EQUITY INCOME NOT ALL EQUAL by Olivia Engel, CFA Head of Active Quantitative Equities, APAC
Equity Income Not All Equal Most individual investors would love to grow their assets (maximise returns), while also guarding their assets (minimise risk). Many retirees however, also place a high importance on income. Given yields on bonds, annuities and term deposits are at all-time lows, income sourced from dividends has become more popular than ever. In this paper, we argue that focusing blindly on recent dividends and ignoring other company fundamentals can be at the expense of shorter-term return and risk objectives. Income investing has a long and proud tradition, however for investors who prize short-term capital stability and want a smooth trajectory of total returns, a more nuanced approach may be needed. Sustainability On a cash basis, the Australian equity market is the highest yielding in the developed world with a 0.5% margin over its nearest rival (Norway) at the end of May 2016. However, for Australian resident investors, imputation credits add another 1.5% to this already healthy margin. 1 The perceived reliability of Australian dividend income could lead some investors to think of the market as being almost bond-like. This is a potentially dangerous misunderstanding. The capital value of an equity security is far more at risk than a bond. Furthermore, unlike bond coupon payments, dividend payments are not fixed. A company can change its dividend at any time. Paying a dividend requires a company to make a capital decision. Either the company pays out its earnings to shareholders in the form of dividend income, or it reinvests those earnings into the future of the business. In theory, when future growth opportunities are scarce, businesses should increase payout ratios. Shareholders also prefer the relative certainty of a dividend payment in uncertain market environments. In 2014, the Boston Consulting Group wrote a report comparing dividends and growth in Australia. To quote from the report, Australian companies have been increasingly paying higher dividends over the last four years and therefore, investing less over time in their businesses This was driven by two factors: investors are looking for higher yields in the equities market because they can t find high yields in the fixed income market; and the management teams themselves feel headwinds in finding profitable growth opportunities in Australia.... 2 In the last five years, payout ratios have climbed to very high levels in aggregate (from 55% to 85%), while dividend yields have remained around the same levels (4.5%-5.0%). In part, this reflects a period during which resource companies and, to a lesser extent, banks held their dividends unchanged while experiencing a fall in earnings. Earnings need to improve to sustain dividends in the Australian market from here, as payout ratios cannot increase much further, and probably need to come down. As the chart below shows, payout ratios are high in a historical context, and are arguably unsustainable. The Australian market is not immune from having payout ratios or dividends cut substantially, as was seen after the Global Financial Crisis in 2009. ASX 100 Leaders Dividends Between March 2004 and March 2016 (%) Payout Ratio (%) 8 90 7 82 6 74 5 66 4 58 3 Mar 2004 2007 2010 2013 May 2016 50 12m Forward (LHS) 12m Forward Payout Ratio (RHS) Source: IBES, Datastream, Deutsche Bank. 2
During times of crisis, both high and low yield companies can suffer large negative total returns. The Dow Jones Australia Select Dividend 30 index aims to represent Australia s leading stocks by dividend 3 and has a long history going back to December 1999. Over the period from December 1999 to May 2016 it outperformed the S&P ASX 200 by 2.2% pa. However, during the global financial crisis, it had a -64% total return, compared with -47% for the S&P ASX 200 Index. More recently, over the year to 31 May 2016, the high yield index returned -13%, compared with -2% for the S&P ASX 200 index. Total Return of Dow Jones Select 30 Dividend Index and S&P ASX 200 Index 31 Dec 1999 to 31 May 2016 600 500 400 300 200 100 0 Dec 1999 2002 2007 2013 May 2016 Dow Jones Australia Select Dividend 30 Index S&P ASX 200 Index Source: S&P. The performance in times of crisis of the high yield index is reflected in increases in the rolling three-year volatility of returns. While investing for dividends may have long-term merit, investors who are concerned short-term capital stability and are unable to ride out capital swings may need to take a more nuanced approach. If it s Dividends You Seek Dividend yield is calculated as dividends per share divided by share price. It can be based on trailing annual dividends paid, or expected future dividends in the coming year. The current expected dividend yield on the S&P ASX 100 Leaders Index is 4.65% and trailing 12 month dividend yield is 4.80%. There is no guarantee that last year s dividend payment will be repeated this year, or even that forecast dividends from sell-side analysts will be paid this year. A strategy of blindly buying companies with the highest reported dividend yield could expose an investor to some high-risk securities. In fact, most high dividend yield indices from providers like MSCI and S&P include a range of additional tests of dividend sustainability for exactly this reason. 4 To provide a simple example, the table below shows the ten companies in the S&P ASX 300 with the highest trailing dividend yield. If we look at the kind of total return these companies have realized in the 2016 year to date, many have had a negative total return that has far outweighed any dividend income. Additionally, the short-term volatility of these stocks is far higher than the average volatility of stocks across the market (currently averaging around 40). With some of the names, the forecast dividend yield is much lower than the trailing yield (e.g. Decmil, Programmed Maintenance, MACA, Select Harvests). In these cases poor earnings has led to a large drop in price, and sell-side analysts are expecting a cut in future dividends as a result. Rolling 3-year Standard Deviation of Monthly Returns MSCI Australia High Index and MSCI Australia Index, December 2005 to May 2016 % 30 24 18 12 6 0 Dec 2005 2008 2011 2013 May 2016 Dow Jones Select 30 Dividend Index S&P ASX 200 Index Source: SSGA, S&P. State Street Global Advisors 3
Equity Income Not All Equal 10 Companies in S&P/ASX 300 with highest trailing dividend yield as at 24 May 2016 12 month Forecast YTD Total Return Name Current Volatility 120 day Programmed 15.7 8.6-39.0 82.7 Maintenance Services Ltd Prime Media Group Ltd 15.4 13.7-31.2 49.5 Decmil Group Ltd 13.4 4.5-23.0 57.1 Slater & Gordon Ltd 12.1 19.3-44.8 195.4 MACA Ltd 11.9 8.2 39.0 59.6 11.4 13.6 3.2 39.8 Genworth Mortgage Insurance Australia Pacific Current Group Ltd 10.9 9.3-42.3 40.1 Monadelphous Group Ltd 10.5 6.9 11.3 48.1 Select Harvests Ltd 9.8 4.1-29.5 58.3 Cash Converters International Ltd 9.6 9.6-17.9 48.4 Source: Bloomberg. Another common way investors have historically chosen direct equity holdings is by selecting well-known brands. The list below contains commonly held direct shares by households: Name Current 12 month Forecast YTD Total Return Volatility 120 day Commonwealth 5.4 5.5-6.8 24.3 Bank of Australia Westpac Banking Corp 6.3 6.4-8.5 27.9 Australia & New Zealand 7.1 6.5-8.4 29.5 Banking Group Ltd National Australia Bank Ltd 7.3 7.1-4.3 27.3 Telstra Corp Ltd 5.5 5.8 2.7 19.6 BHP Billiton Ltd 5.9 2.5 4.2 50.3 Wesfarmers Ltd 4.8 5.1 3.2 20.6 Woolworths Ltd 5.3 4.3-8.5 27.6 Source:Bloomberg, as at 24 May 2016. However, their short-term returns have been poor, and the market is expecting dividend cuts in some cases. Blue chips are not immune to short-term negative returns nor to dividend cuts (think recent announcements from Woolworths, BHP Billiton and ANZ Bank). For investors wanting to take a more nuanced approach than blindly buying reported yields, there are other important questions to ask. These questions can help assess sustainability and include the following: How consistent are the dividends? How levered is the company balance sheet? Is the payout ratio unsustainably high? What is the dividend forecast from the sell-side equity research community? Are the company s earnings growing or declining? Pockets of Yield 12 months ago, the highest yielding sectors based on trailing measures were Financials, Energy, Telecoms, Consumer Staples and Utilities. The lowest yielding sectors were Healthcare, Technology, Industrials and Consumer Discretionary as the table below demonstrates. Some of the strongest total returns over the last year have come from sectors that had the lowest yields at the start of the year. GICS Sectors as at 31 May 2015 performance over 1 year to 31 May 2016 GICS Sector May 2015 Yield (%) 1 year Return (%) 1 year Volatility (%) Drawdown: 31 May 2015 to 12 Feb 2016 (%) Financials 5.02-3 21-15 Energy 4.96-27 36-38 Telecoms 4.60-1 19-6 Staples 4.55-2 20-5 Utilities 4.40 10 17 4 Materials 3.79-13 27-30 Discretionary 3.35 7 18-8 Industrials 3.14 10 16-5 Technology 2.66 2 20-16 Healthcare 1.84 17 17 0 S&P ASX 200 4.34-2 18-15 Source: SSGA,based on price and accumulation index returns. 4
Linking Total Return with Income There are a number of investment strategies available to investors who want to focus primarily on income and are willing to ride out some significant swings in capital values. However trying to make the most out of dividends and franking credits while at the same time managing a smooth trajectory of total returns requires a more nuanced approach. This involves actively assessing a range of factors: Measures of valuation other than just dividends (e.g. forecast or trailing earnings, cash flows or sales) The sustainability of the dividend, which is linked to the quality of the company (e.g. leverage and ability to generate internal growth) The forecast earnings growth of the company The expected volatility of the company share price The Role of Total Returns and Income in Retirement One of the most difficult decisions faced by a retiree is how much to withdraw from a portfolio each year. Withdraw too much and you run out of money, too little and your living standards will be more constrained than they need to be. There is no magical answer to this question, which is why it remains so difficult. However comparing total return strategies with income strategies can provide some perspective. At the other end of the spectrum, a retiree might choose to redeem a fixed amount (say 4% of the initial balance) each year regardless of income or market conditions. This simple strategy has the advantage of certain income but only for as long as it lasts. Among other things, this strategy is exposed to sequencing risk. This is the risk that a retiree experiences very poor returns early in retirement. Even though markets may recover, by this stage it may be too late, as the account balance has already been depleted. A retiree using a fixed withdrawal process is likely to get better protection from sequencing risk using a total-return focused equity strategy. The final decision on living income will involve a mix of income achieved and fixed amounts or capital drawdowns. Total-return focused strategies can play an important role for investors who are either unable to sit tight during large capital swings, or investors who are exposed to sequencing risk. 1 As at 31 May 2016, Source MSCI. 2 From BCG s The Challenge of Growth, October 2014. 3 Source: S&P. 4 Depending on the index, tests include factors like profitability, leverage, payout ratios, dividend consistency and recent price movements. 5 The risk of living longer than you expect, although most people think of this as a good thing, not a risk! At one end of the spectrum, a retiree invested in a well diversified income-focused equity strategy might chose to live on the income only. This simple strategy has the advantage of never running out of money. It requires the investor to ignore capital fluctuations and it deals with longevity risk. 5 However, it will also result in unstable living income as dividends change each year, as well as an inadequate income as the capital is never touched. State Street Global Advisors 5
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