Keep an eye on the income: The price hardly matters

01 February 2017

Business meeting with a tablet in the foreground

Tony Gilham CFP®

Tony started providing Financial Advice to clients in 1973, as a self-employed sole practitioner, offering a range of superannuation and insurance products in what was then a fairly unsophisticated marketplace.

We live in a society that is obsessed with the sharemarket and the price of shares. It's time we tuned out the daily noise generated by the financial media and focus instead on the profit growth and dividends paid by the companies that clients are invested in.

Generally speaking, investors on the whole are obsessed with the price of their investments, be it shares, property, their super fund balance, and even sometimes, the gold price.

And there is little wonder why, because we have been taught to focus on the price, and virtually all reporting in the financial media only focuses on the price of the investments, and hardly ever refers to profit growth or dividends paid.

When we have discussions with our SMSF clients, many of them will bring up the recent poor performance of some of their shares and they are dismayed that the share price has gone down.

Conversely, some share prices have been going up strongly in recent years and many clients, excited with this, usually want to add more to that investment.

But it’s rare that a client wants to bring up the subject of the interest or distribution paid, or the dividend rate, and how that’s tracked over the last few years.

Focus on the dividend, ignore price fluctuations

If you look at the news on television every night, the media only ever talk about movements up or down in share prices or the All Ordinaries Index. But a 1 per cent or 2 per cent change upwards or downwards in the share price is basically irrelevant (unless you happen to be selling at the time), and there’s hardly ever any mention of dividends paid.

But if you are a serious medium to long-term investor, hoping to become financially independent and relying on your investments to generate a reasonable income in retirement, then daily fluctuations in share prices are almost irrelevant. However, what is particularly relevant is the dividend income you are receiving and how that’s changing from year to year.

Warren Buffett once said that the basis of a good investment portfolio is to buy shares in good companies, and if they continue to be good companies, hold those shares forever.

When people finish their working career and go into retirement, they start to very quickly focus on the income generated across their investment portfolio, and many of our clients now have a very good understanding of the level of income generated by the portfolio and how that is changing from year to year.

And because the sharemarket can be volatile, it’s only natural that many investors seek the safety and security of cash and term deposits, where there’s virtually a nil probability of price movements (capital values going up or down), and a relatively high degree of predictability as to the income generated across their portfolio.

Volatility in cash and fixed interest investments comes from the fact that interest rates do change over a period of time, and many investors who became too cautious during and soon after the Global Financial Crisis, are now realising that interest earning investments can actually be much more volatile than sharemarket investments, from an income generation point of view.

In Table 1, I’m showing the share price of the 10 largest companies in Australia, for the financial year beginning on 1 July 2006, a complete full financial year before the onset of the GFC, and then the market value of those shares on 30 June 2015, nine years later.

Over this nine year period, we suffered what is now known as the ‘GFC’, which turned out to be the second largest sharemarket decline in 100 years, and certainly enough to convince some investors that the sharemarket is just ‘too risky’.

table-1

The table is very simple. It assumes that the investor buys one share in each of the 10 largest companies in Australia, on 1 July 2006, and holds those shares through to 30 June 2015, a period of exactly nine years.

Some observations from Table 1

  • One share in each of the 10 companies cost $278.97, and nine years later, those shares were worth a total of $405.82.
  • The dividend in the first financial year was 1256.05 cents, which equates to a cash yield of 4.50 per cent on the outlay of $278.97.
  • For the financial year immediately after the GFC, cash dividends paid were 1147.15 cents, equating to a cash yield of 4.11 per cent on the initial outlay of $278.97.
  • Yes, the GFC was the second worst downturn in Australia in 100 years, but the cash dividend yield declined by less than 0.5 per cent (0.39 per cent to be exact), which was a decline in total income for the investor of 8.67 per cent.
  • But the total dividends paid for the 2014-15 financial year were 1942.49 cents, equating to a cash yield of 6.96 per cent on the investor’s total outlay of $278.97.
  • Over the full period through to the end of the 2014-15 financial year, the total cash income was up an impressive 52.34 per cent.

In Chart 1, we plot the dividend yield over three observations for the 2006-07, 2009-10 and 2014-15 financial years (blue line), compared to the RBA average term deposit rate from banks in Australia for a one year term deposit (red line).

keep-an-eye-on-the-income_graph_1

So what do we see here in Chart 1?

On 1 July 2006, the average term deposit rate was 5.40 per cent, compared to the dividend rate on the top 10 stocks of 4.50 per cent.

Yes, the term deposit investor had a higher cash yield, and capital stability, and as it turns out, the term deposit investor didn’t have to face the brunt of the GFC (which commenced in the second half of 2007), but over time, this investor seems to have done much worse than the sharemarket investor investing in the top 10 stocks.

Now, when you go to the mid-point in the chart on 1 July 2009, the sharemarket investor generated a return in the coming 12 months of 4.11 per cent, a little bit down on their starting point of 4.50 per cent, but the term deposit investor was ‘knocked for six’ with the one year term deposit rate down to 3.70 per cent, much lower than the starting point of 5.40 per cent.

So, as a result of the GFC, the sharemarket investor saw their cash income decline by 8.67 per cent (to 4.11 per cent), but the term deposit investor saw their income decline by 31.48 per cent (down to 3.70 per cent) and all of a sudden, was worse off than the sharemarket investor.

But after that, it only gets worse for the term deposit investor.

These 10 big Australian companies started a profit growth recovery after the GFC, and by the time that we got to the end of the 2015 financial year, dividends paid for the sharemarket investor equated to 6.96 per cent of their initial capital invested, whereas the term deposit investor was down to a very tiny 2.60 per cent per annum.

Putting some figures around that, let’s assume investor A invests in the top 10 stocks on 1 July 2006, and investor B puts their money in term deposits, in each case, with $1 million invested at the outset. (Refer to Table 2.)

Table 2

keep-an-eye-on-the-income-table-2

You probably won’t be surprised, but there are a lot of Investor A and Investor B type clients out there. Occasionally, we see some investors with the vast majority of their wealth invested in Australian shares, and at other times, we will see an investor with a vast majority of their wealth invested in cash and term deposits, and the differences in their results over the last nine years is just astonishing.

For the last financial year, Investor A generated an income of $69,600 (and if you added franking credits, it would make the figure in excess of $80,000), whereas the term deposit investor ended up with only $26,000.

But look at the capital value at the end of June 2015. Investor A has a portfolio worth $1,454,700 and the term deposit investor still has their original capital of $1,000,000, which naturally, in present day terms, has less buying power.

There is absolutely no question that Investor A, investing in the Top 10 stocks on the Australian sharemarket nine years ago, is in a far superior position. Investor A has virtually three times as much income coming in each year, and a portfolio value that has increased by more than 45 per cent, whereas the term deposit investor still only has their original capital.

Yes, of course, the sharemarket investor had to go through a lot of pain during the GFC, with share prices tumbling in some cases by more than 50 per cent, but in June 2015, eight of the 10 stocks were worth more than they were worth nine years ago, and in some cases, substantially more.

Over the nine year period, the sharemarket investor has enjoyed average capital growth of 4.25 per cent per annum (excluding dividends paid), the current dividend yield on his portfolio was 6.96 per cent, and in fact, average dividend growth from the first financial year to the last financial year has averaged 5.40 per cent per annum, with three of the stocks having more than doubled their dividend payouts over the last nine years.

So what about the next 10 years?

Investor A, investing in the top 10 stocks, has capped off a year with a yield of 6.96 per cent. That’s the actual cash yield this investor received on their outlay on 1 July 2006.

As at 30 June 2015, the average dividend yield across the Australian sharemarket was 4.7 per cent, actually quite similar to the starting yield of the top 10 stocks back in the 2006-07 financial year. Over the eight financial year periods from 2006-07 to 2014-15, dividend growth was 5.40 per cent per annum (which is actually below the long-term average of nearly 7 per cent per annum), and we don’t think that things will be too much different over the next 10 years.

We expect good quality Australian companies to continue to increase their profitability and dividend payments, and it would be no surprise to us to see a repeat of the last nine years, certainly up and down market volatility, but probably a good solid growth in dividend yields in the years to come.

But the poor term deposit investor has a starting yield at about 2.60 per cent per annum, and not likely to get any better in the next two or three years, and virtually no chance of catching up to the yield generated by the sharemarket investor over the next 10 years. Plus, the term deposit investor is stuck with his initial capital of $1 million, which maintains its face value, but naturally loses its purchasing power as the years go by.

In conclusion

Since 2007, we’ve suffered the second largest market downturn in the last 100 years, but an Australian sharemarket investor investing in good quality Australian companies is doing far better than a conservative term deposit investor.

Now, we’re not for one moment suggesting that you should cash in all of your term deposits and invest 100 per cent of your wealth into Australian shares, we’re just comparing what has happened with Australian sharemarket investments and term deposits over the last nine years, and we haven’t even considered other asset classes such as international shares, property trusts and so forth.

There will be more volatility in the years ahead (there always is), and some investors will feel uncomfortable, but you’ve got to focus on the long-term and the income generated from your portfolio, not the day-to-day movements.

Most inexperienced investors miss, or don’t understand, a couple of very significant differences between sharemarket dividends and term deposit interest. These are:

  • The Australian economy is getting larger. Many companies within our economy are also getting larger and becoming more profitable and paying bigger dividends, and their share prices are going up.
  • Many investors don’t understand the benefit of franking credits on Australian shares. In Table 1, we show the cash yield for the sharemarket investor in the 2014-15 financial year at 6.96 per cent, but when you add franking credits to that, the actual cash yield would be well in excess of 8 per cent.
  • A term deposit investor getting, say, 2.6 per cent on their term deposit, thinks that they are making a 2.6 per cent return. But they forget that the spending power of their capital base of $1 million is diminished by the effects of inflation, so in effect, interest paid is only offsetting the capital loss through reduced spending power.
  • The Australian economy has a long-term record of growing the size of its economy at about 3 per cent above the rate of inflation (or nominal growth between 5 per cent and 6 per cent per annum), and the large companies operating within that economy should be growing at the same rate (some more, some less), and hence growing their turnover, profitability and dividends paid.
  • When you invest in a term deposit, there is no growth factor involved, you’re simply lending your money to an institution (such as a bank) for a fixed rate of return, realising that the spending power of your capital invested is being diminished by the rate of inflation.

 

Footnotes

  1. Adjusted for South 32 demerger.
  2. Adjusted for corporate action/share split in August 2007.
  3. Adjusted for corporate action – December 2012.
  4. Franking credits not included – just the cash dividend.
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