FYI | Nov 05 2019
By Peter Switzer, Switzer Report
My colleague Paul (Rickard) has been trying to hose my hopes for potential returns from investing in dividends, as we learn to live in an unbelievably low interest rate environment. I know a lot of my subscribers would like a safe 5% term deposit so they can sleep easily at night but when we could get 5% at the bank, inflation was near 3%, so we were only really getting a 2% real return!
This chart shows the real rate is usually around 2-3%.
Undoubtedly, the real interest rate is terrible, with term deposits lucky to be 2%, while the latest inflation rate is 1.7%. So the real rate is just a tick over zero!
This is why dividend-oriented funds like my SWTZ and Vanguard's VHY and Beta Shares' HVST and others seeking good income returns have attracted attention in recent years.
I often make the point to my financial planning clients that as we get worried about the stock market, we will transfer into a more dividend-oriented portfolio of assets and try to maximise the franking credits' payoff as well.
Looking at history, I thought a 4.5% to 5% dividend return with franking could deliver around a 6% to 7% return. Given where inflation is at 1.7%, that's a pretty good return. Throw in a bit of capital gain and that should be the basis of a good fund, which has an in-built, reliable income flow each year.
However, my colleague Paul Rickard penned a piece for Switzer Daily telling us that many of our favourite dividend-paying stocks were likely to be less rewarding in the future.
Paul pointed out that very low interest rates go with low economic activity and therefore lower-than-wanted profits and less fast rising share prices. This has an effect on dividends. He also pointed out that as share prices rise and say dividends don't change, the new yield falls.
Here's the table he produced to give us the heads up on changing dividends. We all too often use an historical dividend to work out what we can expect but the forecasted dividend should be closer to the mark. To date, we do know that the likes of ANZ are not cutting their dividend but are pushing their franking credits down from 100% to 70%, which would be a real bummer if other banks followed suit. That said, no other bank is expected to do so.
So armed with Paul's table and a bit of help from my own research, I went looking for 10 reliable income-payers, with or without franking, to see if I could get 6-7% in a challenging interest rate world.
I've included the rough franking effect and these 10 stocks could deliver around 7%, if you invested in them evenly. But you must understand the risks you're taking, so let me list them.
- First, you'd have a big concentrated risk investing heavily in the banks that face regulatory witch hunts, fintech profit-takers, predictions of an explosion of non-bank lenders, banks that have reduced their money-making activities since the Royal Commission and shrinking interest rates, which are also bad for their bottom lines. It means dividends could be trimmed if rates keep falling and say a global recession shows up.
- BHP and RIO are huge helpers to that 7% return and history has shown that you buy miners for growth and not dividends. So this recent run of great dividends can't be expected to last forever. And when they cut, they can be vicious.
- If a global recession threatens, many of these dividends could be cut or trimmed so a 7% return today could shrink to 4%. But that would be my "worst case" scenario guess.
- I'd prefer 20 stocks in my fund and it's why SWTZ has 30 or so.
I also showed what the FNArena [database of leading] analysts expect in terms of capital gain or loss but these could be a lot higher if a good trade deal excites the market. The banks and the miners, along with the energy play in Woodside, would all be beneficiaries of a boosting to the global outlook for growth, as a consequence of a better-than-expected trade deal.
In a perfect world, you should've been building up a buffer account fed by those years when your overall returns topped what you need to preserve your capital.
For example, let's say you have $1 million in your fund and you want 8% because you're not afraid of being pro-growth and you want $70,000 a year to live on. When you make 13%, you should siphon off 5% into a buffer until that account is say $100,000 plus, which then is used when your portfolio fails to deliver the income you want.
In the old days, a term deposit was an OK place to put this buffer money. But times have changed, though the validity of stock-buying for dividends hasn't. You simply have a tougher market to make money in so you need to do your homework.
Our upcoming income conference will point out that there are alternatives to dividends, as well as term deposits. And while low interest rates are frustrating, it could actually make you be a better investor.
Sure, you have to give up the safety of term deposits but as your own fund manager, that's the job you've taken on. So it's time to lift your game. I hope we can help you do exactly that!
Next week I'll try to find another 10 dividend-payers that might be rewarding, even in a recession and market crash.
PS: Westpac's 16% fall in profit to $6.78 billion has resulted in a $2.5 billion capital raising and a cut in the final dividend to 80 cents per share.
The final dividend came in at $1.74 so next year it could be as low as $1.60, which would still bring in my average dividend yield at around 7%. But this breaking news proves the point of Paul's and my story that we should expect lower yields. And imagine if Bill Shorten had have got his way!
Peter Switzer is the founder and publisher of the Switzer Super Report, a newsletter and website that offers advice, information and education to help you grow your DIY super.
Content included in this article is not by association the view of FNArena (see our disclaimer).
Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual's objectives, financial situation and needs and, if necessary, seek appropriate professional advice.
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