If someone were to ask me to name the three most important ways to reduce investment risk, I could only respond with:

Diversification – Diversification – Diversification! 

It really is that straightforward yet it would be very easy for someone to think that ‘diversification’ simply meant ‘spreading your eggs over more than one basket’ – putting money into more than one investment.  But it’s not that simple because investment diversification needs to be applied at several levels in order to properly reduce risk.

The starting point with a discussion on investment risk management has to be an acknowledgement that all investments are accompanied by risk. It’s impossible to make any investment without taking on some measure of risk.

As if to graphically illustrate this further, the Global Financial Crisis and its aftermath put paid to the often-quoted belief that government bonds are safe.  For several years now the world has been grappling with the possibility of several European governments defaulting on their loan (bond) repayments.

Whether or not any government bond is secure is ultimately dependent upon the ability of the borrower (in this case, a government) to repay the loan.  Note here that government bonds exist because governments need to borrow money from the private sector to fund their operations – be they short or long-term requirements.

Notebook PC with charts, graphs in background

So, if we begin to look at investment risk management from the premise that all investments involve a degree of risk the task becomes somewhat more complex.

Proper investment diversification is a three-step process over sectors, legislation and individual investments:

1.    Sector Diversification

The primary investment sectors are:

  • Cash
  • Fixed Interest
  • Shares
    • Australian
    • International
  • Property
    • Direct
    • Listed and/or managed

Yes – there are so-called ‘alternate’ investments that some, more speculative, investors will commit money to however that’s for another discussion.

At all times, risk exists in each and every of these sectors and managing those risks is achieved by avoiding inappropriate weightings (over or under weight) to them.  Even a 100% cash portfolio entails risk; the risk that what is otherwise good for the economy – low interest rates – is not good for an investor who needs consistent income. While the capital might not decline in a cash account due to a ‘market downturn’, capital can and does decline when the investor needs to drawdown on the capital to meet living costs because the interest being earned is insufficient. In addition, the ‘buying power’ of cash accounts erodes over time due to inflation.

2.    Legislation Diversification

This is perhaps the area of risk most often overlooked by investors simply because it is not immediately apparent to them.  In Australia, very many people have their non-housing wealth invested entirely in superannuation, save for everyday cash and deposit accounts.

The quite onerous legislation within which people save for their retirement comes with a quid-pro-quo relationship between the government and the superannuation member. In return for, generally speaking, quite generous taxation benefits both before and after retirement, superannuation members lose access to their capital throughout most of their working life. This is because governments of the day have increasingly looked for superannuation to be used only to assist funding retirement.

Within this ‘give and take’ type setting is an ever-present risk that a government might at some future point in time, look to make superannuation only accessible as an income stream (a pension) in retirement. Such a decision would see the traditional ‘lump sum’, which many Australians look forward to, placed be beyond reach.

While the political will to make such a change appears to be absent in current times, it is entirely sensible for Australians, particularly younger Australians, to plan to build an alternate ‘lump sum’ of capital outside superannuation. Such planning quarantines the ‘alternate’ lump sum from any future changes to superannuation. Granted it might not be as tax efficient for many investors (to accumulate capital outside superannuation) however, as per my ‘Golden Rule’ No. 1, tax minimisation should never be the primary reason for making an investment(s)

3.    Investment Diversification

This is the final step and, ironically, it is where some investors begin in attempting to diversify their capital.  Over many years, thousands of academic papers have attempted to quantify what is the most appropriate methodology to diversify portfolios. However, it’s arguable that none can claim to be the definitive approach.  That said one issue upon which there is much consistency of opinion is that getting the asset allocation (shares, fixed interest, property) correct will have the largest contribution to the final return.  And this is the irony – investors who start to diversify here (and not focus on asset allocation) – are heightening their portfolio risk and increasing the chances of under-performing.

That said, here are some key guidelines to be mindful of when looking to spread capital over different investments:

Direct Shares

Managed (mutual) Funds

Don’t rely on just one sector of the sharemarket – sectors have their

own cycles.

 

Does the fund have a minimum 5 year track record? If yes – what is the track record?

If no, does the funds management company demonstrate acceptable performance in similar funds under its management?

 

 

 

What is the market capitalisation of the company? How does that compare to its peers?

 

Do you understand the fund’s strategy and objectives? What are they trying to achieve with it and over what timeframe?

 

What is the company’s share of its market?

 

What about the people managing the fund? What is their experience and success (or lack thereof)?

Does the company pay a competitive dividend and what does the dividend payment history tell you?

 

Do you know what the entry/exit/ongoing fees are?

 

Are the fund fees reasonable compared to peers?

What is the outlook for the sector?

 

Limit a maximum 10% of capital to any individual fund.

What about governance? How well run is the business? What about the reputation of the board of directors and CEO?

 

 

Limit total exposure to any single investment institution to 25% of capital

Successful investment strategies recognise that nothing is certain and that risk abounds in every investment made.  Such strategies are, initially, based on a detailed understanding of the state of the domestic and international economies which finally results in a well diversified portfolio of investments.

And because the economies and markets do not stand still, portfolios need careful review and maintenance.

                         IMPORTANT – THIS IS NOT INVESTMENT ADVICE

This discussion is not a recommendation for readers to invest in any or all of the specific investments, or types of investments, discussed in this blog. Please do not act to make investments based in this commentary.  This is a general discussion about some aspects of investing and cannot account for all circumstances. Readers should seek professional advice for their own situation.

 

There – I said it! Negative gearing is all about losing money – it involves debt and high risk yet I’m almost certain that many readers will have never heard it described so bluntly.

 When was the last time you heard anyone point this out?  The promoters of negatively geared investment strategies (into property and/or shares for example) have much to gain from encouraging people to negatively gear so you won’t always receive the full story from parties who have a vested interest. So let’s look in detail at negative gearing: What is it? When is appropriate and what type of investors is it suitable for?

Gearing?

Gearing is a proxy term for ‘borrowing’ – it’s as simple as that.  You might sometimes see the term ‘leveraged investing’ wherein ‘leveraged’ also simply means borrowing.

Gearing, like how gears on a bicycle enable the rider to get over very steep hills, enables an investor to buy a larger investment(s) than their financial position would otherwise allow.  Similarly, like a ‘lever’ can enable the movement of large objects with much less human effort, so too does leveraged investing permit a larger investment(s) to be purchased than might otherwise be possible.

Gearing – leveraging – call it what you like but the bottom line is that involves borrowing money.

Negative?

This is where money is lost.  The negative in ‘negative gearing’ applies wherever the costs of servicing the investment such as loan interest, professional fees, investment maintenance (repairs etc.) exceed the income being generated by the investment(s).  In other words, the investor has to spend more to hold the investment than what the income received from it amounts to.

“Yes – but at least I can get a tax deduction!”

True, but as I once heard it stated quite simply: “That’s like spending a dollar to save 50 cents.”  And note that, under current Australian tax law, a deduction is permissible wherever the asset is Australian based and produces taxable income.  The deduction applies only to the amount of costs (interest etc.) which exceeds the income received from the investment.

So why would anyone ever negatively gear an investment(s)?

This is the key point – such an investment strategy only makes financial sense if there is a likelihood that the value of the investment(s) will increase over time.  And it is time which is a key determinant in whether or not a profit can actually be made from the strategy.

While waiting for the value of the investment(s) to increase, under a negatively geared investment strategy, an investor is losing money on the cash flow – i.e. the costs exceed the income less any tax deduction which might be available.  As such, the longer it takes for an investment to increase in value the higher the accumulating cash flow losses (negative).

So if asset values are being pushed higher quickly during say high economic growth or high inflation periods, the more quickly a negatively geared investment strategy becomes profitable – capital growth exceeds the losses being made on the cash flow.

Who does it suit and when is it best to do it?

Primarily negative gearing is most suitable for investors in the highest income tax bracket. This is because the tax deduction they can receive is at a higher level than someone on the lowest tax bracket, for example.  This just means they have less out of pocket costs in meeting the expenses of the strategy.

Periods of high economic growth and/or high inflation are generally more beneficial for negatively geared strategies simply because asset values increase more quickly at such times.

Note however that, for around twenty years, Australia has had quite low inflation and economic growth, despite the resources boom of recent years, is currently modest.

What’s the risk?

There’s more than one risk but suffice to say the list of risks includes: loan interest rate rises – loss of employment income required to cover the ‘out of pocket’ costs (investment costs – investment income + tax deduction = out of pocket costs) – prolonged injury or sickness of the investor (out of pocket costs) – slow investment value growth – declines in investment values – slow economic growth – low inflation – a future government might cancel the tax benefits …

Neutral? Positive?

Investors don’t have to gear negatively – it is possible in some situations to have a neutral gearing position or even a positively geared investment(s) and I’ll explain these strategies in my next blog.

Ray

 

       IMPORTANT – THIS IS NOT INVESTMENT ADVICE

This discussion is not a recommendation for readers to invest in any or all of the specific investments, or types of investments, discussed in this blog. Please do not act to make investments based in this commentary.  This is a general discussion about some aspects of investing and cannot account for all circumstances.

 

 

You could be forgiven for not knowing about it but 2012 was quite a good year for investment returns.  Goods news rarely makes its way to the top tier of news stories so there is every chance the 2012 results got past many investors.

In 2012 you would have heard or read a lot about continuing problems with European bonds and the on-again off-again debt issues for the United States government.  Those big global headlines easily gained more ‘air-time’ than returns from well-constructed Australian investment portfolios that straddled a rising domestic sharemarket with some quite notable results from some companies.

investment-portfolio-spreadsheets_0

 Smokescreen

Amid all the smokescreen of concern that seemed to constantly circumnavigate the world in 2012 were, for some investors, quite stellar returns.  In fact, investment results for 2012, generally, serve to illustrate the long-term benefits of careful, considered, investing.  The 2012 returns also illustrate the benefits of not making knee-jerk reactions with investing.

One thing remains a constant and that is, investment markets do not rise in value without turning down at some point. Excesses in economies such as household indebtedness are always, eventually, corrected as investment markets price-in the associated risks.  Sometimes this is known as ‘corrections’ – as in correcting the price of assets – and there are less frequent periods where price corrections are labeled as a ‘crash’ because of the depth of price declines.

Run for cover?

At times in 2012 and for several years before it would have been tempting for investors to simply sell-up and run for cover in cash or term deposits.  However, as interest rates declined in Australia through 2012, in order to stimulate the economy, the sharemarket responded with price increases in anticipation of at least maintenance of present growth levels.

While for example, the return for the German share market (the DAX) topped 29% compared to the Australian All Ordinaries Index’s 13.47% there remain large impediments in the Euro region as it grapples with high unemployment combined with low levels of consumer and business confidence. These fundamental economic issues dictate that Australian based investors must be careful not to over-allocate to international markets. Similarly, while the Japanese market topped 22% for 2012 that economy remains seemingly comatose with more than two decades of, at best, sluggish growth.

Way back when…

In looking at portfolio allocations to various economies, investors need to be vigilant to changing world dynamics. In the nineties there was a strong, valid, argument that international exposure for portfolios reduced the overall risk to portfolios as it provided a counter-cyclical defence. This meant that, generally speaking, economies were rarely in exact synchronisation and so a slow down in the Australian economy (and market returns) could be offset by growth available in other parts of the world.

In the nineties the international components of portfolios also received a ‘free-kick’ because the Australian Dollar was, on average, declining against major world currencies. This ‘tailwind’ increased the value of the international component in Australian Dollars.

But – the Dollar’s up and the rest of the world is in sync!

However, in 2013, the Australian currency is up against all world currencies and doggedly refuses to descend and give investors a free kick in the international section of their portfolios (and boost Australian exporters’ competitiveness).  Add to this a ‘rest of the world’ economic slow-down and the case for large international allocations in portfolios is hard to justify.

So where does all this leave investors in 2013?

Last year proved that diversification delivers stability in portfolios over the long term. First hand I’ve witnessed diversified portfolios, with maximum share market exposure of approximately 50%[1] of the portfolio, deliver over 15%[2] total return (income plus growth) for 2012. Note that the All Ordinaries Index is 100% shares – it’s a share market index not a diversified portfolio with exposure to other sectors.

Will that be repeated in 2013? In short, it’s most unlikely and it could be that such portfolios revert to single digit total returns.  In the event of a major share market ‘correction’ such portfolios should better withstand the overall impact. While they too will decline, the depth of their decline should be less than the overall share market simply because, unlike the share market itself, diversified portfolios are not 100% allocated to shares.

The good news of Australian investment returns for 2012 hasn’t made it to the headlines of news bulletins and it’s unlikely to. However, you’ll more than likely hear about it next time markets decline.  In the meantime, long-term investors who have resisted the temptation to run for the cover of a 100% cash allocation, fare better both in income and long term growth.

      IMPORTANT – THIS IS NOT INVESTMENT ADVICE

This discussion is not a recommendation for readers to invest in any or all of the specific investments, or types of investments, discussed in this blog. Please do not act to make investments based in this commentary.  This is a general discussion about some aspects of investing and cannot account for all circumstances.

Readers should seek their own professional advice which can take account of their personal financial position and objectives.

[1] Note this includes Australian shares, international shares (max. 10% of portfolio), listed property and hybrid interest bearing securities.

[2] Past performance is not a guarantee of future investment portfolio returns.

Bond, Skase and Connell are names of just three of the list of high profile entrepreneurial Australians who have failed at some point in their business careers.  In Australia, the latest high-profile entrepreneur to run into financial trouble is Inverell born Nathan Tinkler who, through the good fortune of a ‘tailwind’ of inflated commodity prices and friendly lenders, in April 2012 had an estimated wealth of $1.1 billion.

nathan

Photo: Louie Douvis (Sydney Morning Herald, Business Spectator)

However, with the Australian Taxation Office being the latest creditor to seek payment of the comparatively small amount of $2.7 million in back taxes, Mr Tinkler’s wealth might have fallen to the point of him being in net debt. With his holding in Whitehaven Coal now valued at around $625 million but with estimated debts of $700 million, things are certainly tight for him.

Over the last month he has embarked on selling down much of his thoroughbred horse racing interests and has had his private jet and helicopter repossessed by financiers.  From the outset, the Achilles Heel of Tinkler’s operations was the very high levels of gearing (borrowings) and he is now in substantial financial difficulty.  There are lessons in this for every business owner; for every individual.

Firstly, much of his wealth was based on borrowed money and while, in and of itself, borrowing is not a bad thing, like many things in life too much of it is far from good.  Nathan Tinkler’s ability to borrow very large amounts has to this point been underpinned by two key planks.  Firstly, borrowings were secured by a lien (a mortgage) over his shares in Whitehaven Coal (and predecessor companies) and secondly, lenders lent against the shares on an expectation that the resources boom would continue unabated for a much longer period into the future.

With the decline in global commodity prices over the last calendar year or so, in part a response to slowing demand from China, shares in resource companies like Whitehaven Coal have been bearing considerable downward price pressure.  For all resources companies this has brought on a need to cut costs wherever possible in the face of reduced revenue from sales of commodities – witness redundancies afflicting thousands of mining workers across the nation over the last six months.

From the outside at least, the Tinkler situation appears to be a case of too much (debt) too soon.  Cash flow is ultimately the lifeblood of every business (substitute ‘salary’ for cash flow, for employees) and if it’s impeded (e.g. reduced commodity prices) then things can get grim very quickly.  With an inability to meet debt obligations because of falling revenue, it’s only a matter of time before smiling lenders start to deliver other facial expressions.

The same risks are at play for individuals. Too much debt is never a good thing and myriad risks abound to curtail loan repayment ability. Consider sickness, accident and unemployment as just three of the things that could jeopardise an individual’s capacity to meet loan repayments. Then there are issues like rising interest rate cycles which eventually send some borrowers into default on loans.

Whether or not Nathan Tinkler will be able to resurrect his business’ ascendency remains to be seen. The headwinds that confront him now seem unlikely to dissipate any time soon.

While the very essence of a successful economy is that at points along the way, people have been brave enough to be entrepreneurial and start a business, there can be failures at any time in every business cycle – in good times and bad.  Yet, thanks to sound business management, plenty do succeed.  As in nature, business evolution initially sees the strong (balance sheets) survive along with those that can adapt to a changing environment.

As you read this it’s worth remembering that the very reason you can read this online, right now, is in very large part due to the entrepreneurship of people with names like Gates and Jobs!

 

 

While we live in world seemingly full of unrelenting change, there are some things that will never change in the financial world.  For a very long time, I have maintained a set of ‘Golden Rules’ that are always relevant and good for investors to keep handy when contemplating making investments.

So let’s get started with a Golden Rule that deals with tax benefits.

1.    Tax should never be the primary reason for making an investment.

Why? (people always ask)  It’s quite simple really – taxation law is subject to change so the overriding question you should ask yourself – before investing – is:

If the government were to cancel the tax benefits associated with this investment, would I still be happy to put my money into it?

If the response is ‘No’ then that – in isolation – should be sufficient to deter you from putting your money into the investment.

 

The Australian investment landscape is littered with the carcasses of investments that were marketed to investors on the basis of tax benefits which were, at times, questionable to say the least. As I write, the collapses of more than twenty years of professional practice come flooding back.  Over the years I’ve witnessed, from the sidelines, collapses of investment schemes which involved:

  • Pine trees
  • Jojoba beans
  • Cray fish farms
  • Wild flower plantations
  • Tea tree plantations
  • Ostrich breeding
  • Oak trees
  • Cattle breeding
  • Film production

Rest assured there are more failures than recorded above.  All the schemes above were variations of a theme – investors borrowed all or part of their investment and hoped for that the forecast capital and income returns came true. In many cases it was little more than the proverbial ‘wing and a prayer’ due to the fundamental flaws in the investment structures.  Some such schemes claimed that for every $1 invested a tax deduction of $5 could be claimed.

Consider this excerpt from a 2006 report by the Australian Taxation Office:

The Senate Economics References Committee found support for the view that “the growth of a highly competitive entrepreneurial promoter market … has been the most significant driver of the growth in aggressive tax planning.”

This finding built on the Committee’s previous reports. In its Interim Report it concluded:
“ it is the view of the Committee that a large number of these schemes appeared to be designed specifically to defraud the tax system and to use ordinary taxpayers in that process. Not only have they left many taxpayers with large tax bills, but many of these schemes have ceased to exist. The Committee is of the view that few schemes represented ‘a good investment’ in the ordinary meaning of the term, and that without the ‘tax deductibility’ factor, very few would have got off the ground.”

I recall explaining to students in an adult learning program which I taught that: “If the tax office ever disallows the tax deductions (on these exotic investment schemes) people will march in the street!”  And so I was not surprised to see that in Sydney, Melbourne, Perth and Canberra, so-called ‘tax effective’ scheme investors marched in protest at the Australian Taxation Office’s early 2000s decision to disallow tax deductions on such schemes[1].

To make matters worse (for such investors), the decision was made with retrospective effect to 1992.

What appealed to such investors was, in effect, a view of getting something for nothing; the so-called ‘free-ride’ that investors sometimes believe they receive when tax deductions are on offer. Of course there is no such thing as a ‘free lunch’ and many such investors were subsequently hit by the dual impact of a failed investment followed by a retrospective disallowance of tax deductions from many years previous.  For many investors, the losses amounted to hundred of thousands of dollars.

‘Tax effective schemes’ are by no means the only area where investors focused on tax deductions can be at risk. For example while I’m a great supporter of superannuation as an investment vehicle to accumulate retirement savings, it concerns me when investors have all their investment capital in superannuation. This is because – no matter how many super funds you have – superannuation is subject to constant legislative change and such change isn’t always beneficial for investors.  While it’s a very tax efficient system through which most Australians can save for retirement, there is substantial legislation risk with it.  It is sound planning to accumulate wealth in superannuation and outside of superannuation.

So the ‘Golden Rule’ is:

1.    Tax should never be the primary reason for making an investment.

Tax should only ever be a secondary consideration.  Remember: Tax laws change.

 

 



[1] The Australian Taxation Office has previously referred to the schemes as ‘abusive tax schemes’.

A lot of people in Victoria and southern New South Wales have lost a lot of money with collapse of Kyabram based Banksia Securities Limited (Banksia).  While it appears customers might yet have a reasonable chance of recovering of some of their money[1], the collapse has no doubt caused sleepless nights for many.

Banksia type collapses are nothing new in Australia – it’s happened before. Westpoint springs to mind so too does Estate Mortgage in 1990 and some readers might recall the collapse of Cambridge Credit in the mid-1970s which took more than 20 years to see some money returned to depositors.

You can be sure that unless we see sensible regulation of the non-bank deposit sector, this type of collapse will happen again.

Your task is to avoid these high-risk investments for the rest of your days!

Banksia was not a bank!

Let’s be very clear here – Banksia was not a bank yet, according to some reports, many customers assumed that they had ‘bank’ like security of their deposits.  Similar to a bank, the money deposited by Banksia customers was largely then on-lent to borrowers – home buyers, farmers, businesses and property developers – at a higher interest rate than what the Bankisa depositors were being paid. Banksia’s profit was essentially the difference (the margin) between the interest charged to borrowers and the interest paid to debenture holders (depositors).  While this is not unlike a bank’s primary role, the bottom line is that Banksia was not a bank.

In order for a bank to be licensed by the Reserve Bank of Australia, and thereby have access to a ‘lender of last resort’[2] facility, an Australian bank must meet legislative requirements that are administered by the Australian Prudential Regulation Authority (APRA).

In short, the banking regulations administered by APRA dictate that banks must maintain certain levels of capital in particular assets to protect against ‘bad loans’ – these are the so called ‘Capital Adequacy Requirements’ (CAR).  In return for meeting the CAR requirements, since the onset of the Global Financial Crisis, banks now also receive a government guarantee of the deposits they hold.

While non-bank deposit takers like Banksia also have capital requirements administered by APRA, if they don’t comply the legislation merely requires them to disclose their capital position to investors in prospectuses – it does not preclude them from taking deposits.  In more than 20 years of professional practice, I’m yet to meet an investor who would be able to see the risk that’s embedded in a prospectus which discloses a non-bank depositor taker’s (eg Banksia) compliance failures.

In broad terms, a bank must hold $10 of capital for every $100 of loans it writes.  In Banksia’s case, there was less than $3.60 capital for every $100 of loans.  Leading up to its demise, the number of Banksia loans in default rose quite dramatically. In part, this was a reflection of downturns in the regional economies where Banksia was based however it also reflected the higher risk nature of the parties that borrowed from it.

And ‘debenture’ means?

From an investor’s perspective, a debenture is a document which simply acknowledges that money has been lent to another party at an agreed rate of interest for an agreed term.  In the case of Banksia debentures, depositors lent money to (invested with) Banksia and it then lent that money on to borrowers.

The crucial point here is that there is very little – if anything – securing the debenture.  In general terms the only security which might underpin debentures is a so-called ‘fixed and floating charge’ over the borrower’s (eg Banksia’s) assets however there is no guarantee – no lender of last resort facility for the finance company (Banksia) to rely on in the event of needing to pay back debenture holders.

Debenture investors almost always have absolutely no protection!

If the interest rate is higher than bank interest rates…

Here’s the bottom line on debenture risk! If you see any interest bearing investment offering you interest rates that are higher than stock-standard bank deposit rates you can be sure there is much higher risk.

Why so? Well think about what’s going on here.  An investor lends money onto a finance company (eg Banksia) which then lends that money on to a borrower.  How good (bad?) a risk is the borrower?

Here’s the question you need to ask: Why doesn’t the party borrowing the (your) money from the finance company borrow it from a bank? 

And this is THE point!  The answer is that the borrower is too high of a risk for a bank to lend to so they need to borrow from a lending source that is prepared to accept the higher risk.  However, the lender (eg Banksia) knows the borrower is high risk so they charge a higher loan interest rate than what a bank would charge.  The higher loan rate results in a higher interest paid to the debenture (lender) holder and therein lays the risk for the investor.

Buyer (investor) beware!

On a final note, I should point out that it is possible for investors to earn very competitive interest rates with strong capital stability that are not high-risk debentures.  It’s a matter of knowing where risk exists and understanding how to reduce it, before investing.

[1] The receivers recently indicated they hope to make a payment of 15 cents in the dollar to account holders before Christmas 2012.

[2] A lender of last resort facility is provided to allow licensed banks to borrow from the RBA in the event that they should experience a ‘run’ on depositors’ funds. In such an event the RBA would provide (lend) funds to the bank to cope with the withdrawal requests from depositors.

Put simply shares are just a proportionate ownership of a business (a share of the business) and dividends (from the word divide) are the share owner’s ‘share’ of the profit.  Explaining the long-term benefits of share price growth is relatively easy compared to explaining what I believe is the most attractive aspect of owning a share of a business – the growing value of the profit dividend!

Here’s why it’s difficult for some people to get their head around why dividends are the big winner for long term shareholders.

Future dividends – in $ terms – should represent a higher percentage (proportion) of the original price you paid for the share.  That is, the value of a dividend from a well-run business in 2022 should be higher than it is in 2012.

Following is an example of the changing value of a dividend over time. This matrix details the full year dividends for the 2002 and 2012 financial years for Woolworths Ltd (WOW):

Divs Paid 2002 Fin Year

Share Price 30/6/02

% of 30/6/02 Share Price

Divs Paid 2012 Fin Year

Share Price 30/6/12

% of 30/6/22 Share Price

 

2012 Div as % of 2002 Price

WOW  

$0.30

$13.15

2.28%

$1.24

$26.80

4.63%

9.43%

Source: Iress Market Technology

 

Some observations:

  • The dividend has increased by around 4 times over the 10 years
  • The 30 June 2012 share price is around 2 times what it was on 30 June 2002
  • For the investor who bought WOW shares on 30 June 2002, the 2012 dividend now represents a 9.43% income return on their original investment ($1.24/$13.15 x 100)

Let’s be very clear here: not every business will produce such results and the truth is – just like in your town or suburb – from time to time businesses fail completely or fail to achieve meaningful financial growth.  You can lose some or all of your money in such businesses.  However, the point is that as an economy grows and the dollar value of profits increases over time, the dollar value of dividends – from well-run companies – rises.

Following is a chart that details five different businesses including WOW:

Divs Paid 2002 Fin Year

Share Price 30/6/02

% of 30/6/02 Share Price

Divs Paid 2012 Fin Year

Share Price 30/6/12

% of 30/6/22 Share Price

 

2012 Div as % of 2002 Price

QBE  

$0.30

$6.64

4.51%

$0.65

$13.38

4.85%

9.78%

CBA  

$1.50

$32.93

4.55%

$3.34

$53.10

6.29%

10.14%

WOW  

$0.30

$13.15

2.28%

$1.24

$26.80

4.63%

9.43%

TLS  

$0.22

$4.66

4.72%

$0.28

$3.66

7.65%

6.00%

BHP  

$0.24

$10.30

2.33%

$1.03

$31.45

3.28%

10.00%

Average:

$0.51

$13.53

3.67%

$1.30

$25.67

5.34%

9.07%

Source: Iress Market Technology

 

Legend:

 QBE                           QBE Insurance

CBA                            Commonwealth Bank of Australia

WOW                        Woolworths

TLS                            Telstra

BHP                           Broken Hill Proprietary

 

There is generally speaking a pattern of share price increases and dividend increases. For the notional average price of $13.53 on 30 June 2002 this ‘investor’ in 2012 received a dividend of $1.30 – 9.07% of the original investment.

Almost as a bonus, the investor can derive some comfort that the average share price has risen substantially.

IMPORTANT – THIS IS NOT INVESTMENT ADVICE

This discussion is not a recommendation for readers to invest in any or all of the specific investments, or types of investments, discussed in this blog. Please do not act to make investments based in this commentary.  This is a general discussion about some aspects of investing and cannot account for all circumstances.

Readers should seek their own professional advice which can take account of their personal financial position and objectives.

It’s easy to think that building investment portfolios was a lot easier in the 90s.  Yet in that decade all markets gyrated with substantial volatility at times. It’s instructive to reflect on some of the major financial events of that decade:

 90s Rock and Roll!

  • 1990/91 Recession in Australia (the last ‘official’ recession we for Australia)
  • 1990 Official cash rates at 18 % p.a.
  • 1990 Collapse of the unlisted property trusty sector
  • 1990 Corporate ‘high flyer’ collapses (Bond – Christopher Skase et al)
  • 1990 August, Iraq invasion of Kuwait = plummeting global share prices + skyrocketing oil prices
  • 1991 Gulf War
  • 1993 36% total return (price appreciation + dividend) for the Australian All Ordinaries Index
  • 1994 Global bond market crash
  • 1997 South East Asian currency crisis
  • 2000 The bursting of the ‘Dot Com’ (Information Technology companies) bubble

Those big issues notwithstanding, generally speaking, portfolios which had some exposure to Australian and international shares did quite well over the decade.

At a time when two decades of 10% per year average Consumer Price Index (1970-1990) was still echoing in the back of the cash register, it wasn’t that difficult for investors to derive capital growth (to help cope with the erosion of purchasing power by inflation) and a reasonable income.

‘Normal’ interest rates were very high by today’s conditions and exorbitantly high at the start of the 90s. Dividends were commensurate with todays and property rental yields were generally above (excluding residential) were above 5% p.a.

A well-designed, strategically balanced, portfolio could deliver what typical retirees needed – an income stream with the potential to grow over time and, for that peace of mind factor, a portfolio which could increase in value. There were times when it seemed (to the untrained eye) that all you had to do was put money in shares and you could ‘bank’ on it making capital gains.

Roll on through to the 20 teens and it’s a different ball game.

Same but different!

While the underlying fundamentals will always be the same i.e. only assets which can appreciate in value (such as shares and property) can deliver portfolio growth, the tactical application of such assets into portfolios is substantially different to the 90s.

The conflicted dynamics of debt-laden sovereign balance sheets (which act as both an economic and fiscal brake on a very large proportion of the global economy) versus the powerhouse, capital intensive, growth of the recent past in China and India, makes portfolio construction nowhere near as ‘bankable’.

Change all stations

I recall writing to my clients in August 2004 recommending changes to their portfolios because of what, it was abundantly evident (if professional advisers were taking the time to find the data and analyse it), was coming down the economic pipeline in the United States.  We reduced client allocations to international shares to less than half what it had been and within that we went underweight US shares.

It was a big ‘call’ at the time and one which took a few years to materialise however, it was in that period that it became clear to me that what worked in the 90s was by then history; that it would take at least a decade for the looming crisis to be wash through the global economy.

It meant that from then on there had to be an even greater focus on generating income – even for younger clients because in the absence of reliable portfolio growth at least consistent, tax efficient, income could be accumulated in their portfolios. Yet identifying investments that can generate, with reasonable reliability, consistent and competitive income – without too much risk – is quite difficult.

Next blog? Earlier in this blog I said that dividends in the 90s were commensurate to the 90s. That is to say the % income return on shares (the anticipated dividend as a % of the prevailing share price) were similar today’s dividends. But what’s not commonly identified by investors is the rising dollar values of dividends over time and it will be the subject of next week’s blog.  

 

Welcome to my blog where I hope to bring you some interesting information about investing and other finance related topics as well as the occasional wander into unrelated areas.

There’s always a lot happening in the world of finance however, no matter the economic and market conditions, the rules of investing remain unchanged. The rule of ‘risk versus reward’ and the laws of ‘supply and demand’ underpin all investment decisions – always have and always will.

In late 2012 Australian investors are faced with the prospect of further decreases in interest rates and fickle consumer confidence which will likely be reflected in business confidence. The challenge facing all investors in such an environment is: “How do I make a ‘real’ return (return after deducting inflation) in this environment?”  And for those retired or about to retire: “How can I generate enough income in these conditions?”

So in my blog I’ll do my best to make sense of what’s going on and what the most important issues are for investors.

Ray