If you’re investing for income, one of the first things you’ll look at is the yield. After all, the more yield an investment generates, the more money that should land in your account.
Yield has become even more important with interest rates stuck at historic lows.
However, plod along to your local bank to check out its term deposits and you’ll get little joy. You’ll be lucky to get much more than 2–2.5%.
With rates as low as that, income-hungry investors will scramble for even a fraction of a percent in extra return.
However, it’s not like one bank can offer a much different rate to another. In the main, they all have similar wage and other cost structures.
For banks, it’s a constant battle to finesse their margins. A higher deposit rate might get more money on board. But unless they can lend it out at a higher rate, it puts a squeeze on their margins.
And if a bank doesn’t offer a competitive rate, its customers will quickly go elsewhere. And that means they might need to go offshore to top up their funding.
Because of this, investors putting their money in term deposits are caught in the middle of the banks’ margin squeeze.
With such low rates, and little difference between the banks, it’s little wonder money has flowed into the stock market.
With yields of 6%-plus on offer, investors have flocked to higher-yielding shares.
Not all yield is the same
But while there might be little difference between term deposit rates, there is a lot more at play when it comes to the yield on shares.
For a start, while a term deposit gives you a specific rate, the yield on shares can only act as a guide. That’s because the yield on shares is historical and, as a result, offers no guarantee for the future.
You calculate the yield on a stock by dividing its total dividends over the past 12 months into the share price. So a company trading at $5, which has paid 30 cents in dividends over the last year, has a yield of 6%.
However, as I say, this measure is historic…as Telstra Corporation Ltd [ASX:TLS] investors found out to their dismay.
Management and boards can change their dividend policy as they see fit. And that’s exactly what Telstra did. It decided that its dividend policy was unsustainable, cutting it by one-third.
As a result, Telstra shareholders copped it on two fronts. Not only will they face a haircut on their upcoming dividends, but the share price also took a dive on the news.
Other dividend favourites are the banks. A decade ago, the final dividend on Commonwealth Bank of Australia [ASX:CBA] was $1.49. This year, it was $2.30.
All up, CBA will pay out a total of $4.29 in dividends this year — around two-thirds more than the $2.56 it paid in total in 2007.
Income investors are attracted to stocks like CBA because of their high yield (currently 5.6%), and the stability of its dividend.
However, with shares, you can focus too much on the yield.
Not only can the dividend change — as we’ve seen with Telstra — you can miss out on other stocks. These are stocks whose yield might not look so enticing at first glance.
Looking behind the headline numbers
Take a stock like Sonic Healthcare Ltd [ASX:SHL] — a company which has been on the Total Income buy-list for nearly two years.
If you were to go only on yield, Sonic’s current yield is around 3.7%. Yes, better than a term deposit. But far less than a stock like CBA.
However, going only on the yield can be deceiving.
In 1994, Sonic was trading around 50–60 cents. And for that year, it paid out just one dividend of two cents.
Today, Sonic’s share price is over $21, and this year it has paid a total of 77 cents in dividends. Those that bought back in 1994 would be generating a current yield of around 140% on their Sonic shares.
If a company is growing strongly — and its dividend is too — what might seem a low yield today could change dramatically in the future. Particularly if you hold the shares for a longer timeframe.
While shares like Sonic don’t come around every day, it’s the type of company we’re on the hunt for at Total Income. That is, looking beyond the current yield and searching for the next generation of dividend-payers.
If you’d like to find out more about these kind of stocks, you can do so by clicking here.
Editor, Total Income