(TUESDAY 27TH SEPTEMBER- 08:16 - JAMES GERRISH)...A strong night overseas with the DOW JONES adding +272pts while the S&P 500 was up +2.33%. Locally, the SPI FUTURES are pricing a positive open up 105pts or 2.7%.
Yesterday, our market was lower (-39pts) but that was a large turn around from the open where we saw the index up more than 50pts. The most important aspect of today's trade is that the index holds onto the gains made on the open, and investors don't use the spike as an opportunity to unload.
The optimism last night came on the back of reports that progress was being made to ring fence Greece from the rest of the EU as well as beef up the European Financial Stability Fund which would then be used to recapitalise the banks and buy bonds.
INCOME FOR RETIREMENT
Recent market volatility prompts obvious questions around asset allocation and the best way for those nearing retirement to manage and protect their wealth - whilst ensuring adequate levels of income.
Obviously the most common analysis metric used by investors looking for income is yield. Be that yield on equities, yield on bonds/hybrids or yield on term deposits.
Different asset classes pay various levels of yield and this is often (but not always) reflective of the risk involved. However a lot of investors fail to give enough emphasis on the potential for yield in the years to come. Too much focus is given to the here and now.
The most obvious examples are term deposits or cash management accounts. From some online providers (UBank, Virgin Money, Rabo Direct, CUA etc) you can earn around 6% on your savings. Not bad in the current environment and even more attractive with the Government guarantee. Two questions to ask when considering the returns achieved on these accounts. Will they improve over time and is it a tax effective investment given my current tax situation?
The outlook for interest rates has been fairly mixed in recent times however the consensus has now turned towards a reduction in the benchmark rate. If the market pricing is correct, we'll see a reduction on the benchmark rate of 1% over the next 12 months. For those already locked in term deposits, that wouldn't be a major concern. For those invested in cash accounts, it would be. But whatever type of account you're in, future returns will at best be the same as they are today, but most likely they'll be lower.
The other consideration is the tax environment you earn the income. Its true that a self managed super fund in pension faze pays no tax, but it's important to note that cash accounts or term deposits don't pay franking credits. The benefit of franking credits in a Super Fund environment is significant. If you're fund is in pension faze, you'll be able to claim back the 30% franking paid by the company and issued to you. A 6% dividend turns into a 7.8% dividend.
Bonds and other fixed interest type investments have been garnering attention given increased market volatility. You need only look at the 10 year US Treasury Bonds now offering less than a 2% yield while domestically, the Australian 10 year is offering less than 4.5%. Corporate Bonds will pay more while Hybrid Securities will offer more again.
We've actually been quite keen on Hybrid investments in recent years particularly given that the majority of listed securities in Australia offer a floating rate coupon and interest rates have been rising. This means that they pay a premium on top of the 90 or 180 day bank bill swap rate. For instance, if the 180 day BBSW is 4.65%, and the security pays 3% on top of that, the holder will receive 7.65%.
This return looks good however it is directly correlated to the outlook for interest rates. If the benchmark interest rate is lowered by the RBA, the return on these investments will fall. So when we apply the test of whether the income stream will be higher or lower in the future, most securities will fail given the outlook for interest rates.
The important point I'm making about income or yield centres on its potential growth in the years to come. For an investor looking to live off the income from their portfolio in retirement, it's important to have an income stream that can grow over time. This brings into focus the value of equities given the recent market selloff.
It's true that investing in equities offers a higher degree of risk than putting money in a cash account or buying corporate bonds - therefore we need a higher level of potential returns to make it worthwhile. I'd also argue that the risks involved in investing in the equity markets have fallen, rather than increased as the media would have you believe - but that's an argument for another time.
The key point here is that equities can provide the platform to grow your income over time. Not all equities will give you this opportunity and there is likely to be volatility involved, but by being diligent in the shares you purchase, you can construct a portfolio that will offer a growing amount of income as the years go by.
For instance, a portfolio that yields 6% this year, and is filled with stocks that have strong earnings growth and a policy of sharing that growth with shareholders, can become a portfolio that yields 7.5% next year and 9% the following year. In 5 years time, an investor can be enjoying a yield of 12% or more from their portfolio whilst also getting the benefits of franking credits.
The key consideration is obviously what stocks you buy and at what point in time you buy them. I like to classify dividend stocks into two categories. The first will encompass high yielding securities that pay very attractive returns now.
Examples of these include Telstra (TLS) and Tatts Group (TTS) with current yields in excess of 9% fully franked. I classify these types of stocks as bond like investments and if you take a look at their earnings profile below, you'll understand why. Given the earnings growth profile (or lack of), you're unlikely to get an increase of this distribution over time.
Tatts Group (TTS)
Telstra (TLS)
Now firstly, I'm certainly not against investing in these types of income streams as long as we understand what we're getting - an income stream that is unlikely to grow over time (but pay a relatively high amount now).
The other category of dividend paying stocks are those that pay slightly less now, but have a strong growth profile going forward. Given the strong growth profile in earnings, and the direct correlation this is likely to have on the growth in dividends, these stocks are likely to pay more in the future considering the entry price now.
For example, Metcash (MTS) which currently pays 6.6% FF and has a pretty strong growth profile.
In the mining services sector, Fleetwood (FWD) looks interesting and is currently offering 6% FF but is likely to pay more next year and the year after.
Even the banks offer a strong outlook for dividend growth. Probably more so in the medium term than the short term but that's ok for investors who are preparing an income stream for retirement.
ANZ Bank numbers below although for longer term investors, Westpac (WBC) currently represents the best value.
So I think it's extremely important for investors who are preparing for retirement, to focus on preparing an income stream that has the potential to grow over time. Try not to be focussed solely on the here and now.
MODEL PORTFOLIO STOCKS
We topped up on some stock in the model portfolio on Friday. To see the updates in real time you can view the front page of the website www.mymarketview.com.au
We topped up on ANZ, QBE, CBA, AWC, VOC, QUB, BKN, IPL, CBA and we added new positions in CEO, MTS & FWD.
AUSTRALIAN STOCK PRICES OVERNIGHT
In New York, News Corp rose by US$0.21 to US$16.34, equivalent to A$16.62, A$0.14 above its last close on the ASX, ResMed rose by US$0.07 to US$28.74, equivalent to A$2.92, A$0.03 above its last close on the ASX. In London, Rio Tinto fell 20.5 pence to £29.65, A$0.32 lower in Australian currency terms, BHP-Billiton fell 14.5 pence to £17.47, A$0.23 lower in Australian currency terms, and Henderson Group Plc fell 1.5 pence to £1.10, A$0.02 lower in Australian currency terms.
