Money: Strategy the key to wise investing

New Zealanders are a funny bunch when it comes to investing. We seem to either like taking on lots of risk as we look for the huge return, or we like the no-risk approach and stash our money into bank deposits.

Taking the textbook approach and having a diversified portfolio of shares, bonds, property and cash is something that is slowly starting to happen as New Zealanders take professional financial advice.

As a result of our investment idiosyncrasies, we end up with portfolios that are inefficient and unbalanced. On top of that, our market, particularly for shares, is unusual.

Compared with other developed countries, we own a relatively small (but slowly growing) proportion of the local sharemarket, and it has an unusually high dividend yield and very low capital growth.

If you line up our sharemarket against those in 20 other developed countries, you will find that we have the highest dividend yield. This is a long-standing phenomenon.

Economics New Zealand managing director Donal Curtin has researched this phenomenon and, like others before him, found it hard to find conclusive reasons for it.

A possible explanation is that a high level of income is required to attract investors into a market which by international standards has offered one of the worse total returns over the past decade.

The reason for pointing out our investment peculiarities is to look at ways of investing money into shares for income. Clearly the New Zealand market is great for generating income but, arguably, people approach it the wrong way and are not including the growth element in their strategy.

Craig and Co research manager Cameron Watson says people often use income stocks the wrong way, shifting into them only as they approach retirement.

"It is better to start accumulating income stocks 20 years before this date so the dividend yield has time to build up and generate an exceptional income in retirement."

How does it work? The idea is simply that instead of looking at just the income stream of a share at the time when you need it, you are better to think ahead and pick stocks which pay a dividend now (many shares don't pay dividends), but have an element of growth about them.

While the income from the share seems tiny now (it is in all likelihood less than you will get from the bank), it will grow significantly over time as the company grows and expands its dividend payments.

The important thing to remember is that your income from the share is the dividend as a percentage based on the price you paid for it, as opposed to its present-day price.

Mr Watson uses two examples. If you bought Warehouse shares in 1994 the gross yield on the share would have been a modest 2.6 per cent, but because the company has grown and made greater profits, it is returning more of those profits to shareholders by way of dividend payments.

At present, the smart investor who bought the shares in 1994 will now have a stock with a gross yield of 15 per cent. Way better than putting your money in the bank.

Mr Watson's other example is Fisher & Paykel. If you bought this company's shares in 1991 the yield then was just 2.3 per cent. But that investor now would be sitting on a stock that is paying an 18.3 per cent gross yield today.

Frank Newman, a Whangarei financial planner and co-author of Making Money on the New Zealand Sharemarket, says the strategy can work well, but it has limitations in New Zealand, where few companies could be truly classified as growth stocks. He says a true growth stock is one with annual earnings-a-share growth of 15 per cent.

Mr Newman's alternative strategy is what is known as a contrarian style. That is, buying shares that have good prospects and strong income flows, but are at present trading at deep discounts to their asset backing.

"That is the way to really keep up your dividend yield at present," he says.

The main group of companies which fall into this category are listed property funds, such as Calan Healthcare and Property For Industry.

Also, he considers a company such as Carter Holt Harvey a potentially good yield play because its share price has fallen so low.

"[At this price] Carter Holt has quite an amazing dividend," he says, "assuming they are going to maintain the yield."

That point, where companies are slashing dividends, is the risk faced by investors who focus solely on income.

The most recent major example has been Telecom. For years Telecom was a wonderful yield play and far better than a deposit at the bank. It paid a yield that was often higher than a bank deposit, and the share provided strong growth.

The problem came when Telecom shifted its focus to being a growth company and channelled its profits into buying other companies, rather than into shareholders' bank accounts. Subsequently, the share price fell around 40 per cent.

Another strategy, and one that has worked in the United States for years, is known as "Dogs of the Dow." This involves buying the 10 stocks paying the highest yields of the 30 companies in the Dow Jones Industrial Average.

Its proponents hold that this technique would have provided a 17.7 per cent average annual return for the period 1973 to 1996, beating the Dow Jones Industrial Average, which returned 11.9 per cent during the same period.

It is a simple strategy that shows it can work in the right conditions, but there are caveats to it.

For example, in recent years this strategy has fallen behind as the market has ridden to its highs on the back of growth stocks ahead of high-yield value stocks.

These income-producing strategies have merit, Mr Watson says, but their simplicity can lead to danger.

Investors need to remember one of the golden rules about investing - that is, the higher the income the higher the risk.

In fact, the reason many companies pay such high returns is because the risk is high. These returns can often be a warning that danger lies ahead.

Trans Tasman Properties and Brierley Investments are two recent examples where high yields signalled trouble.

Mr Watson says the Dogs of the Dow strategy seems to work because the companies in the index are very big and very strong.

What's more, they are under scrutiny from an army of analysts and institutional investors, so problems tend to get exposed quickly. Mr Watson says the key message to take out of the Dogs of the Dow strategy is that investors should be looking for income plus growth.

"Investing on the basis of yield alone is not prudent," he says.

Investors who want to adopt a strategy with an income bias using New Zealand shares are limited because there are no managed funds available that are set up with this sole objective.

The one fund that did have an income focus, the Prudential New Zealand Equity Income Fund, was closed down more than a year ago after Colonial acquired Prudential.

* Philip Macalister edits online money management magazine Good Returns. You can e-mail him at philip@goodreturns.co.nz