Highlights in this issue:

*** Dividends are good for long-term growth …
*** Get the power of compounding working for you and you’ll boost your profits exponentially…
*** Share income is no more than a promise – but dividends are cash in your hand…

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From the pen of Karin Iten…

Dear Investment Academy Reader,

Welcome back. I hope you’ve started the year well rested and roaring to go. And that’s what this week’s Investment Academy is all about. After all, I’m sure one of your New Year’s Resolutions for this year was to be wealthier. So today, I’ve asked Tim Bennett – our regular MoneyWeek investment strategist – to show you the importance of investing in high dividend paying shares.

Over to you Tim…

Who needs dividends?

The biggest gainers in last year’s “dash for trash” rally have been the shares of companies that can’t afford to pay any – such as life insurers and resources gains. Investors ignored big blue chips – that still pay reliable, dependable dividends – because they're too dull for them.

But that’s a mistake.

Dividends are critical to making decent money from shares in the long run. For example, based on capital gains only, R100 put in SA shares in 1987 would have grown to R18,467 by the end of 2007 ignoring inflation, according to Mike Brown, then general manager of Satrix Managers.

If you’d reinvested rather than spent your dividends, you’d have R44,063. This vast gap is all down to the wonders of compounding. In the 30 years to 2007, equities returned around 15% per annum in real (inflation adjusted terms). At that rate, every rand in dividend payments you reinvest would roughly double its buying power after five years.

Dividend payers are better in the long run

Dividend payers tend to be good for long-term capital growth too. They’re usually well run. Managers must focus on generating the necessary cash flow to meet payouts as well as covering operating costs and interest charges, which is good discipline. Future share price growth – which is what you’re betting on if a share pays no income – is no more than a promise. But a dividend is hard cash in your hand.

Of course, there’s no point in a firm enticing you with a decent once-off dividend if it can’t be maintained. Giant insurer Old Mutual last year proved that a decent yield doesn’t guarantee sound management. In March 2009, shares in the popular insurer plummeted to just 400c as investors questioned the financial viability of the group’s Bermuda-based US life business. Despite “showing” a 4% dividend yield the group had to cut its full 2009 dividend!

Watch out for very high yields

Equity income is measured using the dividend yield (the share price divided by the annual dividend). So if the share price is R160, the interim dividend was 274c a share and the final dividend 450c a share, the yield is 4.8% [(274+450)/1600 x 100%)]. The higher the dividend yield, the better – with one big caveat.

FTSE JSE TOP40 shares pay an average yield of around 3.0%, so unusually high yields may simply be the equivalent of a bribe to tempt you into a duff stock. Take Hiveld Steel and Vanadium (JSE: HVL) for example. This company used to offer top dividends – often in excess of 7% per annum. But investors who backed the company in mid-2008 (when it topped R180/share) will be sorely disappointed. Each R10,000 invested in Hiveld, 20 months ago would be worth just R3,333 today. An equivalent investment in the JSE All Share Index would still be worth R8,700.

So, what makes for a robust dividend?

The most important test is dividend cover. This measures the number of times the firm could have paid (or “covered”) its annual dividend. One option is to divide profit before dividends, by the total paid out in dividends. So if profits are R100m and the annual dividend R50m, the latest dividend is covered twice. Like I said, the higher, the better!

Cover tends to drop in a recession with profits under pressure. Twice or more is ideal, but it can be hard to find – anything below one is a red flag. A once profitable firm having a bad year can pay its latest dividend out of past profits (known as “retained earnings”), but it can’t keep repeating that trick.

It’s useful to do the cover calculation on a cash-flow basis too – profits are often based on some subjective accounting decisions, whereas cash flow is much harder to manipulate. Take annual free cash flow (operating cash flow after interest and tax have been paid and the firm has covered essential spending). Then divide it by the cash dividend in the cash-flow statement. Low cash cover suggests the directors may be over-optimistic about the company’s ability to raise or maintain future payouts.

And consider cash flow itself. A reliable dividend-payer should be generating steady operating cash flows (near the top of the cash-flow statement) every year. Some sectors – utilities for example – are much better at this than others. A sudden dip is a warning that dividends may be under threat, as chopping the dividend can be a quicker way to save cash than cutting operations.

Regards,

Tim Bennet
For the Investment Academy