Dividend Strategies: Not All About Franking

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By Rudi Filapek-Vandyck, Editor FNArena

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Three types of Australian listed stocks have proved an absolute boon for loyal shareholders and investors in the post-2008 era: reliable dividend payers such as Telstra ((TLS)) and the Big Four Banks, All-Weather Performers such as Woolworths ((WOW)), Amcor ((AMC)) and CSL ((CSL)) and stocks experiencing an operational sweet spot, generating strong profits and shareholder returns along the way.

The eBooklet argues that successful investing is closely correlated to minimising and managing risk. Hopefully the framework we are creating with these regular updates will assist subscribers in executing successful, long term investment strategies.

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Most investors in Australia had largely ignored the importance of dividends prior to the market sell-down of 2008. This, if you think about it, is quite extraordinary given Australia is one of only a few countries with a favourable tax system ("franking credits") that only taxes once and, as a direct result of this, Australian companies pay much higher dividends than companies elsewhere. (Thank you, Paul Keating). Yet, Australian investors still largely focused on what the share price would do. At least they did prior to 2008.

A second observation is that most investors start focusing on dividends when retirement is approaching, which is too late. It means there's pressure to go for high yield only and thus investment options become limited by default. It's very difficult to seek out lower dividend stocks with a higher growth profile when the need for sufficient cash flow is tapping on one's shoulder at the start of each new fiscal year.

Taken from this perspective, the world really has changed, and a lot, for most investors in Australia since 2008. Dividends have pretty much proven the only consistent winning strategy in the share market over the past five years and this has become even more pronounced during the latest share market rally which has been pretty much about sustainable dividends and little else.

Gone are the days when my appearances on Sky Business's Lunch Money triggered phone calls from irate viewers to tell me they'd been investing in shares since the early nineties and never once bothered about dividends, so why would they do so now? Or what to think about the multiple phone calls I received to remind me that "Warren Buffett has never paid a dividend in his whole life and he's the world's most successfull investor". Those were ideal situations to point out that Berkshire Hathaway doesn't pay dividends, but it collects them happily and in spades.

Those phone calls have stopped, by the way. I haven't heard anyone trying to negate the importance of dividends in a long while now.

Instead, I walked into a local coffee shop earlier today and was greeted by two funds managers who grabbed the opportunity to ask me about my view on why investing in the local share market has been all about dividends and little else. (Apparently another well-known market commentator has declared it has all to do with the trend towards Self Managed Super Funds).

My answer was essentially a summary of the opening paragraphs. I know most investors focus on dividends only when it is too late. I also know many investors have lost a lot of money post-2007 and with portfolios stacked with China-leveraged resources stocks there has been little, if any, catch-up since. Add the fact the baby boomer generation is now starting to move into retirement and it is not difficult to see why dividends have all of a sudden become the be all and end all, in particular with interest on term deposits falling sharply.

History shows, however, that investment strategies built around high dividends only are poised to underperform and to generate suboptimal investment returns. This is because it is very difficult to combine high dividends with high growth. Plus, of course, in the share market a high dividend is often a reflection of excessive risks. Analysts at ABN Amro Australia, before the Dutch bank had to retreat from Australia, left a legacy of many market research reports that concluded just that. The third handicap is the pressure for income forces investors to focus on dividends that come with 100% franking. This is why opportunities such as Amcor ((AMC)) and Ardent Leisure ((AAD)) in years past have been largely ignored.

In my view, investors should always pay attention to dividends, regardless whether they need the cash flow or not. Dividends are among the most accurate tools the share market offers investors. Whereas earnings and growth can be fabricated through accountancy tricks and obfuscations, dividends have to be paid with hard cold cash, which is much harder to play tricks with.

A few market observations that can come in handy at any time:

– companies that increase dividends usually see their shares outperform the broader market. This is not necessarily true for resources companies, but then resources stocks and dividends are, in most cases, a bit of an awkward and uncomfortable combination anyway
– share prices of dividend paying companies tend to find support at solid yield levels for as long as the market believes those dividends won't be cut
– never make the error of combining seemingly high dividends with high risks or operational weakness. If the dividends are cut, the damage to the share price is usually very, very serious
– combining growth with dividends makes for a very powerful investment strategy. It's why David Jones ((DJS)) shares beat the return on Rio Tinto ((RIO)) shares by more than 100% over the eight years from 2003-early 2011^(*)
– there's a widespread misconception that dividend strategies are by default defensive. They're not. It's simply another way to seek out better investment returns
– history suggests large diversified commodities companies tend to find dividend support at 4% yield

Given the sharp falls in resources equities in recent weeks, I thought this might be an opportune moment to spend some time, and do some calculations, on where BHP Billiton ((BHP)) and Rio Tinto sit on the dividend scale after the recent market beatings.

As anyone can see via Stock Analysis on the FNArena website, BHP shares currently offer 3.5% forward looking yield while Rio Tinto shares still only yield 3.1%. This suggests there could be a lot more weakness in store before both reach that historical support level, at least from a dividend-oriented viewpoint (and all else remaining equal). This seems even more so with Credit Suisse updating estimates and projections for commodities this week which resulted into severe cuts to below market consensus but with the analysts commenting they believed market consensus would follow their move in time.

The good news in the Credit Suisse market update (published on Thursday morning) was that CS has penciled in a higher than consensus dividend payout for BHP in FY14. Assuming CS numbers are correct, the projected payout of 129c next financial year puts BHP's FY14 dividend yield at around 4% at the current share price. As market consensus still sits at 118.7c for next year, this might well translate into further weakness. All this suggests support should be approaching fast from here, unless investors anticipate a cut in dividends which I believe is not what anyone is thinking right now.

For what it's worth: projecting next year's consensus dividend payout of 118.5c to calculate the 4% dividend support level generates a share price of circa $29.50. The closing price on Thursday was $31.75.

BHP shares also feature in this week's global market strategy report by Citi. Analysts in London had decided to add "dividend momentum" to their stocks selection criteria and with better investment results, reports Citi. Four Australian stocks feature on the global list of preferred stocks; apart from BHP Billiton, there's also Telstra ((TLS)), Wesfarmers ((WES)) and Woolworths ((WOW)).

The good thing about investors' obsession with yield these days is that stockbrokers have re-discovered dividends too. Citi analysts in Australia, for example, have been running a so-called "Yield Model Portfolio" in recent times. Citi is taking a much wider approach to the theme than most investors ever would, as witnessed by the fact that the latest portfolio update, released at the end of March, included the removal of Iluka ((ILU)) and Leighton Holdings ((LEI)). In their place Citi analysts added UGL ((UGL)), Cabcharge ((CAB)), Commonwealth Property ((CPA)), M2 Telecommunications ((MTU)), Woodside Petroleum ((WPL)) and Troy Resources ((TRY)).

In total, Citi's Yield Model Portfolio comprises of 30 stocks, including DuluxGroup ((DLX)), Platinum Asset Management ((PTM)), NRW Holdings ((NWH)) and Invocare ((IVC)). As said, the portfolio clearly takes a broad view on the subject of "yield". Proud Citi analysts reported the performance of their portfolio remains significantly better than the index.

Within this wider approach it's probably worth repeating that UBS analysts three weeks ago pointed out the end of major LNG investment over the next two years provides scope for the major oil & gas stocks in Australia to pay higher dividends to their loyal shareholders. UBS' analysis and projections seems to suggest that Woodside Petroleum and Santos ((STO)) may have the biggest and earliest "surprises" in store. Oil Search ((OSH)) should follow in 2015.

^(*) Remarkable but true David Jones shares beat Rio Tinto by a wide margin fueled by growth and steadily growing dividends. See addenda in recently published eBooklet "Make Risk Your Friend. Finding All-Weather Performers". This eBooklet is for FNArena subscribers only (6 and 12 months). If you haven't as yet received your copy, send an email to info@fnarena.com

P.S. FNArena subscribers have access to dividend specific data via FNArena's Sentiment Indicator and via R-Factor and via Stock Analysis which are all available on the website.

DO YOU HAVE YOUR COPY YET?

FNArena has published my latest e-Booklet "Making Risk Your Friend. Finding All-Weather Performers". This e-Booklet (58 pages) is offered as a free bonus to paid subscribers (excl one month subs). If you haven't received your copy as yet, send an email to info@fnarena.com

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)

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Rudi On Tour in 2013

 – I will present and contribute during the 2013 National Conference of the Australian Technical Analysts Association (ATAA) at the Novotel in Sydney's Brighton Beach, June 21-23

– I will present to members of AIA NSW North Shore at the Chatswood Club on Wednesday 11 September, 7.30-9pm

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