Trust in dividends

February 17, 2009
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, NAIROBI, Kenya, Feb 18 – John D Rockefeller (1839-1937) once said: "Do you know the only thing in life that gives me pleasure? It’s to see my dividends coming in.” Although this may portray a negative image of the great American industrialist and philanthropist, it is perhaps the philosophy that propelled him into history books as the first US Dollar billionaire.

The last two years have left investors disillusioned about the stock market. There are probably two reasons for this. The first is high expectations about the growth potential of stock prices and the second is total ignorance of dividends whose portfolio growth contribution is often underestimated.

The truth is strategic investment of dividends might as well give an investor substantial returns irrespective of the performance of the stock markets. A word of caution however is; ‘not every investor is cut out to profit from it!’ In fact, to make it work for you, you must possess qualities that many professional investors lack. You also have to accept the fact that no single person can predict the performance of the stock market with a great deal of accuracy.

The saying “Patience pays” is applicable to today’s stock market. So investors looking for a quick buck or investing in the stock market as a get-rich -quickly investment option will be greatly disappointed. Infact, interesting and glamorous investments are almost never the most profitable ones.

There is a simple answer to stock investors – buy shares that regularly pay you to invest – that is, those that pay good dividends. Dividends are for wealth-builders who want to be able to afford the finer things in life in 10, 20 or even 30 years’ time. This strategy isn’t without risks. Investing in shares is risky – in any market. It always will be. That’s why people who invest in equities long-term can make more money than those who don’t.

Investors who have just recently begun investing in the stock exchange may ask what are dividends? Dividends are payments that companies make to share holders from a portion of their earnings.

Good dividend payers are less volatile because, since the companies pay out cash, investors are more willing to hold high yielding shares through bear markets. Hence, they don’t tend to fall as far as quickly as low yield shares during the lean times though of course there can’t be any guarantee of that.

Put simply, shares that have income streams attached are treated better especially when people are uncertain. That’s why high yield shares tend to outperform low yielders by even more in down markets than they do in up markets.

Also, if interest rates go down – as often happens in recession – the prices of high yield shares tend to go up because dividends attract yield-hungry buyers. High yielders tend to outperform during the long term whatever the markets.

If you consistently reinvest your dividends during down markets, you can substantially expand your asset base which puts you way ahead of the game when markets recover and stock prices soar as they always eventually do.

Companies that add shareholders to their "payrolls" are good shares to own right now. But in general it’s best to forget about talk of recession or predictions of any kind. The time to invest is now and it is always now for long term high yield investors.

There are several reasons why dividends deliver. The first is that high yielders provide a decent initial income and then crucially, an increasing income over the long-term. Note however, that dividend income is not guaranteed – sometimes a company will cut its dividends or not pay a dividend at all. But, over the long term, average dividends increase.

High yielders provide proven capital growth over the long term. The biggest misconception about high yielding shares is that you’re sacrificing growth for a growing income. But in reality it’s just the opposite. Yes, a dividend stock can get hit in a bear market just like any other. However, with time, dividend payers return a substantial return.

The Treasury is kind to those who receive dividend income because if you are a basic rate taxpayer no tax is due on nearly all dividends. Effectively if you are a basic rate taxpayer you will not pay any tax on your dividend income (because the company that pays you the dividend has already paid tax on its profits).  And if you are a higher rate taxpayer you effectively pay just 25 percent – much lower than the 40 percent you would pay if you got interest or rents.

Investing in dividends acts as a cushion for retirement. And, as far as planning for a wealthy retirement goes, if you don’t require the income just yet, reinvestment of dividends more or less guarantees you income when you need it.

Almost every real-world and academic study proves that reinvesting dividends is the best way for you to grow your wealth over time – with much lower risk than if you were trading shares for in-and-out profits.

Put all of the above together – outperformance compared to other stocks during bear markets, regular income, steady long-term growth, historical outperformance and tax savings – and you have the recipe for the perfect long-term retirement investment.

So investors should concentrate on building a portfolio of high yield shares that will provide a stream of income for life. You’ll do this by making income your primary goal. Long term capital growth is secondary but if it occurs well and good. In fact, as you’ll see in a moment, this strategy has the potential to outperform the wider market in growth terms.

There are several rules for building a thriving High-Yield Portfolio

Stick to the big fish: First and foremost, candidates need to be ‘large caps.’ The reason is security. Investment is in the long-term and therefore large caps have more chance of outliving small caps.

Solid History: Investors need to go through records to check whether there’s an increasing dividend history for the company’s shareholders. The idea is to locate shares that have a proven history of delivering income growth even in years when profits may fall temporarily.
 
Steer Clear of Debt: Financial problems start with too much debt, so you can avoid the problem by preferring low-debt companies if possible. I look at the gearing ratio, which is the debts divided by shareholders’ equity (book value). It’s a good all purpose debt measure. (Note: this rule doesn’t apply to banks, which are high debt by definition.)

Sector Diversification: This is critical. If your portfolio is to weather even the toughest storms over the years, your risk must be evenly spread. That’s why investors should not only look at shares offering the highest yield but also for stocks in sectors that balance your "infinite income portfolio" to minimize risk in all markets.

Strategic Ignorance: No one can predict the future particularly when it comes to stock market investing. Instead of trying to predict the future, concentrate on what you can know which is all of the above.

(Renaldo D’souza is the Marketing and PR Coordinator at Winton Investment Services Ltd, an Offshore Investment Advisory Company based in Nairobi)

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