In last week's column, I looked at the merits of dividend-based investing. In order to do full justice to the subject, this week's column highlights the risks associated with this form of investing.
Investing in shares in order to derive an income is particularly appealing because dividends are not taxed. And, as I said last week, dividend investing has become fashionable now that interest rates are low.
The beauty of the dividend number is that what you see is what you get in your pocket. On the other hand, many earnings numbers suffer from what I call the "if only" syndrome: If only we did not have such a strong rand... If only we did not make an acquisition ... If only we did not have to close down a poorly performing division ... If only we did not have that little mishap with the contract in Africa ... our number would have been X and not Y.
The analysis surrounding the earnings number can get quite intricate. When it comes to companies such as life assurers, the earnings number becomes even less meaningful as a gauge of how the company has done, because its embedded value (a version of the method of calculating net asset value) is a more significant measure of the company's value.
Although the dividend number also depends on how the company has performed, it is much easier to accept the stated figure.
It also struck me, as I went through my list of favourite dividend-payers, that most of them run businesses that are fairly straightforward.
The major risks of investing for dividends can be summarised as follows:
- The biggest risk is that the dividend is not sustained. A long-term record of growing dividends, a healthy dividend cover (calculated by dividing the dividend number into the earnings number) and no major changes on a corporate level (for example, acquisitions or mergers, a change in direction of the business, or a significant loss of talented staff) can give an indication of a com-pany's ability to maintain and grow dividends. Holding a diversified portfolio of dividend-yielding shares reduces your risk still further.
- The second-biggest risk is that the dividend growth is lower than than inflation, making you poorer in real terms if you are relying on dividends as your sole source of income. Over the past decade, inflation has averaged 6.6 percent a year, while the dividends of the companies comprising the All Share index grew, with a rather volatile pattern, at an average annual rate of 11.8 percent.
If you take a share with a long-term record of growing dividends, such as Pikwik, you find that the average annual growth in dividends over the past 10 years has been over 20 percent while inflation has been 6.6 percent. The way to reduce the risk of experiencing a period of slower dividend growth is to diversify, and to treat dividend income like any other - don't over-spend and save the excess income for the lean years.
Another way to reduce risk is to maintain a cash portfolio, as the interest rate cycle tends to behave differently to the dividend growth cycle. Dividends grow faster in a lower interest rate environment and vice versa. Good dividend-payers are also in demand when interest rates fall, so you also get better capital growth.
- The final risk is that the company's ability to pay dividends may be seriously impaired, and you lose significant capital value on your investment. Here too, the way to manage this risk is to understand the company and to have a diversified portfolio.
The simplicity of an investment decision is most clearly understood in hindsight.
While the dividend number is probably the simplest number you will see in a company's results and dividend-based investing with a conservative approach remains a solid, simple approach to investing, simplicity does not absolve you and your adviser of the respon-sibility to treat all investments with caution.