Where to invest in times of low interest rates
I recently tried to put some money on term deposit in California, where my family enjoys holidaying each year.
At the local Chase Bank branch I asked the young lady behind the counter about rates for a six-month term deposit. She looked at me blankly.
"Perhaps you call it a certificate of deposit over here?"
Still nothing. I was asking for something she'd never heard of.
After she referred me to a more senior colleague, it became clear that she was like the proverbial five-year-old frog in the long drought that had never learnt to swim.
The more senior banker explained that "maybe seven or eight years ago we could have offered you something extra but that was a long time ago."
I ended up leaving the US dollars in a savings account earning the princely annual rate of 0.25%.
So perhaps we should count ourselves lucky in Australia where interest rates are still visible to the naked eye.
Even so, 2.5% term deposit rates hardly set the pulse racing and the sharemarket offers an alternative - dividends - that's become increasingly attractive in times of low interest rates.
Dividends have a couple of advantages over bank interest rates.
The first is that they often arrive with tax credits attached (franking credits, which reflect the tax a company has already paid on behalf of its shareholders). These credits can add mightily to your after-tax returns, depending on the marginal rate you pay.
The second advantage is that, unlike a bank deposit, dividends have the potential to rise over the long term (as does your capital).
These attractions have helped underpin a strong performance from the sharemarket over the past few years. But it's a mistake to simply compare term deposit rates and the dividend yield on a portfolio of stocks. The latter entails far more risk and the potential for capital loss.
So I'd like to share with you a five-point plan for considering the potential risk involved in buying a share for income:
- Consider the nature of the business. What are the weaknesses, vulnerabilities and risks that might hurt future profits and dividends?
- Examine the stability of past earnings. How volatile have profits been and how long is the history you have access to? Does the company's cash flow support its earnings?
- Calculate the dividend cover ratio. Is the company paying out a large or small proportion of profits as dividends? Has this ratio been increasing or decreasing or is it stable?
- Reflect on current trends. Which societal, financial or market forces are impacting the business? Which ones help and which ones hurt?
- Reflect on your required return. In light of your analysis, what return do you need to compensate for the risks you're taking on?
- Let's now apply the plan to a stock to see how it works in practice. Woolworths is a good example because it's a business most of us understand fairly well as customers.
Nature of the business
Woolies is a strong business but one vulnerability is that it has pushed its dominance very hard at the expense of suppliers and customers. Its profit margins are the highest in the world that I know of in its industry.
The business is therefore susceptible to increased competition and lower margins in future.
Another soft part is its expensive foray into hardware. Its Masters chain is still a fair way from breaking even, let alone recouping the losses of the past few years and then earning a decent overall return.
Management has acknowledged that the core grocery business has placed too much emphasis on opening new locations rather than refreshing old ones.
Stability of earnings
Profits have marched upwards in a manner befitting a solid blue-chip company. And there is plenty more history available if you wanted to extend your analysis of the company's past earnings.
The record is long and impressive. Woolies' cash flow is also strong and, although it falls short of accounting profits, there are sensible business reasons for it doing so (rather than accounting shenanigans, for instance).
The "dividend cover" ratio is calculated by dividing the earnings per share by the dividend in each year. A low coverage ratio means the dividend might be under immediate threat if profits were to fall.
Woolworths' dividend cover ratio of 1.42 means that earnings exceed dividends by 42%. Theoretically, earnings could fall by almost a third and still cover the dividend (though, in reality, the dividend would most likely be cut if earnings fell by that much).
Once again Woolies has been a model of consistency, with its dividend cover ratio very stable for the past five years.
Our fourth point is the most challenging. Current trends are not Woolworths' friend. A resurgent Coles is taking market share and Aldi continues to expand, nibbling away at both of the major chains from below. And if Australia's economy softens, that will be a negative as well.
On the positive side, over the longer term as Australia grows in population and prosperity, we're virtually certain to be spending more on the products sold by Woolworths. If it can keep market share losses to a minimum, then the company will benefit from that growth.
Finally, we come to the required return given this set of circumstances. There's no fixed formula for determining this. It's a personal choice that depends on a number of things. The first aspect is your own financial goals.
Some people would be happy with 6% annual returns from a stock such as Woolworths while others are shooting for double-digit returns on any investment they make.
Second, it depends on your personal view of the weaknesses, vulnerabilities and current trends and your assessment of how effectively Woolies can protect and grow its business in light of these.
Personally, I see Woolworths as a cornerstone stock for my super fund which, when purchased at the right price, should deliver steady dividends for decades to come. That being the case, I'd be happy with a fully franked "starting yield" of 5%.
From a tax perspective, that's the same as being paid 7.1% in fully taxable bank interest. Over the longer term, I'd expect this income stream to grow by between 1% and 3% a year, for a total annual return of around 8% to 10%.
With expected total dividend payments of $1.39 for the year, I can pay up to $27.80 for the stock and still achieve my target return ($1.39/$27.80 = 5%).
For me, that's reasonable compensation for the possibility that things turn out worse than I expect and I end up with overall returns closer to zero (negative returns from today's price over the next decade are unlikely in my view).
With a superannuation portfolio anchored by such stocks, hopefully I'll be making that annual winter trip to sunny California well into my retirement years.