial investment back every year in dividends. His yield on cost is enormous. If Buffett’s experience is any indication, all investors need to do is buy high quality stocks, hold forever, and watch the yield on cost go up to some ridiculous amount. Life will be good, and soon all the ladies and/or fellas will come around to get their greedy hands on some of that sweet dividend growth swag.
Too bad you’d be doing it all wrong.
Okay, that’s not exactly true. If you’re sitting on a huge gain in one stock, not selling has the nice advantage of deferring taxes – unless it’s in a retirement account or a TFSA. Also, if you have a big position in a stock and continue to see value in the name, by all means, hold it.
To use Coca Cola as an example, it’s silly for Buffett to keep holding Coke. The only reason the company is growing is because of emerging markets, and even those places aren’t seeing spectacular growth. U.S. customers are starting to cut back on the stuff, leading to volumes falling in North America. Yet the stock still trades at a P/E ratio of more than 20x. Coke isn’t a bad investment, but competitors are trading at pretty significant discounts. – including Pepsi, which has a nicely growing potato chip division.
WHOO CHIPS REPRESENT.
Currently, Coke has a dividend yield of 3%. If you buy something for the yield, the current yield is all that matters. Buffett could easily sell his $16 billion worth of Coke stock and buy something else that yields even more.
Most people don’t have the problem of having $16 billion in an individual stock. Let’s take off six zeros for the duration of this post.
Say you bought $8,000 worth of stock A, and it’s since done well. It’s gone up to $16,000 and the yield on cost has increased from 3 to 8%. Each year, you’re collecting $640.
If you sold that stock, and paid 15% capital gains tax on half your gain, you’d end up with $14,800 in proceeds. If you plow that back into an investment that yields 5%, you’ve increased your income almost 15%, from $640 per year to $740.
And this is a worst case scenario, since most of my readers invest primarily in tax sheltered vehicles. If you didn’t pay tax on the above example, you’re looking at $800 per year in sweet, sweet, dividends. That’s a really easy way to not only pocket some gains, but also increase your income.
Investors are taught to not get emotional about investing. But whenever someone gets a little excited about their yield on cost, that’s exactly what they’re doing. There are a million stocks out there that pay a dividend, and a lot of them represent better value than some company that just doubled its share price.
The yield on cost for an investment doesn’t matter. All that matters is the current yield, since any investment can easily be sold and converted into something different. That’s all you need to know. Forget about yield on cost.