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Don't invest just for yield: the smarter way to generate income

Bad news hits the weakest the hardest.

Australian investors already endured a rather disappointing latter half of 2019 when companies, including banks and resources companies, announced sizeable cuts to dividends.

It shows not all was well even before the Covid-19 pandemic spread across the globe and forced countries into lockdown.

Facing the reality of massive dividend cuts

Now 2020 is shaping up as the worst year on record in Australia as far as corporate profits and shareholder dividends are concerned, in particular hitting those shareholders hard whose strategy is aimed at receiving sustainable income from the share market.

However, the truth is that many of those investors blissfully ignored the very basic number one rule when making investment decisions (to quote Warren Buffett from a long time ago):

  1. -Rule number one: never lose money
  2. -Rule number two: never forget rule number one

What Buffett tells us all through this seemingly facetious and simplistic two-rule mockery is that successful investing is about ‘managing’ risk, not about ‘taking’ risk or 'ignoring' it.

And many Australian investors and their financial advisers have ignored the risk that comes with investing in high-yielding stocks on the share market for far too long.

Rethink a faulty income strategy

Many now facing serious budgeted income shortfall would not necessarily have realised but buying 5% or 6% yielding equities (forward looking) in the share market pre-corona implies a serious step up on the overall risk ladder.

This is because government bonds, theoretically the ultimate low-risk financial instrument available beyond cash under the mattress, are now yielding so little, financial markets have pulled back all yields across instruments and markets accordingly.

Years ago, I illustrated this process through the diagram below (first published in 2015).

The validity of this general assessment of risk as implied by stock market pricing of securities follows through the observation that most cuts in dividends last year and in 2020 are from the higher-yielding cohort on the ASX. Plus most dividend cuts announced tend to be much larger than for lower yielding equities.

Investors would be wise not to underestimate this process of absorbing the fall-out from the lockdowns and the subsequent economic recession still has a lot longer to run. Dividends will still be absent and cut next year and in some cases maybe even in 2022.

Maybe this is as good as any time to pause and reflect on what went wrong and set out on a better strategy for the future. A faulty income strategy starts with the wrong focus.

Step number one, for all kinds of investors, no matter experience, age or specific strategies, is to look after your capital.

Step number two is to adopt a total return strategy whereby everything is taken into account, including costs, fees and taxes.

Step number three is to incorporate potential income.

Too many investors, panicked by the change in the yield and income landscape post 2012, ignored the natural order for setting up a robust investment portfolio and moved straight to step number three. And many an adviser failed to inform or educate their clients otherwise.

Even prior to last year’s dividend cuts, and this year’s bear market for equities, the failings of strategies with a sole or extreme focus on income 'right now' had already revealed themselves in spades.

Look no further than the fact three of the major four banks’ share prices had lost about one-third of their value since April 2015, prior to sinking near GFC lows in March this year.

Many a stock held for the sole attraction of the dividend has fared a lot worse, including the likes of AMP, G8 Education and, indeed, Telstra.

Focusing on income and not capital is a mistake

Even those investors hiding behind the fact they purchased their initial shares many moons ago at much lower prices still cannot deny that any strategy providing income while the capital base erodes away is not a good strategy.

Especially not when after the fall in capital comes the realisation there will not be a dividend at all this year, or a substantially reduced pay-out.

A much better strategy is one that incorporates the one key element that separates equities from bonds and other income-providing investment products: growth.

Investors should consider there are two ways for creating income from owning shares: one is through dividends, the second is via selling at a higher level than the purchase price.

The best way to combine both key share market characteristics is through adopting a wholistic approach: by constructing a portfolio that combines growth with income and income with growth. The end result should be a strategy that is much more protected against negative developments, including capital erosion, while offering growth of capital and income instead.

A truly superior outcome.

Sounds too good to be true? I’ve done the groundwork over the past five years. I can report from first-hand experience it’s not a theoretical chimera. Get the basics right and you too can grow your capital while enjoying a steady income.

Past research indicated the share market’s sweet spot lies between 4%-4.5% in forward-looking dividend yield (see also the diagram earlier). But because of the significant drop in global bond yields, I believe the optimal point where risk, income, growth and return meet on the ASX is probably now around 3%.

Even with franking credits added on top, 3% won’t be sufficient for most retirees and pensioners. So we have to be smart and add in growth.

Growth adds two key features to our portfolio: share prices for companies that grow to a higher level plus today’s dividend payouts will be higher in the future as well when supported by growth. By combining income with growth, a portfolio that today yields 3% (for the portfolio as a whole) can yield 4%, then 5%, and more as time goes by.

In the meantime, the capital inside the portfolio grows to a higher level and investors can sell a portion each year to make up for the initial shortfall in income from dividends.

In case you are still not 100% convinced, I’ll meet you half-way.

The importance of growth stocks

A simple ETF (exchange-traded fund) that mimics the ASX200 Accumulation Index would have done a better job than owning a large overweight portfolio positions in banks, energy companies and retail REITs (all bought for their high yield) and the like over the years past.

The ASX200 combines CSL with CBA and other financials, BHP, Woodside, JB Hi-Fi, and others (200 stocks in total) for an average dividend yield of circa 4%.

Assuming most investors are aiming for 6% income plus franking, they would have to sell circa 3% initially each year to generate the required income (there are some costs to take into account as well). 

Starting in January 2015, such a basic index-following strategy would have generated the following returns (ex-dividends)

  • 2015: -2.13%
  • 2016: +6.98%
  • 2017: +7.05%
  • 2018: -6.90%
  • 2019: +18.38%

The above returns are ex-costs, but ETFs are low cost. Also, because of the significant underperformance by yield stocks in recent years, the average dividend yield for the ASX200 has actually been closer to 4.5%, which makes the past return from an index ETF even more attractive.

Even without the spectacular outcome in 2019, a simple ETF would have provided a superior total return than your average ill-conceived, dividend-oriented strategy over the past five years.

Because of the heavy overweight positions for the banks, Telstra and other large cap dividend-paying stocks in the index, a carefully constructed portfolio with less exposure to the share market’s weak spots can generate an even better outcome.

We have managed our 'All-Weather Model Portfolio' in accordance with this smart income principle and it has done better than an index ETF over the period, including this year when losses incurred are significantly lower.

Admittedly, constructing a low-risk basket of stocks during a time when dividends are being deferred, reduced or cancelled, and when company profits are expected to fall by most since the GFC is more of a challenge this year. However, I still maintain the outcome from combining growth with dividends will be superior over the years to come.

 

Rudi Filapek-Vandyck is an Editor at the FNArena newsletter. This article has been prepared for educational purposes and is not meant to be a substitute for tailored financial advice. FNArena offers impartial analysis and proprietary tools and insights for self-managing investors. The service can be trialled for free at www.fnarena.com.

 

11 Comments
Jason
May 20, 2020

I remember years ago, I saw an interview of an early investor investing with Warren Buffett. He said his stake was worth about USD800m and he did not have to work. Berkshire Hathaway never paid a dividend, so all he did was to sell a share or two every year to cover his expenses. Ever since then, I have paid no interest in dividends. Give me growth any day.

Bobcat
May 16, 2020

A great article - you and others have consistently warned about the dangers of chasing high dividends which inevitably lead to big capital depreciation traps. Sadly, I suspect most investors won't change their "penny wise, pound foolish" attitude. When NAB, Westpac and ANZ resume payouts, they'll be saying: "But I get a 6% yield with franking" even though the value of their capital has declined 50% (with no dividend to boot).


But sorry Rudi but you refer to Warren Buffett's "Rule number two: never forget rule number one". Did Warren Buffett forget rule number 2 when he sold airlines recently?


 


 

Warren Bird
May 15, 2020

I think the terminology is a sticking point in this argument. Retirees do need income and when they read something saying they don't they tend to dismiss it as unhelpful or not for them.

However, they don't need their income to be one-for-one aligned with the various forms of income that are paid by their investment portfolio (interest, dividends, rent). What they need from their portfolio is cash flow, which once it hits their bank account becomes what they think of as income.

I've had good success persuading investors in our main fund at Uniting Financial, our Ethical Diversified Fund. Quite a few of them - mostly congregations who've invested to generate 'income' to pay for a ministry activity of some kind - have set up their investment so that they reinvest all the distributions, but have a regular redemption that gives them the cash flow they need. In some quarters/years this amount is less than the distribution and so they've already reinvested the surplus; in some periods the cash flow is more than the distribution, so they effectively draw on a little capital.

Doing this is a lot easier when you invest via managed funds where a structure like the one I just mentioned is very easy to set up. I suspect many retirees, who own shares directly, just see it as too much work having to reinvest a little and divest a little to smooth out their cash flows, and regard it as easier to just live with the volatility of the dividends/their income.

However, at times like these, when dividends do what many have wrongly thought was impossible and taken a nosedive, everyone simply has to rethink how they're generating the cash flows they need to fund their lives. Selling down part of your portfolio shouldn't be frowned upon.

Superannuation is a form of the old fashioned 'saving for a rainy day'. There's no rainier day than retirement, when living off savings becomes essential. But saving for a rainy day was never intended to be about creating an untouchable pool of capital and only deriving income from it. The pool of capital itself is part of the backstop you've established. We're not meant to die with all or most of our super intact. We're meant to use the capital to support retired life.

Of course, the fact that the date of our death is unknown and for many well into the future does mean that we shouldn't draw down capital too quickly, and some growth (especially in the early years of retirement, in our 60's say) is advisable. But that doesn't contradict the general point that Rudi's making in the article or that I'm making here.

Especially in a climate like the current one, folk are supposed to draw on their capital. There's nothing sacrosanct about that pool of funds that it can't be touched.

Carlos
May 14, 2020

Agree that investing for growth is better but not about selling shares. Keep selling shares and you'll have none or few left. Silly to sell your winners. Companies that are growing tend to grow their dividends too, which should be enough for income even if the yield is on the lower side when first purchased.

Shiraz Nathwani
May 14, 2020

I agree Rudi "A simple ETF (exchange-traded fund) that mimics the ASX200 Accumulation Index". Yes it did achieve income of 5 to 6 % provided you trade 4 times and collect all the dividends I have followed the strategy in our SMSF.
Shiraz

Paul
May 14, 2020

A good article Rudi, overall. But, as an investor for over 30 years (no I am not an advisor) I do think you sticking casting aspersions that "many an adviser" failing to education and advise their clients, is a very long bow to draw. Where are your facts actually coming from, or is it baseless and just "your" personal opinion. I am offended for them myself at the "generalisation". I expect that 95%+ of advisers do the right thing by their clients. So Rudi, perhaps you should stick to the facts, rather than taking cheap shots at qualified professionals, much like yourself, really!

Richard Brannelly
May 14, 2020

Terrific article Rudi and I cannot fault your reasoning and approach and hopefully this stimulates the thinking for many investors. However it would have been so much better without the completely unsubstantiated cheap shots at financial advisers. In that regard and based on my 20 years of advising experience you could not be more wrong.

George
May 14, 2020

Hallelujah. Can't understand why retirees are unwilling to sell some of their shares for income and think only in terms of dividends or interest. It's about the total return.

Rena
May 17, 2020

Sure - but if they get sufficient income on LIC or ETF type dividends alone then why bother?

lyn
May 17, 2020

Perhaps because there is no mention of Capital Gains Tax in all of this. When one must sell to access capital to live on, CGT rather takes the edge off what we may actually net to meet current needs especially to those on income to only $37000 & after that the gain then pushes us into the next tax bracket so a further erosion of that capital sold.

SMSF Trustee
May 19, 2020

If managing a bit of tax stuff is too hard, then really, these folk should NOT be using an SMSF. They're meant to be self-managed, not on auto-pilot. If you want auto-pilot, use something else and let the fund manager set all of this up for you.


 

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