At the start of the year I highlighted some key investment themes for 2012, one of which would be for investors to look to companies with solid growth and consistent yields.
And not long before that I identified some stocks that consistently pay high dividends.
Given the rout we are experiencing in the global markets as the bears take control, I thought might be timely to review a strategy that our D2MX clients were given at the start of the year.
Consistent Income Strategy – The Methodology
The primary goal for the investment strategy was to look for opportunities that had a high probability of producing above average returns for the next twelve to eighteen months.
The strategy was developed in an environment where the RBA was forecast to be reducing the cash rate down towards 3% by the end of the year, and the property market was at best flat.
This strategy was developed as a good alternative to trying make money through investing in the property markets, where rental yields are currently only 3%-4% and there is little prospect of significant capital growth near-term. The strategy also has a high probability of offering a better return than simply leaving funds on term deposit, although there is market risk involved.
The first step in this strategy was to identify a stock that paid consistently high dividends and was likely to hold its dividend for at least the next year.
Consistent Steady Income Strategy – The Overview
The stock we selected for this strategy was Telstra, which was trading at $3.25 and was on a dividend yield of 8.6% (grossed up to 12.3%). Telstra was about to have the NBN deal ratified by the regulator and had a confirmed dividend of $0.28 per annum for at least the next 18 months.
We proposed using a margin loan of $100,000 with interest at 9.5% and with the leverage dependent on the investor’s own risk profile.
Consistent Steady Income Strategy – The Metrics
I’ve done some sample calculations to give you an idea of the metrics of the trade – refer to the table at the end of this article. The calculations show the returns if the Telstra share price either falls to $3.00, stays flat at $3.25 or rises to $3.75 at the end of the 12 month period.
This chart shows the returns based on a number of different final trading prices for Telstra, ranging from $3.00 to $4.00. Note: a number of brokerage houses have a 12-month target of around $4.25 for Telstra.
Chart 1: Performance of the Investment with Telstra ending at various levels ($3.00, $3.25, $3.50 or $3.75) at the end of the 12 month period (Cost Price $3.25).
Investment Highlights
The performance chart confirms that the strategy would:
• Generate a loss if the stock closed at $3.00, a 7.7% fall in the stock price. Even including the grossed up dividends it would lose 4.9% on the total investment, and if the portfolio was leveraged at 50% then the investment would lose close to 10% for the year.
• Be profitable even if the share price stayed flat at $3.25. The grossed up yield would be 2.8% on the total investment, i.e. including the dividends and franking credits, and if the portfolio was leveraged at 50% then the investment would generate close to 6% for the year.
• Significantly outperform the returns on a similar investment in property or fixed interest, if the stock price rises to $3.50 or is up just 7.7%, the grossed up yield would be 10.5% on the total investment, i.e. including the dividends and franking credits and if the portfolio was leveraged at 50% then the investment would generate close to 21% for the year.
** Note that transaction costs have not been included in the calculations and that there would be additional tax benefits from claiming on the interest paid on the loan.
Margin Loan Risks
Before proceeding it is worth considering some of the risks of this strategy.
• Borrowing to acquire an investment that falls in value or does not earn a net return greater than your borrowing costs will result in a larger loss or lower after-tax return than if you had not borrowed to invest or not invested at all. But it can also leverage returns.
• The value of your investments can change in unexpected ways and may not earn the net return you expect and you may be subject to a margin call to top up the loan-to-value ratio (LVR). Changes in the price of an investment are usually a key determinant of the return you earn or loss you incur on an investment. Using a 50% LVR considerably reduces the chances of a margin call.
• You are responsible for your investment choices and consequently whether any net return is sufficient to cover the cost of borrowing and other costs and the investment’s suitability to your circumstances and financial objectives.
• Unless you apply for a Fixed Rate Loan the Lender may vary the Variable Rate applicable to your Margin Loan Facility at any time.
Consistent Steady Income Strategy – The Trade
How can you make money in such a strategy?
Let’s evaluate the benefits of this trading strategy.
• This is a way that you can leverage your way into an equity portfolio, in order to build wealth.
• Note that the dividend yield on Telstra was particularly high, over 9% at the time the investment was initiated.
• With the current market pullback we will get another opportunity for this type of investment. The chart below uses a purchase price of $3.50. The returns still have the potential to outperform property and fixed interest investments, but of course there would be more chance that the share price may finish below the original purchase price.
• This strategy cannot be used within a Self Managed Super Fund (SMSF), however we can offer alternatives using installment warrants strategies.
• We can also offer option strategies that can further reduce the market risk on the trade.
Chart 2: Performance of the Investment with Telstra ending at various levels ($3.25, $3.50, $3.75 or $4.00) at the end of the 12 month period (Cost Price $3.50).
Disadvantages
• The stock price might fall over the twelve month investment timeframe.
• Leverage is a two-edged sword and we have shown that the investment would start to lose if the stock price falls too far. However there are option strategies that we can implement to mitigate this risk.
Conclusion
This strategy is paying off handsomely in the current market environment and may well explain why Telstra shares have shot up so much in the first part of this year.
The strategy does offer the investor a viable investment alternative to either property or fixed interest investments, and can be incorporated in SMSFs through the use of installment warrants, which I have touched on in discussions in a previous article about Boosting Your Investment Returns.
We may well get another opportunity to implement this strategy in the near-term using Telstra or some other consistently high dividend-paying stock, given the aggressive market pullback we are currently experiencing.
Contact me at D2MX Trading on 1300 610 024 and I can help you trade using this or a number of other strategies that can help boost your return on investment.
Michael Hevern
Investment Adviser
D2MX Trading
This report was prepared by Michael Hevern. It represents the views and opinions of the author. It is not intended for use by any third party, without the approval of Michael Hevern. While this report is based on information from sources which are considered reliable, its accuracy and completeness cannot be guaranteed. Any opinions expressed reflect my judgment at this date and are subject to change. Contracting Hevern Pty Ltd is a Corporate Authorised Representative No. 408868 of D2MX Pty Limited ABN 98 113 959 596, AFSL No. 297950 (D2MX), and Michael Hevern has been appointed as an Authorised Representative of Contracting Hevern Pty Ltd. Opinions, conclusions and other information expressed in this report are not given or endorsed by D2MX, unless otherwise indicated. The information contained in this Report is General Advice only, as the information or advice given does not take into account your particular objectives, financial situation or needs.
Disclaimer: Using leverage to invest can be a two edged sword, as it can magnify your returns when the stock price rises, but will in turn magnify the losses if the trade does not perform as expected.
TABLE 1: Returns for Telstra ending at various levels ($3.00, $3.25 or $3.75) at the end of the 12 month period (Cost Price $3.25). Contact me at D2MX Trading on 1300 610 024.
