Tuesday, 20 September 2011 - 20:00

 

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The Benefit of Dividends

I am convinced that our generation will suffer from information overload and successful individuals will be those that are able to focus on really important matters. There is just so much out there screaming for our attention that it makes it very difficult to be focused.

Likewise, having too much information can influence one’s investment decisions negatively. This is compounded due to emotions of fear and greed.

Let’s assume an investor builds a share portfolio of about 15 shares, not for tradability and liquidity, but because the companies in the portfolio have proper business models, management that is trustworthy, and steady profit generating businesses. Assume also that the investor is investing into these businesses because of their quality and sustainability over the next 10 years as opposed to being the “next best thing”. A portfolio with the above characteristics can be built relatively easily with a starting dividend yield of 4.5% pa (at current market levels). Key is not look at the share prices for the next 10 years but only at whether the businesses still have relevant business plans, trusted management, and are generating enough cash to pay out dividends.

If this is the case then a lot more people will become investors as opposed to share traders and a lot more investors will make good steady returns over a long period.

To build wealth takes time. There are no short cuts in making money.

Let’s compare the cash flows of a RSA retail savings bond and the cash flows of the businesses we selected by way of our investment criteria.

Currently there is a 5 year RSA retail bond that pays 8% p.a.

The following assumptions are made:
- R1m to invest
- There is a 10 year bond with the same terms
- Income tax is calculated at 25%
- The average starting dividend yield of the portfolio is 4.5%
- The dividends will grow at a modest 8% per annum (6% inflation + 2% real growth)

The likely payoff profile from these two investments net of tax for the next 10 years will be as follows:

From the graph it is clear that after about 4.5 years the annual dividends paid will be higher than the (net of tax) income received from the retail bond.

It is important to realize that the nominal value of the dividends is not dependent on the market price of the share portfolio but rather on the sustainability of the discussed investment criteria.

The above analysis has not taken into account the capital value at the end of the period. The bond’s R1m nominal will be repaid at the end of the term (losing purchasing power). The shares in the portfolio will only be sold if their prices have reached (or exceeded) fair value, based on the above assumptions fair value will be approximately R1.9m. The market value of the share portfolio could be less than R1.9m in which case the likely decision would be not to sell, but to carry on receiving the increasing dividends. Any dividends received in excess of the required income level can be reinvested to grow the capital invested.

Based on the above analysis and with interest rates possibly falling further and tough economic times predicted it makes sense to be an investor, investing in quality businesses that pay out sustainable dividends rather than a speculator that attempts to extract short term capital gains or an investor with a short term horizon that limits their income growth by investing into nominal bonds.

Seed has developed a process to manage share portfolios for private clients based on similar principles explained in this article. If you want to know more and are able to invest more than R1m in a share portfolio then contact us at info@seedinvestments.co.za

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Kind regards

Vincent Heys
info@seedinvestments.co.za
www.seedinvestments.co.za
021 9144 966

Tue, 20 Sep 2011

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