Rudi’s View: Dividends, The New Black

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By Rudi Filapek-Vandyck, Editor FNArena

It has been written and declared by market commentators and investment specialists alike: the Buy and Hold strategy no longer works, indeed, Buy and Hold is "dead". What these experts fail to acknowledge is that investing in the share market is not only about movement in share prices. Investment strategies focused on corporate dividends have generated positive returns and if current indications are correct, dividends will only become more important in years ahead.

Earnings growth since 2008 has proved rather lacklustre outside energy and mining companies in Australia, but dividends have grown strongly as companies have repaired their balance sheets, reduced debt and restored payout ratios to shareholders. This process is still ongoing so it is more than just a fair assumption that growth in dividends in the year ahead will exceed growth in profits.

By how much profits and dividends will grow exactly next year remains the subject of public debate. Analysts' forecasts have been in a downtrend since May last year and about everyone is convinced present forecasts will have to be reduced further in the months ahead. Even then, the differences between individual companies will remain large. Note for example that solid dividend payers such as Australian Real Estate Investment Trusts (A-REITs) and infrastructure trusts have outperformed the broader market in recent months. Not only had many of these securities arguably been neglected for too long (post GFC), which created a valuation gap, but sector analysts are also of the view that overall risks to forecasts are low compared to most other sectors.

With many of these trusts promising payout yields well in excess of the market average of 4-4.5%, the attraction has been thus a double no-brainer. REITs such as ING Office Fund ((IOF)), Bunnings Warehouse Properties ((BWP)) and Dexus ((DXS)) as well as infra trusts such as Australian Pipeline Trust ((APA)) and Spark Infrastructure ((SKI)) no longer trade at excessive valuation discounts, but they still offer above market average dividend returns. REITs and infra trusts offer lower risks and higher dividend returns, but most do not have a strong growth profile. Dividends are expected to increase by 4-6% this year and next.

Potentially larger returns can be achieved from owning dividend paying financials and industrial stocks as many of these shares have been sold off and de-rated over the years past. Today they offer unusually high dividend yields and the potential for large share price appreciation in case of a recovery, but only if present forecasts prove accurate in light of ongoing downward pressures and headwinds. Once upon a time Telstra ((TLS)) and Tabcorp ((TAH)) seemed to offer similar promise, but instead their share prices de-rated, leaving investors caught in a so-called "valuation trap".

How can we avoid this?

Macquarie analysts recently conducted a study into prospective dividend yields and the risks attached. The conclusion was that a number of high yielding stocks carried relatively low risk (which means the analysts have some conviction forecasts that don't need to be cut). Companies selected by Macquarie included major banks ANZ ((ANZ)) and Westpac ((WBC)), retailers David Jones ((DJS)), Metcash ((MTS)) and Woolworths ((WOW)), Toll roads operator Transurban ((TCL)), property developer GPT ((GPT)), property trust CFS Retail Trust ((CFX)), building materials provider Adelaide Brighton ((ABC)), oil refiner Caltex ((CTX)), media conglomerate Consolidated Media ((CMJ)), mining services provider Monadelphous ((MND)) and internet portal Carsales.com ((CRZ)).

Macquarie strategists are of the view that equities are repeating the experience of 1964-1981 when shorter, sharper economic and market cycles kept financial markets volatile and earnings uncertainty unusually high. Despite many ups and downs during the period, equity markets ended at the same level in the early 1980s as they were in 1964. Argues Macquarie: during such periods dividend yield is an increasingly important component of returns. To support their view, the analysts point out capital returns over the past five years have been close to zero, meaning dividend yield has contributed nearly 100% of total investment returns. Clearly, argues Macquarie, in such an environment, stocks with relatively high and sustainable yields will outperform.

Not everybody necessarily agrees with Macquarie, but research conducted by economists and market strategists at UBS and Citi points in the same direction: dividend yields will form an increasingly important part of investment returns from now on. UBS is of the view the new macro environment post-GFC is likely to reduce average annual returns in the share market to circa 8% from 9.8% pre-2007.

On my own analysis, "Buy and Hold" returns from healthy dividend-paying stocks such as David Jones beat those from fast growing, low-dividend payers such as Rio Tinto ((RIO)) fair and square over the past eight years, even with a Commodities Super Cycle taking place (and including a de-rating for retailers).

For investors who want to do their own research, the trick is not to be misled by promises that are simply too good to be true and that are not backed up by growth in profits. Telstra shares have promised throughout the years yields of up to 13%, but shareholders still hold a sour taste today given that, in the absence of sustainable profit growth, the share price kept weakening over time, keeping total returns in the negative. In such an example, investing in dividends proved no different from investing in a stock not paying dividends. "Growth" is essential.

Ideally, an investment today would at least generate the market average yield (4.5%) and grow in years to come. Good dividend investing is all about growing returns. Note that as investors hold on to their shares, and dividends grow in line with profits, yields grow ever higher on the original investment made. This is a factor too often underestimated. For example, the yield on Monadelphous shares bought in 2005 has risen to 18% this year. David Jones shares purchased in 2003 today yield 30%. (Both should only rise further in years to come).

To assess the risks that come with apparent dividend yields on offer, I suggest that paying attention to prospective dividend yield and forward looking Price-Earnings ratio (PE) can provide an indication about how much risk is in play. Investors should always remember the market doesn't offer great bargains for no good reason. If an offer appears to be a good one, it's probably because risks are elevated. For example, property developer FKP ((FKP)) currently offers some 4.5% in yield, but the shares are only trading on a PE multiple of 7. This means the yield only looks reasonable because the shares are very cheaply priced. This makes FKP a higher risk proposition, more likely to disappoint.

Similar assessments can be made about QBE Insurance ((QBE)), Macquarie Group ((MQG)), Pacific Brands ((PBG)), OneSteel ((OST)), APN News and Media ((APN)) and Tatts Group ((TTS)). In most cases, these companies have already had to issue at least one profit warning this year and risks remain high, otherwise PE multiples would not be as low, and prospective dividend yields not as high.

On the other hand, investors clearly are confident about ongoing strong growth prospects for companies such as Monadelphous, McMillan Shakespeare ((MMS)), Iress Technologies ((IRE)) and Campbell Brothers ((CPB)) because these companies are all enjoying high PE multiples. Despite this, dividend yields remain attractive, but these stocks now come with the danger that even a small PE de-rating can have a pronounced effect on the share price (this won't have an effect on investor entry yield though).

The ideal risk/yield reward, I believe, is usually located among stocks trading on PEs of 11-13 while offering above market average yields. Names that fit the mould include Fleetwood ((FWD)), Ardent Leisure ((AAD)), JB Hi-Fi ((JBH)), Metcash, GWA Holdings ((GWT)), GUD Holdings ((GUD)) and David Jones.

The final category of stocks comprises those for which the payout ratio is expected to jump in years ahead. Meaning today's yield may not look overly attractive, but if everything goes according to plan, this will change over the next 18-24 months or so. Examples are Alesco ((ALS)), Downer EDI ((DOW)) and Suncorp-Metway ((SUN)).

I believe the balance between PE and yield is the code Mr Market uses to communicate "risk" to investors. The sooner investors learn to read this code, the better their returns will become.

Note that resources companies are by nature highly volatile, both in share prices and in earnings, and thus not suitable for longer term, dividend-oriented investment strategies.

Australian banks deserve a special mention. Over the past years, major banks in Australia have been sold short, de-rated, re-regulated and re-appointed as the Uber-Villains by politicians in Canberra and the Sunday newspapers. Today, share prices for the Major Four haven't progressed much, on a net basis, from price levels in August 2009.

But shareholders who owned banking shares over the period have received dividends equalling around 12.5% of their investment. These dividends are fully franked, so tax-free which means owning banking shares has beaten cash in deposit which generated less than 12%, and taxes still need to be paid over the accrued interest.

Shareholders could have potentially added extra benefits by participating in the banks' Dividend Reinvestment Plans and today they retain exposure to future upside potential. All this, plus they can continue looking forward to additional and higher dividends.

The example of the banks highlights two important observations: market indices don't tell the full story, plus investors ignore dividends at their peril.

(Please note that, as with all my analyses, appearances and presentations, all above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)  

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