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Tuesday 13 June 2017

The Lividend Approach To Financial Freedom

Homer approves! 
Lividends - I made a word! A word which represents what many investors aspire to.

You see, there are a number of ways to get to financial freedom. You could amass a portfolio of rental properties. Or you could create a business that runs itself. But a method which a lot of people dream of, is to build an equity portfolio large enough that you could live off the dividends - otherwise known as Lividends (patent pending)

So question number one:
Is it possible to live off only the dividends your investments produce?

Well the answer is obviously yes - if you have a big enough investment. A lot of people have thought it, and some people have done it. But just how much is enough?

Off the top of my head, the 4% Rule says if we could find a company which pays a 4% dividend, then we could just buy it and be done (although technically we would need a 5% dividend yield to make up for the 20% dividend withholding tax).

This is why you should diversify
So, for example, if you needed R400k a year, you take your R10 million and you go and buy a share that pays a 5% dividend yield and sail off into the sunset. This can work, except it is extremely risky. All your eggs in the one basket could leave all your eggs all over your face...

If that one company goes bang (e.g. African Bank) then you are done for. Or if the company cuts it's dividend you will have to sell out of that company (usually after a share price knock - the market does not take lightly to reliable dividend paying companies suddenly cutting the dividend) and find another 5% dividend paying company.

So if you wanted to pursue the Lividend route, it would be a far better idea to go for a number of different companies, which would then spread your risk. But by doing this you may have to settle for companies which pay a smaller dividend (seeing that there aren't many companies with a >5%  yield). This means you will probably need a larger investment than what the 4% Rule would dictate.

Okay, so which companies?

Well I thought I would put a bit of an interesting spin on this one, and take each category of expenses on my retirement budget and allow it to be covered by the dividends of a company that operates in the same or a similar industry as the expense. So, for example, how much would I need to invest in Sasol so that the dividend paid out by Sasol would be enough to cover my annual petrol bill?

So here is what I did:
  1. I grouped the annual expenses from my retirement budget (I inflated the expenses by 6.28% to better represent 2017 prices) into categories. 
  2. Found appropriate dividend paying companies for each expense category - I tried to select Top 40 companies where possible, and ones which have higher dividend yields where multiple options existed. The expenses which fell into a category that could not be covered by a listed company (e.g. Electricity) I just lumped together under Other, and selected the Coreshares DivTrax cover it (appropriate yes?).
  3. Based on the selected company's dividend yield, I determined the amount I would need to invest in that company to cover the annual expense. (Note the yield used is correct as at time of writing, naturally it will change as the share prices of the companies move)
The result is the table below (yields obtained at time of writing, and will change daily, so please don't kak me out if they are not accurate when you read this).

ExpenseCost Per AnnumCompanyYieldInvestment Required
HousingR31 323Redefine8.47%R369 809
PetrolR10 203Sasol3.15%R323 901
BankingR1 275Barclays Africa5.84%R21 838
MedicalR49 293Life Healthcare3.80%R1 297 175
GroceriesR66 319Woolworths4.05%R1 637 499
SchoolingR38 261Advtech1.86%R2 057 032
EntertainmentR12 754Naspers0.20%R6 376 800
Cellphone/InternetR8 928MTN6.13%R145 367
InsuranceR5 101Sanlam3.24%R157 452
ClothingR5 101Truworths5.12%R99 638
Investment For JuniorR7 652Investec3.47%R220 523
SavingsR20 406Nedbank4.75%R429 595
Other StuffR19 130DivTrax ETF3.75%R510 144
TOTALR275 746R13 647 044

So in order for me to allow the dividends from the various companies to cover my various living expenses, I would need a grand total of R13 647 044. And that's before tax (to compensate for the 20% DWT you would need R17 058 805. Although in fairness, the property stocks dividends would not be subject to DWT, they would be added to Income tax - which should be 0 if your only income is the dividends...)

Also I could probably get the amount down by choosing something other than Naspers for the company to cover the entertainment expense. Naspers' puny 0.2% dividend yield skews the numbers upwards somewhat.

Would I Retire The Lividend Way?

While living off dividends may sound good in theory, I would not go this route. Of course I am expecting dividends to provide some of the returns and cashflow I need in retirement, but I do not think it is a good idea to rely solely on them.

I see a number of possible problems doing it the Lividend way:
  1. Using the selection of companies at their current yields from above, the first obvious problem I see, is the amount of capital required to make it work. For a total annual expense of R275 746, using the 4% Rule, means I would require R6 893 650 (around half of the value from above). This is mostly due to the fact that it is quite difficult to find dividend paying companies for each expense which have yields better than 4%. And then there is still the Dividend Witholding Tax (although I guess this could be partially avoided by having some funds in a TFSA).
  2. The next problem I have is that you are essentially stock picking. And with individual stocks there is a very real chance that one of them could pull an African Bank on you and go belly up. If that happens you could find yourself in a bit of trouble. Maybe a dividend ETF would be the safer option in this case? (But then again Satrix Divi also suffered as a result of African Bank demise)
  3. You also have more limited tax manoeuvrability by doing it this way. With the 4% Rule you can at least take advantage of the R40k per annum Capital Gains tax exemption, and if you have a cash portion you can also take advantage of the interest exemption. (Although I must concede, in the Lividend approach you could stir up your Tax mix by allocating more capital to REIT's which are taxed as income and not dividends). Furthermore, if the Government increases the Dividend Withholding Tax (as they did in 2017) you would have to take a pay cut. And then Government could also change the laws in a way that encourages companies to do share buy backs instead of paying dividends. This could result in lower yields which would also constrain your income.
So retiring the Lividend way is an interesting approach, but I think I will rather allow any dividends I receive from my investments to form part of a bigger 4% Rule-type strategy...

Till next time, Stay Stealthy!
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