Written by John Abernethy, Chief Investment Officer & Stephen Wood, Senior Analyst.
Where are dividends heading? To examine the outlook we pose the following questions.
What did the latest reporting season tell us about the course of future dividends?
The season continued the theme, which started in 2012, of dividend growth outstripping earnings growth. During this period, listed Australian businesses have generally focused on “cost-out strategies” rather than investing for growth through the business cycle.
This trend has seen the dividend pay-out ratio of the market increase from 60 per cent to 85 per cent, reflecting the highest level in more than 20 years, as seen in Figure 1.
In our opinion, pay-out ratios of these proportions are unsustainable in the medium term unless earnings actually fall. This suggests that a best-case scenario is for broadly flat dividends per share, with the most likely outcome being flat absolute dividends with low earnings growth, seeing falls in pay-out ratios over time.
Figure 1. Dividend payout ratio, forecast dividends per share (DPS), forecast earnings per share (EPS)
Source: Clime Asset Management
What can we expect over the next 12 months for dividends, pay-out ratios and franking credits?
As mentioned above, outlook for dividends broadly across the market will be flat in absolute terms. However this will be made up of the good, the bad and the ugly:
- Good – Stock outside ASX 20 companies with relatively low pay-out ratios that are growing earnings. These include businesses such as Domino’s Pizza Enterprises, Carsales.com and REA Group. However, these businesses are low yielding and therefore unlikely to add meaningfully to the dividend pool.
- Bad – Investors should expect dividends from the banking sector over the next one to two years to remain flat at best. Growth in dividends will certainly be challenging as earnings are threatened by increasing provisions for bad debts.
- Ugly – Falling commodity and energy prices could see further falls in dividends across the resources sector in addition to those already recorded. For example, BHP Billiton, Rio Tinto, WorleyParsons and Monadelphous Group.
We do not expect any issues for franking credit levels, with most companies unlikely to pay unfranked dividends.
Are the main sources of yield (banks/utilities/A-REITs/infrastructure) expensive?
To answer this question, we first need to understand what has contributed to total equity returns over time and then examine the demand outlook for yielding assets; that is, what equities will look like over time.
There has been no change to the structure of returns, with a return from income contributing a larger proportion to total returns over most historical periods, and this is highlighted in the chart analysis below.
Figure 2: Return breakdown for All Ordinaries Index
Source: Clime Asset Management
Over the past two years, the return from income has contributed more than 100 per cent to the total returns; there has been a loss in capital value offset by returns from income or dividends.
When looking at this over a longer timeframe, the same premise holds in that more than 80 per cent of equity investment total return has come from dividends over the past 10 years.
Further, a larger percentage of self-directed investors are moving from the accumulation to the pension phase in retirement, and thereby placing a greater focus on reliable returns; that is, income and maintenance of capital. In our view the demand for yielding investments looks set to continue growing.
Whether these main sources of yield are too expensive needs to be viewed in a relative sense to the yield across all asset classes (for example, bonds, cash or property securities).
With the current official cash rate sitting at 2 per cent and the expectation that interest rates will remain lower for longer, this suggests that high-yielding equities with secure cash flow businesses will continue to be well supported.
Should investors look further down the market for yield, to smaller companies?
At this point in the cycle, caution should be adopted when looking down the market in terms of capitalisation – particularly industrial businesses.
The reason is that generally these companies have lower dividend pay-out ratios and higher growth rates compared to large-cap stocks. This growth is commonly priced into the market by higher price-earnings ratios (PER) and/or higher price-to-equity values.
There is an omnipresent level of downside risk to a high PER share than its potential to grow dividends. This downside can occur from a profit disappointment or the mere decision to increase pay-out ratios concurrent with a forecast of slowing earnings growth.
A higher pay-out ratio may highlight (even without a forecast) to investors that the company’s ability to grow organically is lower than the market currently expects.
There are exceptions to this rule but investors need to properly consider the risks of high PER stocks. We note a select number of names in the small to mid-cap property sector that are demonstrating sustainable growth, solid dividends and are guided by experienced management. Our suggestions (and some of these are currently in our portfolios) include APN Property Group, Elanor Investors Group and Folkestone Limited.
What are the characteristics of companies with good dividend prospects?
First, we assess if the company can at least maintain its current level of dividends from profits. This may sound obvious but there are many companies currently paying higher dividends than profits. For example, some listed infrastructure assets and businesses, for whatever reason, have excess franking or dividend capacity.
Then we scan for companies that consistently generate high return on equity (ROE) because this often highlights operating with some form of competitive advantage. This operating feature reduces the downside risk to dividends and suggests a strong potential to grow them.
Having established that current dividends are maintainable, we then look for the company’s ability to grow dividends by way of reinvesting its retained earnings. This is often shown by financial reports indicating that ROE on retained earnings is higher than the company’s historic ROE. This trend will highlight that a company has the ability to sustainably grow dividends over the forecast period.
Based on the above, we identify three broad categories of companies in relation to yields:
- High-yielding businesses that present stable levels of profitability and dividends but struggle to reinvest retained earnings. These businesses are typically traded on a yield basis and caution is needed.
- Cyclical businesses which over time have seen dividends vary considerably depending on the underlying business cycle. These businesses need to be considered as countercyclical investments with yield a minor consideration.
- Small/mid-cap stocks, as highlighted above, are exposed to a valuation decrease over and above the expected income return from increasing the pay-out ratio.
What are some stocks that meet our dividend criteria?
It is hard to talk about dividends in the Australian market without a focus on the major banks. Our current view is that banks will adjust pay-out dividend payout ratios down, possibly reduce actual dividends per share, which will set a new base for growth.
Current yield projections of above 6 per cent fully franked certainly highlight the risk that earnings may struggle to grow for the next few years.
However, this sector has increasingly become exposed to the heavily indebted household sector and in our view the risk of disappointment, stemming from slowing economic growth, is elevated. Our preferred banks are National Australia Bank and Commonwealth Bank of Australia.
The broader industrials sector is facing economic headwinds, with many sectors showing signs of a plateau in earnings, which will place pressure on pay-out ratios. With that background comment we suggest the following quality companies retain solid yield prospects:
- Building – Adelaide Brighton is uniquely positioned to capitalise on the expected east coast infrastructure spending boom, and therefore is well positioned to at least hold its current dividend level.
- Retail – Wesfarmers is a quality business with excellent management that actively manages capital, most recently seen by its deployment of capital into Europe. In our view, Wesfarmers sees yield support around $39 representing a 5.2 per cent yield, excluding the benefit of 100 per cent franked dividends.
Yielding infrastructure assets remain in favour, but careful consideration is needed of their gearing (debt to equity ratio) and exposure to economic headwinds and tailwinds.
In our view, Qube Holdings is the best placed in the sector although offering a below-average yield of around 2.5 per cent fully franked. We expect it to grow solidly over the next five years. Qube is a beneficiary of Australia’s growing two-way trade generated from population growth and a range of free-trade agreements across Asia. It is mildly geared and run by a well-respected management team.
Written by John Abernethy, Chief Investment Officer & Stephen Wood, Senior Analyst. The following article appeared in the ASX Investor Update, April 2016.
Disclosure: Clime Asset Management owns shares in BHP, RIO, CTX, APD, ENN, FLK, NAB, CBA, WES, QUB on behalf of various mandates where it acts as an investment manager.