Dividends as a Low Risk Investment Strategy

Let's say the house next door is for sale at a low price because your neighbour got into trouble with equity margin loans. You hear of a potential tenant with good references willing to pay rent on the property, providing a cash yield of 9-10% pa. If you had sufficient cash, would you consider buying the house and living off the income?

How would you feel if you purchased the house without finance, and then six months later house prices fell in your area? Yes, this would be unsettling, but would it really impact your long-term wealth?

Realistically, you may not be too troubled, as the only price that matters is the one you settle on when you actually sell and receive the cash. You would be happy getting an annual cash income of 9% from the property and accept there is a cycle; property prices go up and down. You know property prices today are significantly higher than 20 years ago, and so you could just sit out any financial storm and sell at a later date for a higher price. You know you will make a good return on a 5-10 year view - high annual income plus capital gain.

However, the moral of the story is that right now, it is easier to find good stocks paying an attractive annual cash return and offering long-term capital gain, than to find good tenants paying a 9% plus yield.

This is my third article for the newsletter this year. In early February I warned: "The banking world is now de-gearing and when many entities go to roll over their loans it will not happen. Assets will have to be sold but as credit will be limited or at best significantly more expensive, asset prices will have to be slashed to reduce or repay these loans. In my view, there is unlikely to be an orderly market in such an environment, with ongoing shocks and scandals emerging." Now, in November 2008, I still hold this view. I would be surprised if we are much more than 50% through the clean-up process.

In the July note I stated: "No one can forecast short-term movements in the market and indefinitely get it correct. The short-term is not a matter of calculable trends, but a chaos, subject to the emotions of the moment, in which almost anything is possible.

"The lowest risk method of investing is to buy excellent companies at attractive prices and be prepared to take a five-year view. It is impossible to predict the exact timing, but the odds are great that sometime in any five-year period the market will either fairly value, or even overvalue, a stock."

My first stock market investment was in the bear market of 1974 and it has often surprised me how quickly the market can turn. There is no magic formula for predicting this - it often happens when least expected. What's more, I suspect there is more pain to come and it is disheartening to buy and then see prices significantly cheaper a couple of months later.

What is an investor to do? I refer again to my July note: "The one certainty is that the stock market will go up over the longer-term, no matter when you buy. Of course we would all love to buy on the dips to maximise returns, but even those people who bought the market on its high multiple prior to the crash in October 1987 are ahead, despite our market falling around 44% in 1987, 19% in 1990 and 15% in 2002/3."

The ASX Accumulation Index is currently down 38% from its peak in October, 2007. If you purchased the market at the worst time possible (September 1987) you would be up 310%, which works out at a return of 7.3% pa over almost 21 years. CPI over this period averaged 3.4%. This is an acceptable return for the market average, which includes both good and bad companies. Investors who purchased only good companies in 1987 will have achieved significantly better than a 310% return.

It would be great to be able to pick the bottom but this is not the key skill to investing. Warren Buffett has proven that stock selection is far more important than market timing. Buffett and Charlie Munger are not just good at picking winners, they are also skilled at avoiding mistakes.

A key skill to successful investing is assessing RISK/REWARD. Strangely, many stock market participants over the past couple of years have taken high risks, buying mega-leveraged stocks such as Allco, for negative reward. The smart strategy is to do the opposite - low risk/good reward.

Let us start with cash. A government guaranteed deposit with one of Australia's trading banks offers an interest reward for a low risk. That reward has declined over the past couple of months, with the Reserve Bank cutting official rates. With the decline in commodity prices, increasing unemployment and consumer nervousness, inflation is likely to fall from its current level of 4.7%. This, in turn, may encourage the Reserve Bank to cut interest rates further to stimulate the economy.

With 90-day bank bills at 4.3% and falling, is it possible for investors to achieve a higher return than cash for an acceptable risk? Another way of addressing the issue is to ask: "What is an acceptable return and what risk do I have to take?" Global liquidity, global consumer growth and high stock market returns during the period 2002 to 2007 were significantly assisted by the huge growth in cheap debt. Now we have seen a substantial shift, and over the next five years the ASX index is unlikely to increase per annum by more than the 10-year bond rate plus a premium for risk, which is likely to be in the 4-6% range. This means investors in general should be comfortable with annual returns of 8-10% from the stock market.

It is interesting to note that if you gross up fully franked dividends for a number of companies, you can achieve this targeted pre-tax 8-10% return solely from this source. To gross up a fully franked dividend you multiply the cash payment by 1.43, enabling a comparison to the return against interest rates on a pre-tax basis. If you can seek out companies that are unlikely to reduce dividends, and whose share price in five years time is expected to be at least the same as today, then you are looking at a good risk/reward relationship. If the share price ends up being higher in five years' time you will make super returns. To repeat an earlier point - history has shown that over the longer-term the share price of good companies does go up no matter when you buy. You may make a theoretical short-term capital loss but this need not matter if you do not have to sell the shares, and are prepared to sit on the investment for five years. You would still earn an annual 8-10% pre-tax CASH return during this period.

Equities are never a risk-free investment. However, the following checklist should assist in finding companies at the lower-end of the risk scale.

• Company must sell a product or service that customers will want or need in the foreseeable future.

• The underlying business must be transparent - if you do not truly understand how the company makes money, do not invest in it. Do not invest in black-box smoke and mirrors companies.

• Management has a good track record.

• Do not rely on promises. If the company is not already achieving, do not invest.

• Business must produce strong, reliable cash flow to service dividends.

• Company should have a five-year dividend track record and the dividend payment must never have been reduced during that period.

• Average dividend pay-out ratio (dividend/EPS) to be no higher than 80% over a three-year period (no more than 60% for a capital-intensive business). Most businesses need to retain some earnings to pay for capex and/or working capital growth (either expansionary or to cover inflation) and unexpected contingencies. A constant high dividend pay-out ratio increases the risk of a capital raising, which will either cause you a cash outflow or dilution. Special dividends paid solely out of the proceeds of an asset sale should be excluded from the calculation.

• Gearing of no more than 60% (debt/equity) and interest cover of at least 3.5 times.

• Historic and future expected return on equity of at least 10%.

• The expected average annual EPS growth rate over the next five years divided by the price earnings ratio should not be less than 0.6. This is the PEG ratio.

• The expected average annual EPS growth over the next five years plus projected dividend yield divided by the price earnings ratio should not be less than 1. It is a ratio that the respected veteran US fund manager John Neff called the "total return ratio".

There will be a number of good companies that do not meet some of the above guidelines, and indeed some will out-perform, but our objective is to achieve a low-risk outcome. You may ignore some of the guidelines but your risk will increase. Stick to the golden rules of investing and keep the faith.

Reproduced with the permission of Huntleys' Your Money Weekly Newsletter: http://ww.huntleys.com.au

Written by Tony Young, a former head of research at Credit Suisse First Boston. Tony is now a consultant to Morningstar. The views expressed in this note are not necessarily shared by Morningstar. Huntleys' Your Money Weekly is Australia's leading independent weekly newsletter providing analysis and recommendations for Blue Chips and Second Liners. Published 48 times annually.

Important Information

The above information provides an overview or summary only and it shouldn’t be considered a comprehensive statement on any matter or relied upon as such. The above information doesn’t take into account your personal objectives, financial situation or needs. It’s important for you to consider these matters before making any financial decision and I recommend you seek help from a financial adviser.