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The case for

dividend investing

author image

Gary McNamara

Portfolio Manager

Increasing numbers of investors have enquired of late whether investing for dividends is still a good strategy. The answer is always ‘yes’ – despite dividend withholding tax, which was hiked from 15% to 20% in February this year, the case for dividend investing remains strong and patient investors are likely to be well rewarded.

The main benefit of investing for dividends is that investors can be provided with an income by being paid a portion of companies’ profits each year in cash without having to sell shares. This type of investment strategy is ideal for retired people who need to live off their investments. If a company can grow its profits at a rate better than inflation and generate a real return, investors should be able to watch their yearly income grow without having to change their strategy too much.

Dividend withholding tax unfortunately wrests away some of the benefits of this strategy. One option to counter this is to hold the investment in a retirement-type structure such as a living annuity or, if you haven’t yet retired, a retirement annuity. Both of these structures would receive the dividend declared gross of dividend withholding tax. This will allow a greater amount to compound if the investment is held in a retirement annuity, and won’t force a sale to generate income if the vehicle is a living annuity.

The key to a dividend investment strategy is holding a portfolio of high-quality shares that have proven their ability to grow profits at a real rate and have a track record of paying out a certain portion of these profits in the form of dividends to shareholders. These types of shares tend to be high cash flow and less cyclical companies, making the forecasting of earnings and dividend growth easier.

In the South African market, banks and life companies have a good track record in this regard. The likes of British American Tobacco and cellular providers could be added to this list – food producers and retailers are also long-time favourites of those following this investment strategy.

A company’s so-called payout ratio or dividend cover is an important factor, in that it will allow it to pay dividends but still have sufficient capital to grow the business. If a company is paying too much in dividends or even worse, borrowing to maintain its dividend level, the share should not be held in a dividend income portfolio. Companies that depend on a particular business cycle or commodity price to drive profits are unlikely to provide smooth earnings – hence a certain dividend is more difficult to forecast and investors using this strategy should avoid the share.

All in all, the case for dividend investing has been proven over time, with dividend returns comfortably outperforming the newer growth industries and more cyclical stocks. In the South African market, this investment strategy has returned a dividend yield of around 5% gross of fees. It has also often been proven to provide a smoother total return (dividends plus capital) when bear markets prevail.

Taking a long-term view of investments, and not jumping from one investment strategy to another, is one of the basic tenets of successful investing. Approaching dividend investing with this in mind – allowing dividend yields to grow over time – will stand patient investors in good stead in the long run.

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