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Investment Strategy
Thursday, November 1, 2007
All in the yield

On retirement your investment needs change from capital growth to income. But this should not mean that you should sell all your shares and stick the cash in a fixed deposit account, warns Sunel Veldtman, director at Barnard Jacobs Mellet Private Client Services.

“What may appear to be a safe investment in cash is actually a high risk, low reward strategy. Cash fails to outpace inflation over the long term and pensioners often find their funds running out,” She adds.
Veldtman says in retirement people tend to focus on capital preservation. However it is actually income growth that is far more important. “Traditionally people would cash in their investments at retirement and purchase a life annuity with a set income. This made capital growth before retirement critical as it determined the level of income you could purchase on retirement.
“However, with a move to living annuities, which allows the investor to transfer his portfolio into a new retirement structure, with the resulting change in the approach towards income generation, there is no set time that you would have to sell your equities.”
Veldtman says that this means one is able to use a portfolio far more effectively to ensure a long term steady income. “While capital growth is important to ensure that your capital base stays pace with inflation over the long term, a steady and growing income stream is far more important.” She explains that as long as you are receiving an income, your capital value can fluctuate over the short term. “This is the essence of income investing – to remember that you can withstand a great deal more capital fluctuation than income fluctuation.”
To this end an investment in equities or listed property can be more prudent than cash. A solid company will grow its dividend yield over time, while cash yields can change on a monthly basis.
Veldtman uses the example of Firstrand compared to money markets in 1998. This was the height of the interest rate cycle, but prior to a major stock market crash which resulted in a bear market for several years. Despite the intense market volatility, the dividends have proven a better income stream than cash. For example in 1998 money market yields were around 17% while FirstRand was paying a dividend of 10.39c per share, which was a relatively low dividend yield of only 1,4%. However, today money market yields are around 7,5% while FirstRand is paying shareholders 73.5c per share which is a 600% increase in income.
“Over time, the capital value of a share tracks its dividend growth. While there may be short term fluctuations, the growth in a company’s dividend will eventually reflect in its share price,” Veldtman says. By buying a company with a strong dividend yield, you will eventually be rewarded with good capital growth as well. “The day you buy a share you effectively peg the price you paid for it and therefore as dividend payouts increase each year, so does the dividend yield relative to the share price you paid.”
Using the same example with FirstRand, if one had bought the share at around R7,50 in 1998, the dividend yield today would be 9,8%. Through dividends your income increases each year and is the best way to keep up with inflation.
Veldtman says a similar view should be taken when buying listed property “There are a few opportunities which provide a good buying opportunity and the sector re-rates providing spectacular capital gains. However generally speaking this asset class should be bought for its income stream.”
If investors had only focused on the income from listed property, they would not have sold out of the sector during the panic sell-off in June last year and would have been rewarded by a rapid recovery in the share prices as well as continued strong income.
“Even when the value of listed property fell by 20%, it had no impact on the investor’s income. They could afford to wait out the volatility.”
We are seeing a very similar situation with preference shares at the moment, which is an indication of a classic bear market, and hence a great opportunity for investors looking for yield.
Veldtman says that the market over-reacted to the changes in secondary tax on companies. Price weakness has driven the current yield on the preference share portfolio to some 9,5%, which is equivalent to a taxable interest rate of over 16%.
“Investors with a long term view should be using the opportunity to invest.
“There are, however, different considerations when it comes to living annuities.” There are some structural reasons why a high equity allocation may not be prudent. Firstly interest income in a living annuity is not taxable, therefore the investor can afford to have a higher weighting in asset classes whose income is ordinarily taxable, such as cash, bonds and listed property. There is also the issue of the amount of income one can draw down. As investors have to draw down between 2,5% and 17% (from the 1st of October) of their capital value, having high levels of volatility may impact on the amount you can draw.

Copyright © Insurance Times and Investments® Vol:20.10 1st November, 2007
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