“The [share] market yields about 4.2 per cent,” he says, “and you can get reasonably similar returns on term deposits.”
Hershan warns against buying into “highly cyclical” mining companies for their dividends. “They’ll pay you the best dividends at the top of the cycle and when the cycle turns they’ll get cut,” he says. “History has proven this time and time again.”
Reece Birtles is lead portfolio manager of Martin Currie’s Real Income fund, which holds property, infrastructure and utilities. Holding hard assets that “provide good inflation protection” is a good way to avoid business cycle risk, he says.
Although he expects growth in earnings and dividends across the index to slow over the next year or two, investors can remain calm.
“Companies are in a very good position,” Birtles says. “Their balance sheets are strong, the dividend payout ratio currently is not high – it’s lower than pre-COVID – and they are benefiting from very strong business conditions.”
Not all sectors are the same, however. Fairly steady dollar-value dividend yields for the banks are high because valuations are low, and distributions for energy and resources companies whipsaw up and down with business conditions.
Altogether, dividends for Australian equities display very low volatility. In cash and bonds, variability is higher. “Whilst you have more capital volatility in shares, you actually have more income stability than other more defensive asset classes,” Birtles says.
It’s fair to assume some investors who favour Australian shares think of some companies that pay a predictable yield as proxies for bonds.
Yes, some big names on the board do pay what look like defensive earnings= streams – think tollroad/infrastructure operators, telcos, some real estate investment trusts (REITs) and huge retailers, for example.
As bond yields and term deposit rates have risen, along with the official cash rate, the appeal of such companies has faded, Hughes says.
“Often, those [bond proxy] companies are geared, and yields are susceptible to being cut if the cost of their funding increases,” he says. “As rates go up, your distributable income goes down.” (If using a screening tool, “interest cover ratio” is the field to check.)
Why have dividends been so generous lately? Many companies cut dividends during the pandemic as they sought to protect their balance sheets, Hughes says.
As the pandemic receded, and earnings recovered along with the economy, boards approved dividends to flow once more.
Measured against recent history, distributions to shareholders for the past year look splendid. Taking a vanilla exchange-traded fund over the S&P/ASX200 as a benchmark, State Street’s SPDR S&P/ASX 200 ETF (STW) paid 7.58 per cent in the 12 months to January 31 against an average 4.69 per cent since inception in 2001.
Before stacking up today’s generous payers, Birtles says investors should make a checklist.
First, they should diversify at a stock level and sector level, seeking out companies that can easily defend their market position so that dividends are reliable (such companies will be “market leaders in each sector”, he says).
Finally, the goal is to find companies where cashflow and earnings are capable of sustaining dividends. Keep your search within the top 200, he suggests. “You are looking for established companies with sustainable profitability patterns.” Automotive products conglomerate GUD Holdings springs to mind, he says.
Dividends are a rearview mirror, Hershan says. “They tell you how a company traded last year.” It’s very hard to argue that shares in listed companies should be thought of as defensive assets that provide reliable income.
When picking shares, companies with growth profile, solid dividends and a reasonable payout ratio can offer “really attractive long-term returns”. He points to the telco sector, Lottery Corporation, JB Hi-Fi and Nine Entertainment (publisher of AFR Weekend) as examples, including the insurance companies for income.
When Hershan has income to reallocate in his fund, he will reinvest in a company if its dividend reinvestment plan offers shares at a meaningful discount. Otherwise, he will look over the market for the “best possible home” for every other dollar.
Before being “seduced by an attractive-looking yield”, Hughes says investors can check the prospects for future payments by looking at a company’s earnings cycle with the understanding that a boom in profitability may recede.
Also, look at the latest report to see whether the dividend is easily covered by cashflow. If it includes borrowing and/or passes too high a share of earnings to shareholders, little will be left for reinvestment for growth.
Tips from Hughes on companies with sustainable earnings/strong yields include Medibank, Deterra Royalties and major bank ANZ.
Every investment has to earn its place in a portfolio and there should be no sentimentality attached to individual companies. It’s notoriously difficult to forecast a stock’s growth potential and only slightly easier to be confident about estimating how much of its profits will be shared as dividends.
When deciding whether to hold a stock for income, the quality and sustainability of its dividends are key. BHP may have yielded above 9 per cent over the past year, but the five-year average is 6.75 per cent (on Morningstar data) and it paid below 5 per cent for six of the past 10 years.
No professional investor would recommend buying mining companies for dividends alone, although many DIY investors probably went against that mantra when the miner, along with Rio Tinto, followed progressive dividend policies that pledged dollar-amount payments would only ever go up – incrementally.
Both companies ditched the policy about seven years ago. In BHP’s case the progressive dividend policy “bore no resemblance to how the business was going”, Hershan says. “Some years the business goes up, some years it goes down.” And Rio Tinto dramatically halved its dividend this week.
Managed fund menu
A less complex route for DIY investors following an income strategy might be to turn to the menu of exchange-traded funds and listed managed funds that claim to do it all for you. It’s a long list, however, with eight standing out (ignoring those with less than five years’ data).
Providers who engineer income-strategy listed products are a curious bunch. On the one hand, it looks as though they are saying your money will harvest a greater dividend yield than the market can deliver. One danger there, though, is they might pick high-yielding stocks with falling share prices.
How do they fare? Not all that well. Looking at eight funds, three yielded less than an ETF for the ASX200 (STW), two beat it by a fair clip (BetaShares Australia Top20 Equity Yield Maximiser and SPDR MSCI Australia Select High Dividend Yield Fund) and the rest were bunched around it.
But the real number to watch is total returns, where growth and income are combined – because what’s the point of high yield if the payoff is below-market capital growth? On that measure, only one ETF beat the market (VHY), although it paid a marginally lower yield.
For the record, and without matching names with performance, the three fund managers quoted above have delivered total returns of 6.67 per cent, 5.98 per cent and 6.45 per cent over five years.
Investors who choose the easy route with an index fund, and take whatever yield the market is paying, should feel pretty confident.