The Wine Cellar - The Remarkable True Story of a $146,194-Per-Year Income Portfolio

There are a number of takeaways here, first is focusing on dividend over the long run. Patiently building positions over a long time horizon.


Then there is the importance of dividends in long term investing. The story of Hayford Peirce is a concrete example of James Montier's Dividends Still Matter example, which shows that on a one year time scale dividends and dividend growth account for only about 20% of total return to the investor. However over a five year time horizon, dividends and dividend growth account for around 80% of the total return. In my opinion, its foolish to invest for only one year, too many things can happen, and so investing requires a longer term outlook.

Given that then dividends come to the fore in any investment analysis. What we need to look for varies slightly though. Its less about current yield although that clearly matters. A useful metric is Yield on Cost (or effective yields):

30% yields

That Altria investment is spinning off incredible "effective yields" -- measuring today's dividend checks against the original cost basis, rather than the current share price. Hayford's getting a 37% yield on Altria and a 28% yield on Philip Morris International.

That's by design. About half of the $146,194 in investment income will come from Hayford's annuity and the lone bond. The other half will come from a very deliberate investment process in dividend stocks. On a 1995 trip to Tahiti (where he lived for 25 years), Hayford sat down with a legal pad, pen, and his collection of stock tickers:

I was looking over my portfolio. And say there were 12, 14 companies in it, and 8 of them were blue chips like GE and Coke and Johnson & Johnson. … I said, "These suckers are bringing in $14,200 in income this year. Let's see what would happen if we just increased that dividend by 10% every year for 30 years."

Upon returning to the States, he transferred his legal pad scribblings to a series of spreadsheets, and the long-term vision for these 12-14 dividend stocks took hold. His stated goal was to increase his annual investment income from $14,200 in 1995 to $250,000 in 2025. "Up until a year and a half ago, I was ahead."

Then the financial crisis hit, former widow-and-orphan stocks like GE and Bank of America (both owned by Hayford in '08) slashed their dividends, and even the best-laid of plans went to mush. Hayford tilted his dividend portfolio toward high-yielding MLPs.

Yield on Cost is a misunderstood metric, as an input to current decision making its mostly useless.

For example, would I rather own Chevron or Exxon? Chevron (3.3%) pays a higher dividend yield today than Exxon (2.9%).  But let's say I bought Exxon back in 2005 and since then their dividend has doubled. So my effective yield on Exxon is more like 5.8%, so wouldn't I rather own Exxon at 5.8% than Chevron? No because the 5.8% is only on cost and if I sold all my Exxon and put it all into Chevron then I would increase my current yield by more than 13% (the difference between 2.9 and 3.3). That current income is predicated on current yield not yield on cost.

So if current yield is all that matters then why focus on Yield on Cost at all? Yield on Cost is useless as a comparison metric but in my view its very helpful for planning and goals because it clarifies what you are shooting for. In other words, my goal as a dividend investor is to generate as many double digit percentage yield on cost as possible. Getting to 30% can take awhile, but 10% Yield on Cost is doable for a number of different companies. A 4% current yielder that  raises its dividend 10% year will be over the 10% Yield on Cost hurdle in ten years.

So focusing on identifying candidates for double digit Yield on Cost percentages means that you are looking for companies that will be there for the long haul. You have to look at different factors. Quality matter, sustainability matters. Flavor of the month companies need not apply. The companies need to be able to withstand two business cycles, recessions and other events that a decade can throw at it. Its a totally different game and totally different metrics than trying to handicap what iPhone 5's impact will be, Twitter's IPO or almost any headline that dominates business news. But for long term return generation, the fact that dividend corner of the market is underfollowed is a great opportunity.

The question to ask to generate high yield on cost is not so much what the company is going to do this year or next, but rather can the 3-4% yielder triple its dividend over the decade? This mindset is about as far from a short term mentality as you can imagine. 

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