Money to live on- 21st August 2002

Barbara Drury - Sydney Morning Herald

In Jane Austen's day a person's wealth was measured in terms of how much they ``had" a year. Almost the first thing the reader learns about Mr Darcy is that he is rumoured to have $10,000 a year. In other words, wealth was defined by income generated.

These days wealth is measured by the value of our possessions a house, cars, artworks and jewellery. According to the people who measure these things, Australians feel wealthy because the value of their homes is increasing while Americans feel poor because the value of their share portfolios is decreasing.

With share prices in retreat around the globe and capital growth a fading memory, it is easy to overlook the fact that the dividend stream from equities is not just flowing, but growing steadily from many solid companies that have long been household names.

Peter Thornhill, principal of Motivated Money, points out that if the things you own don't produce income you are really quite poor.

``We need to reassess the way we look at wealth," says Thornhill. ``Income will enable my wife and I to do the things we want to do in retirement. No-one knows how long they will live, so if you rely on assets there's a danger you could run out of assets, and that would be a disaster."

The key indicator for income investors is the dividend yield, which shows dividends as a return on your investment based on the current share price.

Before turning your back on shares to chase higher-yielding assets, it's important to note that the dividend yield is derived from two real dollar figures that rise and fall over time. Dividend yield is calculated by dividing the most recent annual dividend per share by the current share price, and expressing the result as a percentage.

Thornhill warns that, rather than focus exclusively on the percentage yield, investors should concentrate on the dollars that end up in their hot little hands.

In recent years investors have flocked to listed property trusts (LPTs) because the yields outstrip those available from industrial shares. Yet, as Thornhill points out, the income from industrial shares, measured in dollar terms, has outperformed LPTs.

The graph shows that investors who put $100,000 into LPTs in 1979 earned more income than investors who put the same amount into industrial shares in the first few years. But over the long term, the share investors received far more income as the capital value of their investment and the dividend per share increased.

``The reason for this anomaly is that the capital performance of property is relatively weak, so a low denominator [unit price] gives a high `yield'," he says.

For similar reasons, term deposits have proved a disastrous income investment over the past 20 years despite periods of relatively high yields.

When selecting shares for a reliable income stream, Thornhill looks for quality businesses that make food or provide goods and services, irrespective of investment fads or taxation policy. He advises investors to stick to companies whose businesses they understand, with a history of reliable earnings and solid dividend growth.

It also pays to understand where these rivers of cash come from. Companies pay dividends to shareholders out of profits, but they also retain some earnings to plough back into the business. This is important because retained earnings produce future growth that, in turn, will ensure a healthy income stream.

Dividend cover shows how much after-tax profit is being used to finance dividends. This is calculated by dividing dividend per share by earnings per share. The result is expressed as the number of times dividend is covered by earnings.

Thornhill believes that shares have a core role in an investment portfolio at all times, and says he and his wife are 140 per cent invested in shares because they borrow to invest. He views this as pre-purchasing retirement income that is, he borrows to buy shares today that he couldn't otherwise afford and uses the dividends to repay the loan while he is still working and doesn't need the income for living expenses.

Income from shares is doubly attractive because of the tax benefits when compared with income from alternative assets. Dividend income is taxed in shareholders' hands at their marginal tax rate but they get a tax credit for tax already paid by the company thanks to dividend imputation. However, companies that earn a sizable proportion of their income overseas may only offer partly franked or unfranked dividends.

Investors whose marginal tax rate is lower than the company tax rate may use excess franking credits to offset the tax liability on other income.

It's little wonder that investors who have chosen shares wisely for their total return, and not just short-term capital gains, are unperturbed by the sound and the fury emanating from Wall Street.


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