May Stock Purchase – GSK, SHP and The Importance of Income 4

The month of May continued to see markets at record highs. For someone like me who is in the asset accumulation phase of their life cycle, this is terrible news. This is because I don’t like paying top price for ownership stakes in companies. I or anyone else for that matter who has a long time horizon in front of them should wish for languishing markets so that we get the most bang for our back – we get more shares for the same amount spent. Unfortunately the persistence of low interest rates by various central banks has meant stocks are at record highs and I need to pay up if I want to own stakes in great businesses. Although I hate paying top price, I need to realise that there are still pockets of value to be found.

One sector that still looks appealing in relation to the wider market is healthcare and in specific pharmaceuticals. There is still uncertainty surrounding Obamacare, Trumpcare or what ever you want to call it and this has meant that pharma/biotech stocks haven’t really joined the wider market rally. The two companies I bought shares in using the monthly stock purchase programme (LINK) are both in this sector and are:

  • GSK – Bought 10 shares at £16.30 each. Dividend Income : £8
  • Shire – Bought 4 shares at £47 each. Dividend Income £1.07

(Both these are additions to existing positions in my portfolio. I know have a total of 50 shares in GSK paying out £z40 a year and 10 shares in Shire paying out £2.67 each).

In addition to the above two shares bought using the monthly stock purchase programme, I also bought shares in Imperial Brands which I wrote about earlier this week. All in all, my annual dividend income has now crossed the £1,500 mark. To be precise, my annual dividend income is £1,527.

It does really feel amazing to cross that £1,500 psychological milestone. Less than 19 months ago I had £0 in dividend income. Yes that is zero! But by being persistent in my push to own money generating assets, I have slowly built up a conservative portfolio that throws off wads of cash. I did have some luck along the way (or is it reward for being patient) by bagging Royal Dutch Shell and BP and close to 10% dividends yields. But I also faced challenges most notably when Cobham cut its dividend – I haven’t sold this position and I expect dividends to resume within the next 2 years which would be a bonus.

For new readers, it might sound weird that I seem to focus on income so much.There is a reason for this. To put it simply, income is your true wealth. Income is what you live on. Income is what gives you the freedom to enjoy your days and take vacations.

When you buy 100 shares of a stock that pays £1 a year in dividends, you’ve just set yourself up for £100 a year in income. With a little bit of investing acumen, that income stream should rise. And a dividend is even more than just an ordinary income stream. Dividends of great companies grow every year above the rate of inflation. Furthermore, dividends are vital to the overall returns of your portfolio. According to studies, dividends have accounted for about 43% of the performance of stocks in the S&P 500 since 1926 (most historical studies are US based so it is hard to get figures for the FTSE but we can assume it will be about the same).

That means if stocks return 7% a year, about 3% of that is dividends. That makes for a big chunk of returns.That difference grows over time via compounding. An investor who collected and reinvested dividends from 1940 to today would have earned 10 times as much as an investor who collected the capital gains on stocks alone.

Simply put, paying dividends is exactly what the stock market is about. After all, a dividend can’t be faked. Companies can employ a range of accounting tricks to beef up earnings. They can come up with new grand “strategic plans” to paint a bright picture for the company’s future. At times, some even engage in outright fraud. But a dividend comes as real cash, straight from a real bank account. It can’t be faked, cajoled, or conjured. Only companies with sound financial footing and real profits can pay dividends. By focusing on sustainable dividends, you’ll immediately ignore many of the junk stocks out there in the market.

Dividends also play the important role of helping you avoid the biggest investing mistake of selling at market bottoms. When you focus on dividends, you tend to ignore your overall portfolio value – you tend to ignore the daily stock market fluctuations. So in a market downturn, an income investor like me is more likely to hold on to my stocks as opposed to selling due to focussing on the dividends I will get paid. In fact dividend investing may actually help you in buying at the bottom as you will now be able to ‘buy more dividends’ at lower prices.

While I am on this topic, I may as well talk about the dividend-payout ratio. This is the percentage of earnings the company pays out as dividends, usually on an annual basis. You can find dividend-payout ratios for most stocks on finance sites such as stock flare (LINK). The key is to look for sustainable dividend payout ratios.

For example, a dividend-payout ratio of more than 100% is, by definition, not sustainable. At that pace, the company will eventually run out of money. Usually, a dividend-payout ratio of more than 100% is due to an accounting quirk that has reduced the company’s earnings on paper for a quarter or two. Less often, it may indicate a special dividend was paid in the last year. (It is important to note that with cyclical companies it is better to check the payout coverage over the whole economic cycle as opposed to year on year)

It’s also helpful to read statements from management to find its “targeted” dividend-payout ratio. When management announces a target and hits it consistently, it shows the company has the earning power to stay on track. It also shows that management is credible and able to deliver on promises.

When investing in dividend paying stocks, you want reliability and and longevity. The longer a company has paid dividends without cutting it, the better. For a quick measure of this, find out what the stock did in 2008. If the company continued to pay its dividend throughout the 2008 financial crisis, then that is a stock that has a strong balance sheet and could potentially survive anything. Look for stocks that have paid a consistent amount of dividends for at least the past 8 – 10 years. Look for stocks whose average dividend growth rate over this time period has been at least 5%. Look for dividend payout ratios of below 70%. The dividend-payout ratio can tell you a lot about an investment – including whether the company delivers consistent payouts. And that’s vital for anyone investing in income.