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Why dividends help you to invest better

It takes a relatively small piece of dough to bake a fresh loaf of bread.

For better results, leave the dough in the oven until it is fully proved and baked. If you become impatient, as I often do, and open the oven too soon, it will fall flat and might end up smaller than the original piece of dough. The patient baker takes the loaf out of the oven only after it has been properly baked.

One of our greatest fears is that we may not have made sufficient provision for our needs after retirement. Much like baking bread, your protection lies in proper planning, the right “ingredients” and patience. Those who still have enough time and can afford a little more short-term volatility may consider shares that render high dividends.

Build future income

Let’s say you have a portfolio of R2m from which you would need a monthly income of R6 300 (in today’s rand currency terms) after 10 years. By investing in the stock market at the current average dividend rate of 3.11%, you would earn around R5 200 per month. The actual dividend payments on the local stock market increased by nearly 4% more than inflation over the past 50 years. That means if you invest your R2m in the stock market and the dividend payments increase by 10% (expected inflation of 6%, plus 4%) per annum, you should have the required R6 300 per month after 10 years, and at a more tax-favourable rate (15% dividend tax vs. income tax rates).

Looking at the JSE’s All Share Index (Alsi), you will see that dividend payments over the past 50 years showed much less fluctuation than the share prices themselves, proving that you should focus on the long-term ability of the company to generate income, rather than short-term price fluctuation.

Valuation tool

We have heard experts tell us the market is currently expensive. A number of reports and recommendations over the past year refer to the current average historical Price/Earnings (PE) ratio of 17.5 as an “extreme level” (see graph), and they may even be right over the short term.

But compare the income from shares (dividend yield) relative to the money market: if you take a closer look at this ratio (see graph) you will see that the historical dividend rate paints a somewhat different picture.

For the longer term investors seeking future income for their investments, the current “expensive” on a PE basis market shouldn’t cause the least bit of discouragement.

Your own annual "increase"

Investors can buy directly into shares that have good dividend potential. Based on Bloomberg consensus, I have identified five shares that should enjoy good growth over the next few years, both in price and dividend yield: Billiton, FirstRand, Imperial, MTN and Sasol.

These shares currently stand at an average historical dividend yield of 5.3%, very favourable not just when compared to other shares, but also the money market. Had you invested your R2m in equal parts in these five shares 10 years ago, your income would have been R47 800 in the first year. It would have grown to R383 100 at the end of the 10-year period (i.e. by 23.4% per annum).

Of course, we cannot ignore that this included the market correction of 2008, where investors simply had to shut their eyes and “leave the bread in the oven”.

If you want to experience the joy of freshly baked bread, leave the dough in the oven for the right period of time. It will prove itself. 

This article originally appeared in the 4 September 2015 edition of Finweek. Buy and download the magazine here.

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