MoneyMorning Special Report

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1 MoneyMorning Special Report Why Dividend Stocks Are The Key To Retirement Wealth And How To Supercharge Your Dividend Income Now Nickolai Hubble

2 Money Morning - Special Report Why Dividend Stocks Are The Key To Retirement Wealth And How To Supercharge Your Dividend Income Now The Aussie share market has been a brutal place for investors over the last five years. It s getting a lot harder to get rich quickly. But this doesn t mean you can t make money from shares. Quite the opposite. In this report I ll show you that you CAN make money in a flat or down market. Mind you there is always the risk that shares can do down. But did you know that studies show dividends account for the majority of profits from stocks? Dividends are a tried and true way to make income from your investments even if stock prices don t rise quickly or at all. In this report I ll show the power of investments that pay dividends. I ll also introduce you to 12 dividend paying shares which you might find interesting. And then I ll reveal the most powerful way to invest in dividend shares for exponentially growing returns. But why focus on income investing? Imagine having enough income in your retirement that you don t have to sell your investments. Imagine not having to worry about the market prices of the assets you rely on to enjoy life. Imagine a situation where the income from your investments exceeds the costs of your lifestyle. Income investors call that situation living beyond the crossover point. The crossover point is where your income from investments equals your living expenses. Source: Your Money or Your Life Theoretically, living on the crossover point means you won t ever have to sell the investments that are providing you with the income you need. But it s obviously preferable to continue growing your wealth, even in retirement. You want to live beyond the crossover point where your income from investments are greater than your living expenses. And dividends are the best way to achieve that. 2

3 Why Dividend Stocks Are The Key To Retirement Wealth Why Dividends? Companies exist to generate cash for their owners. That s why they make things to earn a profit. That s their purpose, from the investor s point of view. Small business owners understand this because they have to live off the income their business generates. But most stock market investors completely forget this basic truth somewhere between picking up the phone to call their stock broker and hanging up. They get led astray by stories of takeovers, striking oil, or the infamous ten bagger. That s a stock that goes up 1000%. And they are infamous for a reason. Unless you are very skilled, astute and dedicated, those kinds of gains are nigh impossible to eke out. More to the point, the odds are not on your side. With income investing, there is less wishful thinking. The expected returns are realistic and the probabilities are firmly in your favour. And that leads to much better results. But don t take my word for it. Consider what some of the world s greatest investors think of dividends: Do you know the only thing in life that gives me pleasure? It s to see my dividends coming in. - John D Rockefeller, once the world s richest man and its first billionaire. Dividends accounted for 99.76% of Warren Buffet s estimated personal 2009 income. And his investment holding company, Berkshire Hathaway, holds 27 dividend payers out of its 33 shares. Professor Jeremy Siegel, author of Stocks for the Long Run, calls dividend-paying stocks bear market protectors. It s not just professor Siegel who s noticed dividend paying shares bear market benefits. Historically, mature dividend paying companies have tended to experience far less dramatic share price falls in bear markets than smaller growth companies, and therefore tend to be a popular choice when markets are not performing well. - TD Waterhouse Paper, Dividends Dissected But why risk your capital in the stock market when term deposits are paying out a much safer type of income interest? Income for All Seasons Dividends should be the focus of the majority of your stock market investments, even in high interest rate environments. Eagle Assets investigated this claim and reported that dividendpayers have been shown to outperform non-payers across a range of interest rate environments. One of the reasons is that dividends grow. If you invest in a share that costs you $10, which pays a 60 cent dividend, that s a 6% dividend yield. Not bad compared to a term deposit. But over time, that dividend can grow, while the interest rate on a term deposit remains put. The company might raise its dividend to 90 cents, giving you a 9% yield on your initial investment. If you invest in companies that grow their dividends, over the course of several years, you could easily begin earning vast yields. Take for example ASX listed company Blackmores (BKL). If you had bought the stock at $6 in 2003, it would have been yielding about 5%. Based on last year s dividend, the yield on your initial investment would be more than 21% - and that s before reinvesting any dividends during the previous seven years. 3

4 Money Morning - Special Report Blackmores Dividend Growth Source: Sharedividends.com.au Because dividends can grow over time in virtually any market, they are clearly one of the strategies you should look at using. But how? I d like to introduce you to twelve ASX listed investment opportunities that meet the basic criteria of good dividend stocks: 1. Stability 2. Dividend growth 3. Dividend yield There are plenty more criteria you need to be aware of when choosing which shares are right for you personally. The following twelve shares are not recommendations. But I want to show you that once you start looking, you ll see there are plenty of dividend-paying stocks to choose from in the Australian market. I ve identified four basic types of dividend paying shares. They are: 1. Cash cows safe companies with a high yield 2. Performers companies that have grown their dividends and look to continue doing so 3. Investment companies companies that specialise in investing 4. ETFs Exchange Traded Funds You can and should consult with your financial advisor about the benefits and risks of each type of investment. Some may be more suitable than others and some may not be suitable for your needs at all. That s another reason these shares aren t recommendations. I ve outlined some of the advantages and disadvantages of each type of share are, and some of the basic information you need to know about each individual share below. As share prices vary each day, the dividend yield is not included in the summary of each share. But each one mentioned featured a yield between 6% and 12% at time of writing. Cash Cows These companies are the basic blue chip dividend payers. They are intended to be boring, straight forward, and suitable to most portfolios, but don t expect anything special. 4

5 Why Dividend Stocks Are The Key To Retirement Wealth Metcash (MTS) Metcash encompasses a wide range of household names including IGA, Cellarbrations, and Mitre 10. The dividend has grown a spectacular amount at a steady rate. Telstra (TLS) Telstra is also a household name. The telecommunications company has been on a steady upwards trend. It seems that the dividend yield has created demand for the share. As you can tell by the chart below, Telstra has a remarkable history of paying out stable dividends. 5

6 Money Morning - Special Report SP Ausnet (SPN) SP Ausnet is an electricity and gas distribution company, and the story is much the same as with Telstra, although the company doesn t have quite as remarkable a history of stable dividends. Utilities are often good dividend bets, but they don t often come with dividend yields like SP Ausnet s. 6

7 Why Dividend Stocks Are The Key To Retirement Wealth Performers These stocks are riskier than the cash cows, but also offer more opportunity for dividend growth. Tatts Group (TTS) Tatts Group is a large gambling and lottery company. It has seen gradual but consistent dividend growth. Beyond International (BYI) Beyond is the producer of television programs around the world including Mythbusters and Hot Property. It is a volatile stock with a debt load that may become a concern, but dividend growth has been good and the volatility may end up being an opportunity for income investors to pick up a great starting yield as well. 7

8 Money Morning - Special Report Blackmores (BKL) Blackmores is a health supplement producer. It does not yield more than 6% like the other shares in this report, but its impressive dividend growth makes it an excellent contender. 8

9 Why Dividend Stocks Are The Key To Retirement Wealth Investment Companies There are several ASX listed investment companies which pay significant dividends from their diverse holdings. If you would like to diversify your investments without the cost of purchasing a variety of shares, and would like to access the specialised skills of fund managers, these might be for you. Australian Leaders Fund (ALF) ALF invests in Australian listed companies based on their valuation. We value a business as if intending to buy the company in its entirety. The fund managers then proceed to buy undervalued shares and short sell overvalued ones. Australian Ethical Investment (AEF) AEF invests in ethical projects around the world that are supportive of the environment and community. Renewable energy and recycling are just two examples from an extremely diverse list of projects located around the world. Don t let the ethical focus make you think the fund isn t a high yielding dividend opportunity with steady dividend growth behind it. 9

10 Money Morning - Special Report Hastings High Yield Fund (HHY) If you would like to gain access to the world of debt securities, the Hastings High Yield Fund is a straight forward way to do so. It pays out quarterly distributions from interest income and capital gains. Exchange Traded Funds If you would like to diversify your holdings into a collection of Australian dividend stocks, but don t trust fund managers to act in your best interest at an acceptable fee, here are three dividend share ETFs. Each of them seeks to track the performance of a different dividend share index, meaning the ETF effectively recreates the performance of a portfolio of the shares in that index. All three are fairly new and only slightly different. The following quotes describing their investment objectives are taken from marketing material distributed by the ETFs. 10

11 Why Dividend Stocks Are The Key To Retirement Wealth IHD The S&P/ASX Dividend Opportunities Index is comprised of 50 tradable, Australian exchangelisted common stocks that offer high dividend yields. Capping of individual stock weights at 4% and a maximum sector weight of 20% ensures a broad, diversified portfolio. RDV The Russell Australia High Dividend Index is... specifically designed to address Australian investor s needs of generating income and attaining capital growth. It is an equity index that provides an investable portfolio of around 50 large, blue chip Australian companies and has a particular emphasis on dividends. SYI The MSCI Australia Select High Dividend Yield Index is designed to reflect the performance of listed Australian companies with higher than average dividend yield and the potential for franked dividend income. Please note that SYI s methodology allows it to go overweight a certain classification of shares. For example, it was overweight financials based on its November 2010 factsheet. This lack of diversification makes it more risky. 11

12 Money Morning - Special Report To summarise the ETFs, IHD holds a diversified set of high dividend shares, RDV also considers capital gains, and SYI s focus on dividends leads it to be overweight sectors of the market that are paying high dividends. When considering whether these ETFs are suitable for you, it is important to consider their fees and current holdings. How to get the most out of dividend investing Academics agree when it comes to dividends. Study after study has confirmed that dividends are the most important part of investing. But there s a twist. Investment firm Eagle Assets reviewed the literature on dividends and summarised some of their key findings on the topic in November last year. Emphasis added is our own: From 1871 through 2003, 97 percent of the total after-inflation accumulation from stocks came from reinvesting dividends. Only three percent came from capital gains. Many academic studies confirm that reinvesting dividends has been a major source of stock market returns over the long term: anywhere from 40 percent to 70 percent of returns can be traced to dividends. To give an example of the power of reinvesting dividends, $1 invested in the broad S&P index on Jan. 1, 1930, would have grown to $55 by the end of During the same period, with dividends reinvested, that same dollar would have yielded $1,449. And this recent Barclays study found the same conclusion: Dividend income makes up the lion s share of total returns according to the 2011 Barclays Equity Gilt Study. 100 invested in UK equities at the end of 1945 would be worth just 255 in real terms today without the reinvestment of dividend income. With reinvestment, the portfolio would have grown to 4,370 over 17 times more. The Telegraph It wasn t the dividends themselves that provided the superior returns, but reinvesting those dividends. That s because reinvested dividends add the power of compounding and enhanced capital gains to your portfolio. It s best to show this using an example. But first, let s look at why DRPs are the secret to reinvesting dividends in an efficient way. The Nuts and Bolts Dividend Reinvestment Policies (DRPs) are essentially automatic reinvestment of your dividends into shares. Rather than receiving cash dividends, you receive shares. You might have heard about DRPs, but not many people realise just how powerful they are. So here s an example to convince you. This is based on an actual stock, its actual DRP discount and its actual dividend. Price: $10 Dividend: 50 cents per year ($0.25 per half yearly payment) DRP Discount: 7.5% The way a DRP discount works is that it increases the amount of shares you receive to more than what you would have received if you had reinvested the cash dividend yourself. In this example, a holding of 1,000 shares would mean a dividend of $250. If you reinvest that cash yourself, that s 25 shares at $10. But if you sign up to the DRP, you would receive 27 shares because of the DRP s discount that s 2 bonus shares, or $20 worth of shares pulled out of a hat. 12

13 Why Dividend Stocks Are The Key To Retirement Wealth In addition, under a DRP you almost always don t have to pay your broker commissions or fees saving you about $30. Now, on to what Einstein missed when he pointed out the powers of compound interest dividend growth. The company on which the example is based has grown its dividends an average of 20% per year over the last fifteen years. If it continues to raise its dividend in the way it has been in the last 15 years for the next 15 years, your dividend yield on your initial investment in 15 years time would be close to 2,000% every half-yearly dividend payment or 4,000% per year if you signed up to the DRP. That means turning a $10,000 investment into a four hundred thousand dollar per year income stream truly a supercharged investment. Now that I have your attention, let s look at some more conservative assumptions. Let s say the company manages to grow its dividends at 10% a year, that s half the rate it has been growing it. After fifteen years, you would be earning a dividend yield on your initial investment of 100% per year. If you had invested $10,000, you would be receiving $10,000 a year in the form of two dividend cheques. In other words, using this strategy means a little patience is rewarded with a lot of cash. If 15 years sounds like a long time to own a share, it is. At least, it is according to your broker, who earns money each time you buy and sell. I think you should hold your shares for much longer than 15 years. Several times longer. As Warren Buffet says, our favourite holding period is forever. Why? Because owning a business that pays out its profits means you don t have to sell to get the gains. It s an income stream as well as an asset. Why would you want to sell an income stream in your retirement and in an environment where capital gains are hard to come by? Considering the remarkable returns you are getting on your initial investment each year, it is usually better to stick with the investment, unless it is set to perform very poorly. So how does the DRP strategy work? What makes it so powerful? First of all, the example above is an optimal example. But stocks even better than this do exist. Secondly, it s all about the power of compounding. Because you reinvest dividends for additional shares at a discount to the market price, the next time dividends are paid you receive dividends on your dividends. Eventually, your holdings will suddenly explode upwards. The key is getting to that point the tipping point. Whenever you decide to, you can elect to begin receiving the cash dividend from your vastly larger holding of shares. This makes DRPs the perfect investment strategy for preparing for retirement. You steadily build up a holding in a dividend paying stock at a discount, and then cash in on the bigger dividends when you decide you want the income stream. Because that money will come to you in the form of dividend income and not capital gains, it won t diminish over time. You won t be selling anything, just getting paid by the cash generating business that you own a part of. What s the catch? So, those are the benefits. I think you ll agree they are impressive. But what s the downside the risk? To be honest, there are plenty of risks. But not all of them are bad. For example, the price of the stock you are buying could drop, just as it could go up. That would detract or add to your gains as it would without any DRP. Only once you sell the stock, of course. But DRPs have a little delightful twist to them when it comes to falling stock prices. You see, if 13

14 Money Morning - Special Report the price of a stock falls, your dividends will be reinvested at a lower price. So if the dividend remains stable, you ll get even more shares than you would have at the higher price. A quick example might look like this: If the price of our $10 stock above goes to $9, but the dividend and DRP discount remain the same, you will get 60 shares instead of just 54 in the first year. In terms of investment strategy, this means you have to select your stocks carefully to avoid ones that might never recover from short term problems the really bad eggs. Any stocks that fall, but eventually recover, will see you steadily picking up their shares on the cheap if you sign up for the DRP. This is the perfect strategy for a bear market if you don t pretend to know when it will end, or aren t willing to bet on it. When it does end, the DRP will mean you have been steadily acquiring shares as prices bottomed out. Now on to some of the bad kinds of risks. First of all, the example we ve been using is optimistic, but still realistic. It is based on a real company which offers a high 7.5% discount on its DRP, but has volatile dividends and has recently suspended its DRP. This illustrates two risks DRP investors face. Firstly, DRPs can be suspended by the board of a company entirely at their whim. And the same goes for the discount applied to the DRP issued shares. The discount can be adjusted up, down or to 0. All at the discretion of the board. This might sound like quite a risk, but consider two things. All this is true of dividends generally. The board can choose to increase, decrease, or stop paying them, too. Different boards follow different strategies with their dividend policy. Some try hard to maintain a constant dividend. Some pay out an amount based on profits, as is the case with the company our example is based on. These kinds of factors are just another thing to consider when you are selecting which company makes the best investment for your purposes. (By the way, investing in a company solely for its DRP is a big mistake. I m trying to tell you about the added benefits of signing up to the DRP of a good company.) The second thing to remember regarding the risk of a DRP being changed is that, if the DRP gets suspended, you are still left owning the shares of a good company and collecting its dividend. In fact, this is what would have happened to you in 2010 if you had bought the stock our example is based on. And that stock is performing extremely well since, as well as paying out impressive and increasing dividends. So the risk of DRPs being amended or suspended just means you have to pick your stocks carefully. But you have to do that anyway. The DRP is just an added benefit and a strategy for growing your wealth exponentially without adding a cent to the initial investment. There is one significant problem with DRPs which doesn t have a silver lining. Sadly, tax laws have been changed. According to the Australian Tax office, if you participate in a dividend reinvestment plan you are treated as if you had received a cash dividend and then used the cash to buy additional shares. This compromised one of the major benefits of DRPs. It means you have to pay income tax in the year you receive the new shares on the amount of the dividend. And there is an additional nuisance that the ATO springs on DRP participants when they choose to sell their steadily accumulated shares (if they ever do). Capital gains tax must be calculated separately on each time you receive new shares. That would be each time a dividend is paid, so twice a year for most shares. If you sell your shares after fifteen years, that could mean 31 different CGT calculations in the year you sell them. This is why many financial advisers only recommend DRPs to people who are meticulous record keepers, and who rarely buy and sell shares. 14

15 Why Dividend Stocks Are The Key To Retirement Wealth The tax complications mean the optimal strategy for DRP investing is slightly changed, but still very powerful. It makes sense to hold the shares for a long time to avoid difficult and expensive tax assessments. This is advisable anyway though, as the power of dividends compounding takes time to pay off. Secondly, you have to be mindful of the fact that you are receiving shares, but have to pay your dividend taxes in cash. So now you know the benefits and costs of DRPs. Of course, an investor could just as well choose not to participate in a DRP and just collect the cash dividend. Or to participate only partially in it. That would mean you receive a combination of new shares and cash when dividends are paid. Overall, DRPs are a great way to supercharge a long term investment s returns. So why not consider signing up to the DRPs of some of the shares you already own it usually takes just one page of paperwork. On the final page of this report is a list of DRP offering stocks. Your Subscription to Money Morning In the coming days, your Money Morning subscription will become active. Dividends are something we often write about. But as you ll see, the finance game and investment markets cover so much more, so we do too. We look at the ideas and events of the past to understand the present and sometimes predict the future. There is a whole universe of ideas from history to economics to geopolitics that we explore to make sure we re on the right track. Our goal is to present these ideas to you. They re often unique. Sometimes provocative. But that is the secret to investing. You absolutely must not blindly follow the crowd and must question every assumption. Looking at things differently is how we do this. Make sure to check out our website for the latest articles, commentary and updates on dividends and other stories. Don t ever hesitate to join the conversation. Regards, Nick Hubble Contributing Editor, Money Morning Warning: While useful for detecting patterns the past is not a guide to future performance. The value of any investment, and the income derived from it, can go down as well as up. For any investment, never invest more than you can afford to lose, and keep in mind the ultimate risk is that you can lose whatever you ve invested. While useful for detecting patterns the past is not a guide to future performance. Some figures contained in this report are forecasts and may not be a reliable indicator of future results. All advice is general advice and has not taken into account your personal circumstances. If in doubt of the suitability of an investment please seek independent financial advice. Please download and read our Financial Services Guide Money Morning is published by Port Phillip Publishing Pty Ltd. Registered Office: Port Phillip Publishing Ltd Pty, Level 1, 10 Fitzroy Street, St. Kilda, VIC 3182 Port Phillip Publishing Pty Ltd (ACN: ) (AFS License: ). All content is 2013 Port Phillip Publishing Pty Ltd. All Rights Reserved. [email protected] 15