Churchouse Letter
June 2016               by Peter Churchouse

Diving Into Dividends

Dividends can be the hallmark of a great company. High dividends are attractive... but dangerous. And what you have to know when it comes to dividend ETFs.

Dividends are critical for income investors, but there are plenty of easy and costly mistakes to be made - we highlight them and explain what you need to consider.
We analyse the dividend ETFs available for the U.S. and Asia and give you our top picks for your portfolio.

For me, it all began in the summer of 1971 with a man named Tom.

Tom had that faint smell of snake oil about him. But he was a good listener and quickly won over our university crowd, pitching up at parties, always with enough beer to go around.

Unlike the other students, Tom was always smartly dressed in trousers and a business shirt. And he got on well with everyone. It was his job.

Tom was an insurance salesman.

I was a prime target. Tom knew I was studying economics. He also knew that I was a saver, and had worked for years in all sorts of jobs to pay my way through university.

He rightly guessed that I was highly motivated to become financially self-sufficient. Money was important to me… alongside surfing, travel, parties and all those other great things in life, of course.

Long story short, Tom persuaded me to sign up for a life insurance policy. Not that life insurance was even on my radar at the “invincible” age of 19. He’d cleverly pitched it as a savings vehicle.

The idea was that after five years, I would be able to draw down on this policy to fund some real estate purchases. The numbers quoted to me looked like I could expect to make enough to purchase at least one, probably two small apartments.

What total fiction that turned out to be.

But now, I can thank Tom for igniting that spark of interest I had in real estate. The property investment angle had persuaded me to take out the insurance policy in the first place. Even at that early age, when most of us were thinking about the next party, I was drawn to the property play.

Despite the insurance policy being a flunk, the exercise pushed me to figure out what investing in real estate is really about.

Capital gains? Sure. But the other side of the coin is cash flow from rental income.

It got me thinking about buying assets that would one day be debt free, and spinning off enough cash to fund a great lifestyle and, ultimately, a comfortable retirement.

That motivation, that thinking, has stuck with me ever since. And it has served me well. At least so far…

 

Beware the Snake Oil

After some great adventures on the road in Africa and a stint in London, my wife and I finally landed in Hong Kong in 1980, where that saving mind-set kicked in again. Earning decent money and paying low taxes it was possible to put cash aside for my next investment.

We already owned some real estate in London, but buying real estate in Hong Kong was out of the question back in 1980 given the massive bubble the property market was experiencing. So where to invest?

I was relatively naive about financial markets at the time, but I still had that deep-rooted urge to build assets for longer-term cash flow.

Like many young professionals, I slipped into the hands of people a bit like Tom. They were selling savings vehicles wrapped up in some kind of insurance structure.

Again, they were positioned as investment products, which would give us wonderful cash flow in X-number of years, and provide some insurance benefits along the way.

I did not expect to get rich from these by any means, but I did expect them to provide some growth of capital and cash flow in the future.

Once again, the reality was very different. And, again, a lesson learned the hard way.

These barely returned the capital invested let alone any cash flow. But they did serve to keep the savings going and at least some prospect of asset growth and income.

The lesson? Be extremely sceptical about the investment value of any instruments sold under the banner of insurance products.

I know a great many people who have been sold these kinds of insurance-wrapped investment vehicles and are sitting on massive losses.

It served as a harsh reminder to follow my gut, not the guy with the snake oil. Having a good portion of one’s savings in genuine cash-producing investments such as real estate and hard assets is VITAL.

This has never been more true than today.

Investment in real estate is a much better insurance policy than all those things that the insurance industry throws at you. It gives two things that most insurance-based investment vehicles do not.

First, capital growth over the long term. And, second, a reasonably reliable and transparent cash flow over whatever period you want or need. Moreover, real estate has handsomely beaten inflation over the long term in just about every major developed economy.

It is that reliable dividend, or cash flow, that we increasingly look for as life progresses.

In the early stages of life, we look more for capital growth in our investments. But, later on, we need the security of cash flow from rental income or dividends.

And that is what we are looking at in this edition of The Churchouse Letter.

 

Rates and REITs

In the history of modern finance, I cannot think of a period like the present where investors are focused on income the way we are right now.

Low and negative interest rates are forcing us to seek alternative dividend and yield producing investments. Low rates have crushed the recurrent income returns of a great many investment products and vehicles.

This world of zero/negative interest rates is having two important effects that we need to take advantage of.

Firstly, low rates are underpinning capital values of hard assets such as real estate. We are seeing this around the world.

In many countries, increasing real estate prices have raised fears of a bubble. This has prompted central banks and governments to lay down monetary and fiscal initiatives to cool excessive enthusiasm in real estate markets.

We have long recommended taking advantage of low rates by being invested in real estate.

Secondly, this low-rate-world is forcing investors to seek yields in assets and investment vehicles outside of the normal income-producing bank deposits and bonds. Real estate in both its forms (ownership of actual bricks and mortar, and through publicly traded vehicles such as REITs) does just that.

Real estate investment trusts (REITs) play to both of these themes. They hold real estate assets for long-term rental income and capital appreciation. And, they are typically required by law to pay out around 90% of their net income to shareholders in the form of dividends.

Preferential tax treatment also makes REITs an attractive investment. In almost all jurisdictions, REITs get more favourable tax treatment than “normal” companies.

In our low-interest-rate world, we need to be invested in real estate, and we need yield.

We see real estate generally as likely to benefit from ongoing capital growth. It also offers good dividend yields, especially investment via REITs.

Outside of REITs, there is a universe of companies that pay reliable dividends, and have done so for decades.

Any number of funds, vehicles and ETF's focused on dividends and yield are on offer in the US markets.

We take issue with a number of these dividend ETFs because of the way the underlying stocks are chosen. We’ll cover that in more detail, but first… dividends.

Investors often dramatically underestimate the importance of dividends.

Think about it. When buying a stock there are only two ways you can profit. One, by selling it for more than you paid for it (capital gains), or two, by collecting dividends (income).

Ultimately, a dividend is just a portion of earnings that is returned back to the shareholders. Why? To make sure shareholders either hold onto the stock or buy more of it.

Dividend returns depend largely on the maturity and growth prospects of the company.

At one end of the spectrum, a young technology company will be looking to re-invest earnings and grow the business. At the other end, you have the oldschool blue chips of the world like Coca-Cola and IBM, who value a stable long-term investor base and are committed to keeping them happy.

 

Measuring Returns

What impact does dividend stocks have on your long-term returns?

Let’s start with the US. Its stock market is the deepest and most developed in the world. There is a plethora of listed companies with dividend histories going back decades that gives us plenty of data to work with.

In order to compare “dividend” stocks with the broader market, we’re using...


Discover what dividend-paying income opportunities we've discovered in this edition of The Churchouse Letter and leverage them to add some much needed cash flow to your portfolio.

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