How To ... earn an income??from shares

2014-11-03 07:00

When it comes to passive income most people think of property, yet a share portfolio can also be used to generate an income – one that is well diversified, tax efficient and does not require any tenant management

When it comes to investing in shares, most people focus on the share price. This is unsurprising, given the value of the All Share Index is covered in most news reports and market pundits watch every price movement as if their lives depend on it.

The real genius behind share investing, as investment guru Warren Buffett will tell you, is the dividend or income you receive from your investment. By building up a share portfolio of high-dividend-yielding investments, one can live off a relatively stable income.

A dividend is a sum of money paid from a company’s profits to its shareholders. While a company’s share price in the shorter term can be driven by market sentiment rather than fundamentals, dividends, on the other hand, are the real measure of a company’s health.

A company cannot pay out money it hasn’t earned so dividends are a good measure of a company’s growth and real earnings. Over time, quality dividends will be reflected in the company’s share price so investors have the added benefit of longer-term share price growth.

The key to dividend investing is leaving the investment long enough for the dividend yield to grow and provide you with a decent income.

Currently, the average dividend yield for companies listed on the JSE is about 3%. That might not sound as attractive as a bank account paying 5%, but South African companies have been growing their dividends well above inflation.

The Marriott Dividend Growth Fund – a domestic equity fund – has grown its distribution by 8% in excess of inflation since 2003.

That means within 10 years, an investor’s income yield relative to her/his original investment value would be 7% in real terms and, unlike interest in the bank, the rate of income continues to grow.

After 20 years, you would be receiving a 14% level of income per annum in real terms, which makes this a very attractive option for saving towards a retirement where you would be able to live off the income.

You also have the benefit of capital gains on the original investment that you would not receive from a bank account.

Dividends are also more tax efficient as they are taxed at a rate of 15% compared with rental income or interest income, which would be taxed according to your personal income tax rate.

Dividend-paying shares

While the average dividend is about 3%, you can build up a portfolio targeting shares that tend to pay a higher dividend. Companies such as Standard Bank, British American Tobacco and MTN all have dividend yields in excess of 4%.

Certain unit trusts, such as the Old Mutual High Yield Opportunity Fund or the Marriott Dividend Growth Fund focus on income from shares and will contain companies with above-average dividend yields as well as companies that have good prospects to grow their dividends.

As Feroz Basa, who manages the Old Mutual High Yield Opportunity Fund, points out: research on the JSE’s returns shows that dividends have contributed more than half of total returns over 25 years.

Duggan Matthews, an investment professional at Marriott, says when investing for income, one needs to select companies that are consistent “salary payers” – these are companies with a track record of consistent dividends and which are not cyclical in nature.

These tend to be companies that make up a basic basket of goods and services consumed by households – such as retailers (Spar, Mr Price), telecommunications firms (MTN, Vodacom) and banks (Standard Bank, FirstRand).

Each year, they grow their profits and each year they increase their dividends. In contrast, mining companies are inconsistent dividend payers as they tend to be very cyclical and their profits are determined by forces outside their control, such as the price of gold or platinum.

Building a dividend portfolio

A dividend portfolio strategy in retirement can provide a relatively stable retirement income. If I think back to 2009 after the market had halved in value, my mum asked me why she was still receiving her regular monthly income from her retirement portfolio when all her friends had lost money.

The simple reason was that she was receiving dividends, not selling shares to generate her income.

During the market crash, South African companies were still growing. Shoprite was still selling groceries, Standard Bank was still making money from banking and SABMiller was still selling beers.

So their earnings continued to grow with their dividends.

Dividends are inherently more stable than share prices so those investors who relied on the dividend income were unaffected by market fluctuations.

Marriot, which specialises in investing for income, recently introduced a retirement annuity that aims to produce a specific income in retirement by building up a high-quality dividend portfolio.

Unlike traditional funds that set targets to achieve a specific capital return, the Marriott Dividend Growth Fund targets income and offers an online tool that helps you calculate how much income your retirement annuity would produce in retirement.

While predicting future share prices is very difficult, future dividends are far more predictable, according to Matthews.

“An accurate projection of a likely investment experience allows younger investors to set up a savings plan that will ensure the income from their investments will be enough to maintain their lifestyle in the latter years,” he says.

If, by the age of 40, you had saved R500?000 for your retirement in shares that continued to grow, with their dividends at 8% above inflation, in 20 years’ time that R500?000 would generate you an income in today’s terms of about R70?000 a year.

The capital value of that R500?000 in 20 years’ time is simply not relevant.

The income it can produce is what matters most to retirees.

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