INVESTING FOR INCOME Without compromising growth
Introduction If you re like most investors, you want your investments to grow over time and provide you with reliable, consistent income. While equities can provide investors with great capital gains, Aussie companies are particularly renowned for rewarding shareholders with dividend payments. That s why many Aussie investors tend to have a natural home bias towards the major dividend paying stocks. But yield hunters should also be searching for stocks that can grow their earnings because when a company earns more dividends tend to grow too! From SMSF trustees, to retirees, to mum and dads all investors can benefit from gaining exposure to high-quality dividend-paying stocks to ensure their investment portfolio can weather the times. I hope you enjoy the read! Sincerely, Peter Switzer Leading financial commentator & founder of the Switzer Group Ultimately, it s about striking the right balance in your investment approach to achieve both income and capital growth. So how do you do it? There are various investment vehicles available to help you capture both income and capital growth and achieve the best overall return possible. This ebook will identify the investment options available for those focused on sustainable dividend growth. 22
Contents The importance of both income and capital growth...04 Australia as an income market...06 Australia for income, global for growth...09 The value of a rising dividend stream...10 How investors can achieve both income and capital growth...11 3
The importance of both income and capital growth Most investments, apart from your cash holdings, offer some combination of income and capital growth, which go toward the overall return. This is particularly true of the so-called growth assets, such as shares and property, but it also applies to income-generating investments like bonds. That s because bonds are tradeable in the secondary market and a professional bond investor can generate capital growth on a bond portfolio as well as income. However, if a bond is held to maturity and never traded, income is the only component of the return. Shares generate income for their owners through the flow of dividends paid out of the company s profits. Although equities are firmly in the camp of growth assets, and are considered by most investors to be primarily a capital gains generator, the dividends paid by Australian shares are a major contributor to the total return. In fact, in Australian equities, the total return is made up of capital growth (price return), income (dividend return) and franking credits, which can be used to offset a portion of the investor s taxable income. Peter Switzer, economist and joint-founder of Switzer Asset Management, says roughly half the return from Australian shares comes from dividends. Australian investors can usually expect about a 5 per cent return from dividends a year, plus about 1 per cent from franking credits, regardless of what share prices have done, says Switzer. That s the payoff for believing in stocks. Some years, the dividend component edges the S&P/ASX 200 Accumulation Index (which counts capital growth plus reinvested dividends) over the line to a positive return. ROUGHLY HALF THE RETURN FROM AUSTRALIAN SHARES COMES FROM DIVIDENDS. 4
Franking credits can significantly augment an investor s return. Franked dividends are particularly attractive to superannuation fund investors because they can claim a refund of unused credits. This refund is partial in the case of super fund members in accumulation phase, where the fund has a 15% tax rate, and full in the case of fund members in pension phase (where the tax rate is 0%). accumulation phase, and by 1.5 percentage points for members in pension phase, according to Association of Superannuation Funds of Australia (ASFA) research 1. However, it must be remembered that equity dividends come out of company earnings, and are not certain in any financial year. Nor is the proportion of franking, which can change. Franking credits improve returns on domestic equities by about 1.3 percentage points a year for super fund members in 1. Dividend imputation its rationale and its impact on superannuation outcomes, the Association of Superannuation Funds of Australia (ASFA), August 2015. 5
Australia as an income market Australian listed companies have typically had higher payout ratios (the proportion of profit paid out in dividends) than companies in other major world markets, which has reflected Australia s generally higher interest rates. Averaged over the period 2005 to 2015, Australia s payout ratio was 67 per cent, well ahead of the United Kingdom (60 per cent), Japan (57 per cent), Europe (55 per cent), Canada (52 per cent and the USA (48 per cent) according to the Reserve Bank of Australia 2. The dividend payout ratio across Australia s top 200 stocks has climbed to a record 87 per cent, against a 20-year average of 65 per cent, investment bank Goldman Sachs says 3. Goldman Sachs says dividends are 20 per cent higher than five years ago. This rise in part reflects the effect of dividend imputation, introduced in July 1987, and more recently, a conscious choice on the part of Australian companies to boost ordinary dividends. Companies have the choice between lifting dividends, reducing debt or investing capital for expansion or in pursuing mergers and acquisitions (M&A) opportunities. Australian companies in the 2000s have consistently opted for the first choice. RBA analysis describes the Australian payout ratio as evolving in three phases since 2003: first, falling as dividends grew less strongly than earnings during the early high-investment stage of the resources boom; second, rising temporarily during the global financial crisis, as dividends fell but by less than earnings; and more recently, rising quickly alongside large increases in dividends, while aggregate earnings have been relatively flat. The central bank also points out that Australian companies ratio of dividend payments to operating cash flow has risen in recent years to 50 per cent, which is high by recent standards (outside the global financial crisis). 2. http://www.rba.gov.au/publications/bulletin/2016/ marpdf/bu-0316-6.pdf 3. http://www.theaustralian.com.au/business/opinion tim-boreham-criterion/companies-divided-on-dividends/news-story/5f678be9545931be0c1f3ca141185e50 6
However, the RBA emphasises that the increase in Australian dividend distributions over the past decade has been driven entirely by the S&P/ASX 200 companies, and in particular, by the ten largest dividend payers. These companies vary over time, but usually include the four major banks, the major diversified miners (until 2016), Telstra and the major supermarkets (Woolworths and Wesfarmers, the owner of Coles.) The dividends of the largest payers account for more than half of total dividend payments. At the company level, the RBA says about three-quarters of dividend-paying companies increase their dividend payments in periods where earnings have increased: in contrast, when earnings fall (not including periods when a loss was recorded) a majority of companies still seek to increase or maintain their dividends. Companies are reluctant to cut dividends, but are usually willing to do if they make a loss in a period. 7
Another factor is that Australia s system of dividend imputation has changed investor behaviour. They have flocked to the major dividend-paying stocks. In particular, Australian self-managed super funds (SMSFs) which are highly yield-conscious because of the tax-advantaged nature of income from fully franked shares now own 16% of the stock market and favour high-yielding stocks, according to Credit Suisse 4. Over the decade to March 2016, SMSFs enjoyed a total Aussie equity return of $120 billion, of which $88 billion, or 73%, came from dividends, says Credit Suisse 5. The 50 largest companies pay more than three-quarters of ASX 200 dividends and this is where the SMSFs focus their attention. In turn, the behaviour of companies has changed to match the desire for yield, and hence, the rising Australian payout ratios. Paul Rickard, co-founder of Switzer Report, says the rising dividend payout from Australian companies is primarily a function of personal tax rates and dividend imputation. It s unquestionably investor-driven. The dividend imputation system, particularly for zero-rate taxpayers (for example, a SMSF that is in pension phase), where there is the potential full refund of unused franking credits, continues to drive a huge bias toward stocks that pay fully franked dividends, and companies have responded by having high payout ratios. If franking credits were not refundable, it might be totally different, he says. But SMSF investors in particular want high yields, company boards have responded to investor demands for increased dividends; that demand then supports their share prices so investors keep investing in those companies, and it becomes self-fulfilling, says Rickard. The S&P/ASX 200 average yield is currently 4.45% 6. In the hands of an SMSF in accumulation phase (paying 15% tax) this is equivalent to a pretax yield of 5.46%. To an SMSF in pension phase (where the fund s tax rate is nil, and all franking credits are refunded) it equates to 6.35%. Some of the elite stocks of the market in particular, the four major banks and Telstra offer dividend yields well above this average, and have come to be regarded as reliable dividend-yield generators. For example, NAB is currently priced on analysts consensus forecasts (as collated by FNArena) at a forecast FY18 dividend yield of 5.9%, fully franked. In the hands of a SMSF in accumulation phase, that yield is equivalent to 7.2%, and if held in pension phase it is equivalent to 8.4%. Charlie Aitken, chief executive officer at Aitken Investment Management (AIM) and member of the Switzer Dividend Growth Fund investment committee, cautions that investors should not buy stocks solely based on the dividend yield they should be comfortable that the stock s dividend flow can grow, through rising earnings and a sustainable payout ratio. You have to be very careful on payout ratios: we ve seen some of the banks payout ratios get up to 70 per cent 80 per cent, and that becomes a concern. The big resources stocks abandoned their progressive dividend policies, under which the dividend could not fall, he says. Telstra shares tanked in August when it said it would cut next year s full year payout by 30%. Aitken would rather buy a dividend yield at 4 per cent and growing, representing 60 per cent of profit, than a dividend at 6 per cent and static, and paid out of nearly 80 per cent of earnings. There is no room for error in the latter case, and that is where the banks got to. Yield-oriented investors should focus on sustainable dividend growth prospects, not absolute yields, he says. 4. http://www.theaustralian.com.au/business/business spectator/a-million-yieldchasing-smsfs-cant-be-wrong/ news-story/44d1bcb64eb9f8ec216d3ee88284368f 5. http://www.theaustralian.com.au/business/business spectator/a-million-yieldchasing-smsfs-cant-be-wrong/ news-story/44d1bcb64eb9f8ec216d3ee88284368f 6. http://www.theaustralian.com.au/business/busi ness-spectator/a-million-yieldchasing-smsfs-cant-bewrong/news-story/44d1bcb64eb9f8ec216d3ee88284368f 8
Australia for income, global for growth This heavy preponderance of yield in the ASX has given rise to the investment strategy of Australia for income, global for growth. This recognises that Australian investors natural home bias toward the companies they know best a leaning that is strengthened in Australia by the benefits of fully-franked dividends exacerbates their relative lack of international diversification. Australia represents only about 2% of the global stock market by capitalisation, making overseas diversification critical. Moreover, because the Australian stock market is highly concentrated at the top end, the top ten stocks account for more than half of the Australian market s benchmark index, which is dominated by banking and resources. Therefore, adding global share diversification is vital for gaining exposure to industries and world-scale companies that are not represented on the Australian market. Another consideration in adding some of the major world companies to a portfolio is that the investor is not only buying exposure to the US or European economy, where a particular stock is domiciles: many of the largest US and European stocks are actually global mega-cap companies, which generate earnings all over the world. For example, the big consumer-goods companies that represent a play on the emerging consumers in Asia, for example Procter & Gamble, GE, Johnson & Johnson and Unilever, give global investment exposure. 9
The value of a rising dividend stream The attraction of using shares for income generation, compared to deposits or fixedincome investments, is that the dividend stream can be expected to grow over time. Dividends are paid out of company profits, so as companies become more successful and the economy grows, company profits and thus dividends tend to grow. This growth in dividends redresses the impact of inflation, which erodes the purchasing power of an income stream that does not grow, such as that from a term deposit. The highest-quality stocks on the market provide a combination of income in the form of dividends and an increase in the stock price over time. Usually, these attributes come from the fact that businesses have developed major competitive advantages often called high barriers to entry and reliable, trusted brands and services, and a proven history of commercial success. All of these factors reduce the risk of equity investments. Companies that possess these features tend to exhibit a strong dividend flow, which is much less volatile than the share price. For example, Commonwealth Bank s dividend has failed to increase in only one financial year since 1991-92 in the GFC year of 2008-09 (see below chart). This low volatility of dividends in the highest-quality stocks compensates somewhat for the volatility in returns from the share market. CBA Dividend: cents per share 10
How investors can achieve both income and capital growth Investors can seek to capture income and capital growth by choosing the stock market s highest-yielding and most reliable dividend payers themselves, or by using a professionally managed vehicle designed to do this. Some options include unlisted funds established to capture the best yielding investments, or a lower cost vehicle like an exchange-traded managed funds designed on the same principle. These exchanged-traded managed funds have been introduced to enable investors to target a specific style of investment return by purchasing units on the ASX. They use an actively managed investment style to choose a portfolio of shares, just like a regular managed fund. This can give investors easy access to a high-yield solution in a single, easily tradeable investment. The high-dividend ETFs are designed particularly to suit the needs of SMSFs and retirees, investors who want as high a yield as possible in a low-return environment THE HIGH DIVIDEND ETFS ARE DESIGNED PARTICULARLY TO SUIT THE NEEDS OF SMSFS AND RETIREES, INVESTORS WHO WANT AS HIGH A YIELD AS POSSIBLE IN A LOW RETURN ENVIRONMENT 11