Dividend Growers: The Importance of Yield-on-Cost

In Brief

With uncertainty around future interest rates and market volatility, investors may be searching for alternative sources of income. We think one source worth considering is U.S. dividend-paying stocks.
While current dividend yield is a focal point for investors, we think it is more important to consider the future income that could be generated by dividend stocks—especially those with a long-term history of annual dividend increases.
We believe one important measure in that regard is yield-on-cost, which is annual income relative to the originally invested amount.
Future dividend income can potentially be enhanced by employing an active manager with experience in selecting quality dividend growth stocks.

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When researching dividend-paying stocks, investors often focus on the current dividend yield—the rate of payout their investment is generating now. This is understandable, as a typical goal of a dividend-focused investor is to generate current income. But only paying attention to the current yield misses out on what we believe is the real power of dividends: the potential growth of future income from your investment. For dividend stocks, we think this concept is best illustrated by a metric known as yield-on-cost, which we believe has several strategic advantages over merely focusing on current yield.

Yield-on-cost is calculated by dividing the annual dividend income by the original purchase price of the investment. This measure reflects how much an investor is earning on their initial investment over time. Looking through this lens can help illustrate the potential for the long-term growth in income from dividend-paying stocks.

Rising Dividends, Rising Income

A good way to visualize this concept is to compare the income generated over time by an initial investment of $10,000 in each of the S&P 500^® Index and the Bloomberg U.S. Aggregate Bond Index (see Figure 1). Investments in bonds and related vehicles like bond-index funds are expected to produce higher current income as compared to dividend stocks, and we see this behavior in the first few years depicted in the chart. Yet over time, the earnings growth of the S&P 500 companies leads to higher annual income. (The ending market value figures reflect price appreciation only, as the chart assumes that dividends are being withdrawn each year.)

Figure 1. Comparing Income Generated by Bonds and Dividend Stocks Over the Long Term

Annual dividend income (S&P 500) and interest income (Bloomberg Aggregate) on $10,000 invested on January 1, 1979 (1979-2023)

Source: FactSet. A company's dividend payments may vary over time, and there is no guarantee that a company will pay a dividend at all. Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment.

It is important to note that over this time horizon, the S&P 500 dividend yield averaged 2.5% while the yield on the Aggregate Index averaged 6.7%. But if we focus on yield-on-cost, we see that our initial investment in the stock market is yielding more than 74% as compared to its bond alternative at 2.36%.

The experience of one of the most well-known investors of our time, Warren Buffett, underscores the importance of yield-on-cost. In 1994, Buffett’s company, Berkshire Hathaway, completed a seven-year purchase of Coca-Cola shares for $1.3 billion. The cash dividends from that investment produced $75 million of income for Berkshire in 1994. As of this writing, Coke’s current yield is around 3% and has been for the last 15 years (see Figure 2). While some may see the stagnant yield as a detriment, the annual dividend has grown 242% while the stock price appreciated by 160% over this period. As a result, those cash payouts grew to $736 million by 2023, resulting in a yield of 57% on the initial investment. Should the soft-drink giant continue its multi-decade run of sustainable growth and annual dividend hikes, the yield on cost will continue to increase as well.

Figure 2. Dividend Increases Fueled Rising Income from Coke Shares Even as Yield Remained in Narrow Range

Berkshire Hathaway’s annual dividend income from its mid-1990s Coca-Cola investment (left axis) and Coca-Cola’s dividend yield over time (right axis), 1994-2023

Quality Counts

The Coke example highlights the importance of finding quality companies within the dividend-paying universe. Within the universe of dividend-paying stocks, we believe investors can benefit by focusing on companies with a long history of dividend growth. These companies typically have stable earnings, robust cash flows, and a disciplined approach to returning capital to shareholders. This focus naturally aligns with selecting quality stocks that can sustain and grow their dividends over time, reducing the risk of income instability. In contrast, a focus on current yield may lead investors toward higher-yielding, but potentially riskier, companies.

Research has shown that the companies with the highest dividend yields have historically lagged the broader universe of dividend-paying stocks. These companies can face high volatility dealing with challenges maintaining its dividend or can have limited equity market participation as “bond proxies” (securities in sectors like real estate, utilities, and consumer staples that have high valuations with relatively low earnings growth). In addition, these “bond proxies” tend to be very interest-rate sensitive and can face headwinds during periods of rate volatility.

We think the potential long-term benefits of dividend-paying stocks are clear. However, we believe a thoughtful approach to dividend investing is vital to accessing these benefits while balancing risk and reward. We believe it is important to target quality companies that are not only willing to increase their dividend but are also able to do so in a manner that keeps their future growth intact.

LAMYX

Class I

Dividend Growth Fund

The Dividend Growth Fund invests primarily in stocks of large U.S. companies that have a history of increasing their dividends. Learn more.

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About the Contributors

Darnell Azeez, CFA

Partner, Portfolio Manager

Subrata Ghose, CFA

Portfolio Manager

Jeffrey Rabinowitz, CFA

Portfolio Manager

JJ Titus, CFA

Product Specialist

Important Information

Unless otherwise noted, all discussions are based on U.S. markets and U.S. monetary and fiscal policies.

References to fund yields are for informational purposes only and are not meant to represent any specific Lord Abbett bond fund or portfolio.

Asset allocation or diversification does not guarantee a profit or protect against loss in declining markets.

No investing strategy can overcome all market volatility or guarantee future results.

The value of investments and any income from them is not guaranteed and may fall as well as rise, and an investor may not get back the amount originally invested. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon, and risk tolerance.

Market forecasts and projections are based on current market conditions and are subject to change without notice.

Projections should not be considered a guarantee.

Dividends are not guaranteed and may be increased, decreased, or suspended altogether at the discretion of the issuing company.

Dividend policy: A stock is classified as a dividend payer if it paid a cash dividend any time during the previous 12 months; a dividend grower if it initiated or raised its cash dividend at any time during the previous 12 months; and a non-dividend payer if it did not pay a cash dividend at any time during the previous 12 months.

Equity Investing Risks

The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. Value investing involves the risk that the market may not recognize that securities are undervalued, and they may not appreciate as anticipated. Smaller companies tend to be more volatile and less liquid than larger companies. Small cap companies may also have more limited product lines, markets, or financial resources and typically experience a higher risk of failure than large cap companies.

Fixed-Income Investing Risks

The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. High yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price.

The credit quality of fixed-income securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer’s creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.

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The Bloomberg U.S. Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment-grade, fixed-rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.

Bloomberg Index Information

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The S&P 500^® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

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