Five ways to look at dividend investing

Christine St Anne | 09 Sep 2011

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Christine St Anne is Morningstar's online funds and ETFs editor.

 

The recent reporting season proved a little lacklustre. While companies on the whole met expectations, it is clear that earnings continue to disappoint. The reporting season, however, was typified by a larger number of companies increasing their dividend payments to shareholders.

"Companies are starting to simplify their businesses. They are starting to pay excess capital out to their investors. So while earnings have disappointed, dividend payments have been good," Russell Investments portfolio manager Scott Bennett says.

Bennett is responsible for managing the Russell Investments high-dividend exchange-traded fund (ETF). The Russell Australian High Dividend Index (RDV) tracks a number of companies that are well positioned for dividend growth.

Bennett says while dividend yields are currently attractive, investors need to look at a number of factors to ensure these yields remain sustainable.

 

1. Look at the past and future

"To ensure companies are positioned for long-term dividend growth, we look at what companies have done in the past and their ability to grow going forward," Bennett says. 

Bennett says investors could determine whether companies will be on track to pay their dividends by looking at fundamental research, consensus data, company announcements and guidance notes.

For example, this reporting season, BHP Billiton (BHP) management announced that the company was committed to growing dividends.

Morningstar also includes three-year forward estimates for company dividends in its research reports.

"Dividends are not guaranteed like term deposits. It is important that investors not only look at past dividend payments but also place greater emphasis on the company's ability to pay future dividends," Bennett says.

State Street Global Advisors head of active equities, Olivia Engel, says investors should also be mindful of the level of volatility in dividend payments.

"A consistent level of divided returns in the past indicates that a company is better placed to continue its dividend payments, rather than a company whose dividends jump from year to year," Engel says.

A company like Qantas (QAN) tends to have volatile dividend payments. This year, it did not generate any dividends for shareholders despite its higher yield.

2. Look behind the yield

High-dividend stocks can be deceiving. If the share price falls, the yield generally goes up. But that does not mean the company will be paying out higher dividends. 

"Investors need to be wary of companies paying high dividend yields because often the company is cheap for a reason," Engel says.

"Investors should ensure that companies have the capacity to pay their dividends. To ensure companies maintain their dividend payments, companies must be in good financial health, have sustainable cashflows and earnings, and have a low probability of default."

Engel says that typical industries that rise to the top in terms of high-quality companies tend to be healthcare, telecommunications, consumer staples and utilities.

In building an effective dividend investment strategy, investors should also look at a company's capacity to grow its dividends.

Russell Investments recently conducted research comparing two companies that revealed the difference between quality dividends and cheaper imitations.

Telstra (TLS) is viewed as a good yielding stock, while a resource company like BHP has not historically been known for returning dividends to its shareholders.

If an investor was to invest $10,000 in Telstra 10 years ago, they would now be receiving income of around $370 per year. Under the same scenario, an investor in BHP would be receiving about $750 in dividends plus franking credits.

In addition to the extra dividends, the investor in BHP would pick up capital growth. Telstra was trading at around $9 about 10 years ago. Today, it is hovering around $3. In comparison, BHP is now worth $35, up from $10. 

"Besides quality dividends, investors need to ensure a company has good growth prospects," Bennett says.

 

3. Look closer at cyclical stocks

Companies in the airline and media sectors are known as cyclical stocks. For Bennett and Engel, these companies tend to generate volatile earnings, which could impact their dividend payments.

"We tend to stay away from highly leveraged and highly cyclical industries," Bennett says. "This is because the earnings from these companies are based on cycles, and similarly, so are their dividends."

Cyclical companies may also have a tendency to pay sporadic dividends.

For example, Newcrest Mining (NCM) had a history of paying a dividend of 5 cents a share, but now its dividend has increased to 40 cents a share.

"The company has generated good dividend growth but there has also been a lot of 'special' dividends paid out. While the company has been returning its dividends to investors because of the high gold prices, investors need to question whether these dividends can be sustained once the gold price falls," Bennett says.

Cyclical companies may also strive to maintain stable dividends while earnings fluctuate during a cycle.

Again, Engel notes investors should look at the company's historical trend of paying dividends, not just the most recent dividend.

"This will detect whether the company is likely to cut a dividend at the first sign of an earnings downturn," she says.

 

4. Look beyond banks

There is no doubt that banks have been highly favoured among investors because of their attractive dividend payments.

Engel says financial stocks have become increasingly volatile. Over the past 12 months, the market has experienced 15 per cent volatility. However, financial stocks have experienced 20 per cent volatility.

"While dividend yields have been sustainable, capital fluctuations should concern investors," Engel says.

Building a high-dividend portfolio, therefore, needs diversity.

"Investors need a healthy dose of defensive stocks so they can collect dividends in hard times," Bennett says.

Recent statistics from Commsec showed while households were increasing savings, spending on alcohol remained steady. Similarly, in difficult times, people still need to spend money at the supermarket.

Consumer staples like Metcash (MTS), Woolworths (WOW) and Wesfarmers (WES) are offering good dividends after franking credits, according to Bennett.

 

5. Look for tax implications

Investors should also be aware of companies which do not pay franking credits.

"A lot of good dividend-paying stocks like REITs [real estate investment trusts] and infrastructure companies don't have franking credits. While their headline dividend rates may look better than other companies, their dividends are lower because they do not have franking credits," Bennett says.

For example, if a shareholder got paid a 5 per cent dividend, which was 100 per cent franked, on an after-tax basis this return would be 7 per cent.

"The headline dividend yield on a REIT or an infrastructure stock may be 6 per cent. However, the rate would not be high compared to a 5 per cent dividend yield of an industrial stock because the industrial stock is fully franked," Bennett says.

Franking credits may be beneficial for people in self-managed superannuation funds (SMSFs) but not necessarily for those on higher tax rates.

"For SMSF investors, franking credits are invaluable. But if you are on a higher tax rate, franking credits are not that valuable," Bennett says.

This report appeared on www.morningstar.com.au 2021 Morningstar Australasia Pty Limited

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