Dividend Power

24 January, 2007 at 10:42 pm | Posted in Markets | 1 Comment

Investors often neglect the effects that dividends can have on the performance of their share portfolio over time. If one went about constructing a portfolio based primarily on large and mid cap companies with a high dividend yield, the ‘dividend return’ could conceivably be around 4-5% (tax free) in the first year! At current rates, and assuming a 40% marginal tax rate, an after tax cash yield would only equal this dividend yield.

Doing a simple, back of the matchbox, calculation shows that investing in a share that has an initial dividend yield of 5% (whose dividends grow at 15% p.a. in line with earnings growth) will result in the investor receiving a 10% yield (on cost) by the end of the 5th year, and a 20% yield after 10 years! This excludes the impact of reinvesting dividends which, over time, adds significantly to performance.

Obviously one may argue that dividends are at the discretion of management. This can be countered somewhat by only selecting those companies that have a good history of regularly declaring dividends. Companies are loathe to reduce/cancel their dividends owing to the negative signal it sends to the market. By selecting companies with a stable dividend policy, one is generally implicitly selecting stable companies, which should further reduce the volatility of the portfolio.

If one went about slowing picking up high yielding stocks early in life, or even 10 to 15 years before retirement, and held onto these stocks, reinvesting when the dividend cash account is high enough (or by adding dividends to other savings), one could conceivably live off the dividends in retirement. The attraction of living off dividends is that there is no pressure in deciding when to sell shares, and the fact that dividends will generally increase at a rate higher than inflation.

At the moment dividend yields are historically low (reflecting a bull market that is nearly 4 years) but there are still companies with attractive yields.

As always, patience is a requirement for long term capital accumulation.


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