I don’t want to sound like a Masterchef contender, but we all know that you can bake an amazing bread with a relatively small piece of dough. This is possible, because prior to baking, the dough should be left to rise properly in the oven, and then baked to perfection.
If you (like me) become impatient, however, and open the oven before the bread is done, your half-baked bread will collapse and you may end up with a piece of bread that’s even smaller than the original piece of dough. But the patient baker who waits for the bread to finish baking before taking it out, will be able to enjoy a delightful bread.
A fear that most of us struggle with, is the possibility of not being able to make sufficient provision to earn a decent income that will be able to fulfil in all our financial needs after retirement. Much like baking a loaf of bread, your protection against this fear lies in proper planning, the right ingredients and patience.
Those who still have enough time and who can afford the risk of a little short-term fluctuation, can consider investing in shares that yield higher dividends. Well-known investor, Warren Buffett, has often said that he gives clear preference to companies who tend to pay high dividends and manage to consistently grow these dividend payments over time.
Building your future income
Let’s suggest that you have R2m to invest, from which you will need a monthly income of R5 000 (in today’s rand-terms) for 10 years, but the idea of having to delve into your capital makes you very uncomfortable. If you invest your R2m in the local stock market at the current average dividend rate of 2.96%, you will earn roughly R3 950 per month after the current rate of 20% dividend tax has been taken into consideration. This is more than R1 000 less than you need.
Actual dividend pay-outs on our local stock market have increased by inflation plus nearly 2.3% over the last 50 years, which means that if you invest your R2m in the local stock market, and dividend pay-outs manage to rise by 8.3% per year (expected inflation rate of 6% plus 2.3%), you should be able to reach your R5 000 monthly requirement (with today’s purchasing power), and even at a more tax-efficient rate (20% dividend tax vs. income tax rates).
The graph below clearly shows us that dividends have been far less volatile than the share prices themselves over the last 50 years. This proves that it is more important to focus on a company’s long-term potential to generate an income, as opposed to short-term price volatility. By following this method, it will help to prevent you from “rushing through the recipe”.
Graph 1: Share dividends generally acting less volatile than share prices themselves (source: PSG Wealth Old Oak & Iress)
More and more experts are claiming that we find ourselves in an expensive market, because it’s trading at a higher price-to-earnings ratio (P/E). I have come across quite a few reports and proposals that refer to current market levels as “overheated”, and they may actually be right over the short term. It is trading at over one standard deviation higher than the 20-year average of 15.4 times, after all.
When we have a look at the income from shares (dividend yield) over the long term (Graph 2), the historical dividend rate paints a whole different picture. Investors looking for higher returns over the long term shouldn’t be fazed by the expensiveness of the local stock market.
Graph 2: FTSE/JSE All Share Dividend Yield relative to SA Money Market rate (source: PSG Wealth Old Oak & Iress)
Your own annual “pay increase”
Investors can directly buy shares with good dividend potential. Based on Thomson Reuters consensus, I have identified 10 shares that should deliver good growth over the next few years, both in terms of price and dividend yield:
2. African Rainbow Minerals
9. Wilson Bayly Holmes-Ovcon
These shares are currently trading at an average historical dividend yield of 4.8%, which not only looks attractive when compared to other shares, but also when compared to money market. If you had invested your R2m in equal shares in each of these 10 shares 10 years ago, your annual dividend income for the first year would have totalled R80 960 (taking 20% dividend tax into consideration). That is approximately R6 750 per month after taxes. The initial R80 960 annual income would have grown to R275 000 ten years later (at 13% per year).
It’s important to remember that this period included the great market correction of 2008, a time where investors simply had to close their eyes and “leave the oven door shut for the bread to finish”.
The point is that if you want to enjoy the taste of the proverbial warm freshly baked bread, you will have to leave the dough in the oven and let the baking process run its course. The good results will “prove” itself.
Schalk Louw is a portfolio manager at PSG Wealth.