If you sit down with a financial advisor, the first thing they will tell you is that your age will be a huge deciding factor on your investment strategy. When you are young, you have most of your working life in front of you, which means you can take more risks as you have more earning years left.
When you are older and are approaching the end of your working life, you will live off your savings, not your earnings. Ideally, your savings will be invested in securities that yield annual income (such as dividends or interest payments) enough for you to live on.
Australia has one of the highest levels of retirement savings in the world, so the demand for income is strong. It is also why our tax system is so supportive of dividends (the sum of money paid out regularly by a company to its shareholders out of its profit). Allowing dividend receivers a tax deduction (or refund) on the corporate profits already paid on these profits, that have been paid out by the company.
The importance of dividend yield
Many portfolios are designed to maximise income. Which is achieved by finding not just the biggest dividend payers in the market, but those with the highest dividend yield. The dividend yield is the annual dividend received as a percentage of initial investment.
As formula, this looks like:
Dividend yield = annual dividend received / share price
For example, if XYZ Company is paying a $0.05/share dividend and you bought shares at $1.00 you have a 5% dividend yield. In general terms, a 5% yield is quite good, especially in today’s extremely low interest rate environment. Where term deposits from the big banks are yielding significantly less than 1%.
It’s important to note, that the yield you receive is dependent on the price you pay when you invest. Even if the share price moves – and it will – the yield you receive is locked in. This can be a problem if you invest in a company with a very attractive yield, but is a poor quality business.
Another example, you bought shares at $1.00 in the company above and you receive your $0.05 in dividends for the year. But after a year the share price has moved to $0.91. What is your total return for the year? You’ve earnt $0.05 in dividends but lost $0.09 in capital, so you have made a net loss of $0.04.
That loss is technically only realised if you sell at that point. If the price recovers there is no problem, but you have to be confident that it will. It also demonstrates how important investing in good businesses is when investing for income. You need to be confident that not only are you getting a good cash return every year, but that your capital is also safe.
Telstra’s dividend over time
Telstra is a good example that demonstrates the point even further. One of Australia’s largest, most mature companies, retirees, and super funds flock to Telstra because of their attractive dividend yield. In May 2015, Telstra shares were selling for $6.22 and received a dividend of $0.31 for a dividend yield of 4.9% – quite acceptable. To put some real numbers around it, if you bought 10,000 shares you owned $62,200 in shares and received a dividend of $3,100 in the next 12 months.
Typically, retirees are long term investors and they tend to buy shares to hold and continue receiving dividends. However, fast forward to 15 January 2021 and the share price has halved to $3.09 and the company is expected to pay $0.16 in dividends. This is a 5.3% yield, still quite acceptable, in fact it is marginally higher than in May 2015.
However, if you are still holding your 10,000 shares, your portfolio is now worth $30,900 and your dividend is $1,600.
You are now yielding 2.6% per year on your initial investment and you have wiped out half your capital.
The 10-year chart below, shows the Telstra share price (blue line, right hand side) and the dividend yield as a % (green line, left hand side). The graph shows the dividends per share that Telstra paid out. Notice how the dividend yield, for the most part, stayed within a band of 5-7%, but when the dividends declined, so did the share price.
Fair enough, this is a cherry picked example and hindsight is 20/20. Telstra hasn’t been a great business for a long time, in 2015 the NBN began its roll out, which meant Telstra’s monopoly on its Australia-wide network of copper wiring was about to become obsolete. Sure, Telstra have been compensated for this, but the long term damage has been done.
The power of a growing dividend
What happens when the opposite occurs?
This can be a powerful earnings driver for your portfolio in the long term.
Here is an example, our XYZ company from above, but instead of the share price dropping to $0.91, it increases to $1.09. Your capital has increased by 9% and you received a 5% dividend for a total return of 14%. That’s fantastic.
But, look what happens over time. Let’s say over 10 years you don’t buy or sell a single share. The company grows 10% per year and the dividend yield remains at 5% (just like it did with Telstra). By year 10 the dividend you received is now yielding 13% of your initial investment (see the bottom row of the table). This means if you have $10,000 invested, in 10 years your annual dividend will be around $1,300 (second row from the bottom).
Fortescue’s dividend over time
That’s obviously all theoretical and real life is never as tidy as that so let’s pick another example, Fortescue Metals Group (ASX:FMG). They have been on a monster run lately based on growing production and a strong iron ore price after bottoming out early 2016. In May 2015, (same date as our Telstra example), Fortescue was trading at $2.26 per share and being at the bottom of the cycle had seen its dividend decline to $0.05 per share for the year, a yield of 2.2%, which is quite low. (It should be noted that at this stage of their lifecycle FMG was not paying out all of their free cash flow as dividends as this was a time of heavy investment for the company, whereas Telstra would have been much closer to paying out all of their cash as it came in.)
Fast forward to 15 January 2021 and the share price is now $24.76. The dividend has also grown to $1.76 for the 2020 year resulting in significantly higher profits and a much higher profit payout ratio. The net result is a current dividend yield of 7.7%. That Fortescue remains on a low price/earnings ratio certainly helps keep the yield in check. Here’s the same chart for Fortescue.
Let’s say, you bought shares at $2.26 in May 2015. not only has your capital grown 10-fold in 5 years, but you are also receiving a huge dividend on your initial investment. Your initial investment is now yielding a whopping 79% based on the $1.76 most recently received.
Let’s put some numbers around this as well.
If you had bought 10,000 shares in 2015, your holding at purchase would have been $22,600. In 2016 you were paid $1,500 in dividends (at $0.15 per share). In 2020 you would have been paid $17,600 just in dividends. This is before you factor in that your holding is now worth $228,100.
Another example, to demonstrate how powerful a growing dividend can be. It is also worth noting that buying Fortescue in 2015 – in the depths of the commodity bust – would have been very brave too. I am also not patting ourselves on the back, as we only invested in Fortescue earlier this year.
What’s the point of all this?
It’s all well and good to talk about what could have happened if this and that happened. To bring the conversation full circle, we want to find the companies that will be big dividend payers in the future. We want to buy a stock at $2.26 and one day in the future be paid 79% of this back every year.
The companies Oracle are seeking may not be the biggest 20 stocks on the market today. But, they might be in 10 years. The analysis to find these companies is essentially the same process as finding a good growing business, because a good growing business should – in theory – grow its earnings each year (thereby increasing in valuation and share price), and grow its dividend in time (thereby increasing income paid each year).