If an investor was to lob at their local bank with a wad of money to invest, no doubt they’d be soon ushered into the manager’s office for a nice cup of tea. And depending on how big that wad might be, they might even get a biscuit.
Australian banks source something like 65% of their funding from their depositors. Mums and dads, kids, retirees and everyone else park their funds in a bank (or some other financial institution) in the hope of earning a little interest. And it works well for the banks. For them, it’s a cheap way to fund their business.
Despite a few ‘special rates’ on offer, someone looking at a term deposit will be lucky to get much over 2%. Hardly anything to get excited about, especially given the amount of time they’ve got to tie their money up. After paying any tax, there will be precious little left over.
It’s little surprise that so much money finds its way into the stock market. With a current market yield of 4.2%, it certainly beats what’s on offer from the banks. Plus, depending on an investor’s marginal tax rate, they might not have to pay any tax on their dividends if they come fully franked.
Of course, not everyone invests in the market to generate income. For some, it might be to trade in and out of the latest hot sector for some nice, quick profits. It might be lithium stocks one day, and technology stocks the next.
Trying to make consistent profits this way can be a pretty tough task. For most, it can go either way.
What they make on one trade can be just as easily handed back on the next.
That’s not the way the professionals approach it.
It’s all about income
Instead, professional fund managers gauge stocks by a very clear premise. That is, it’s the cash a company generates ultimately determines its value.
Sure enough, a stock price can soar even when there’s little substance behind it. But unless you’re nimble enough to get out before gravity sets in, there’s a good chance you’ll be left holding a stock that nobody else wants a bar of.
Think about it this way: If you were looking to buy into a business, how would you judge its value? The first thing you’d do is get your hands on the books and read them from line to line. You’d want to establish that it was profitable for a start. The more profitable it is, the more you’d be willing to pay for it.
If it was running at a loss, why would you buy it? Unless you’re some kind of turnaround specialist, you’d be better off holding onto your money and waiting for a better investment to come along.
Well, it’s the same with the stock market. The market will place a higher value on a stock that pays consistent and growing dividends, than one whose financial history is sporadic at best. There are some very clear things to look for in an income stock, so let’s take a look at them now.
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It’s not just about the yield
When it comes to income investing, a common place to start is with the yield. It’s a simple thing to calculate; all you do is add up the dividends it’s paid in the last 12 months and divide that into the share price. A company trading at $20 that’s paid out $1.00 in dividends has a yield of 5%.
While the yield is a starting point, it alone isn’t enough. One thing you want to avoid is a ‘yield trap’. It’s where an investor buys into a stock based on its current yield, only for the company to cut back its dividend — like BHP Billiton [ASX:BHP] did earlier this year.
One way to help steer away from this trap is to look at a company’s dividend history. It’s easy to find — all you need to do is go to its website, click on ‘investor centre’ and take a look at its historical dividends. Some will go back for decades. The more stable its dividend history, the less likely it is to surprise. But nothing is set in stone, so always be aware that a company can change its dividend policy.
Apart from the stability of its dividend, an investor will want to check for growth. You can take a look at its financial reports (also on its website), and see if revenues, profits and dividends are growing.
For example, take a look at the following dividend history of Sonic Healthcare [ASX:SHL]. This is one of the stocks on the Total Income buy list, my investment advisory devoted to hunting out the next generation of income payers.
Source: Sonic Healthcare 2016 Annual Report
[Click to enlarge]
You can see that dividends plateaued out through 2010–12, but began growing again over the last four years. And compare its two cent dividend in 1994 with the 74 cents that will be paid out this year.
And what has the share price done over this time? The share price finished 1994 at just 56 cents; today it’s trading at over $22. The market has placed an ever higher value on Sonic’s share price as the profits and dividends have grown.
It’s this kind of growth that fund managers dream of — profit (and dividend) growth lead to capital gains as well. While nothing is ‘set and forget’ in the markets, it certainly beats trying to trade in and out for some quick profits. And much less costly and stressful as well.
Imagine if you paid just 56 cents for Sonic shares back then. This year you’d be getting a 132% return (74 cent dividend) on your original investment, not to mention the capital gain as well — a near 40-fold increase in the share price.
Maybe income investing isn’t as exciting as punting on the latest hot stock tip, but I’d take these returns on Sonic any day of the week.
An even better way to spruce up your returns
While dividends can be a great way to generate income, there’s another strategy that can help propel your returns even higher. It’s a strategy many have heard of, but few appreciate its real wealth-building potential.
It’s the kind of strategy that could potentially grow a portfolio exponentially if put to good use. To find out all about it, please check into The Daily Reckoning tomorrow, where I’ll show you how.
Editor, Total Income