In a recent article I explored the feasibility of retiring off the dividend income generated from a portfolio. The conclusion was that this could be a sound strategy provided investors were aware of the risks involved and positioned their portfolio accordingly. I heard from countless readers who were currently taking this approach in retirement which further underpins the feasibility of this strategy.

In the original article I cautioned readers that the income generated by the Australian market was heavily concentrated in several large companies and in the mining and banking industries. I explored the 10 largest contributors to overall ASX 200 income and the future prospects for their dividends in a two-part series which can be viewed here and here.

In the original article I focused on the topic of dividend growth. Too often investors reflexively focus on the companies with the highest yield when implementing a dividend strategy. There are two underlying issues with this approach.

  1. The first issue is that dividend yields are backward looking which does not mean that high dividends will continue to be paid in the future. Savvy income investors must focus on the sustainability of the dividend.
  2. The second issue is that even if a high yield is sustainable, it may be harder for the company to continue to grow their dividend if they take up a high portion of their earnings as reflected in the payout ratio. A high payout ratio means there is less money to be re-invested in growth and it may be a signalling mechanism that management does not believe there are strong growth prospects. A lack of dividend growth can be a problem during a multi-decade retirement since retirees will want to at least keep a steady real income which means keeping up with inflation.

As is the case so often in investing the key to addressing risk is diversification. The concentration risk in the Australian market can be reduced by a focus on individual holding, sector and geographic diversity in a portfolio. The sustainability and growth issue can be diversified away by focusing on both high-quality companies with high current dividend yields and companies with better prospects for dividend growth.

I’ve looked at two Morningstar indexes as a way to provide some additional information on methodologies to identify companies that have a sustainable dividend and strong prospects for future dividend growth. These indexes use the underlying characteristics of shares – or factors - to identify securities that meet the criteria for sustainable dividends with high current yields and companies with strong prospects for dividend growth.

I’ve looked at the Morningstar Australia Dividend Yield Focus Equal Weighted index and the Morningstar Global ex-US Dividend Growth Index and picked out a couple names from each index as examples.

Morningstar Australia Dividend Yield Focus Equal Weighted

The index offers exposure to high-quality Australian companies with strong financial health and an ability to sustain above average dividend payouts. The index consists of 25 stocks weighted by dividends.

To be included in the index a company must have a Morningstar Economic Moat rating of narrow or wide and a Morningstar Distance to Default score in the top 50% within its respective Morningstar Sector. The Morningstar Distance to Default score is a quantitative assessment of the financial health of a company. Dividends are not guaranteed, and a shaky balance sheet may put dividend payments in jeopardy. A study looking at market data between 2005 and 2019 showed that companies with higher distance to default scores were less likely to cut their dividends. More information can be found here.

Investors can assess sustainability by looking for moderate payout ratios, looking at overall debt levels compared to the industry and by assessing the cyclicality of cash flows of the underlying business.  

Transurban (ASX: TCL)

Transurban Group is an owner/operator of toll roads in Melbourne, Sydney, and Brisbane. It also owns toll roads in Virginia, USA and Montreal, Canada.

Morningstar equity analyst Adrian Atkins assigns Transurban a wide economic moat rating due to the efficient scale of their road networks which provide strong barriers to entry due to inelastic demand of roads and the substantial upfront construction costs to build competing networks. Atkins also believes that Transurban’s balance sheet is sound and the distribution policy is appropriate.

The shares have a current dividend yield of 4.51% and Atkins forecasts moderate growth in the dividend in fiscal 2024 and 2025. The shares are currently fairly valued based according to Atkins.

ASX Limited (ASX: ASX)

The Australian Securities Exchange is a vertically integrated securities exchange business offering listing, data, trading, clearing, and settlement services across equities, debt, and derivatives.

Morningstar equity analyst Roy Van Keulen assigns ASX a wide economic moat rating based on network effects and intangibles in its listing, trading, clearing, and technology and data businesses. Van Keulen believes ASX’s balance sheet is strong and financial risk is low given high operating margins, a capital-light business model, no debt, and forecast positive cash flows.

The shares have a current dividend yield of 4.03% and Van Keulen forecasts flat dividends in fiscal 2024 and 2025. The shares are currently trading at a 22% discount to fair value.

Morningstar Global ex-US Dividend Growth Index

The index is designed to target dividend-paying stocks with a record of consistent dividend growth and the capacity to sustain that growth. To be eligible for inclusion, companies must have increased their dividend payments for five or more consecutive years. Forward-looking screens are applied to favour companies with the strength to continue their dividend growth. Criteria includes companies with a positive consensus earnings forecast and a payout ratio of less than 75%.

CSL (ASX: CSL)

CSL is one of the largest global biotech companies and has two main segments. CSL Behring either uses plasma-derived proteins or recombinants to treat conditions including immunodeficiencies, bleeding disorders and neurological indications. Seqirus is now the world’s second largest influenza vaccination business.

Morningstar equity analyst Shane Pronraj awards CSL a narrow moat rating based on the cost advantage afforded by its large-scale plasma collection and fractionation, and intangible assets based on the intellectual capital in its existing products and the proven success of its R&D efforts over time. CSL’s balance sheet is in sound condition. Financial risk is low given low revenue cyclicality and product demand being largely driven by chronic indications.

The shares are currently yielding 1.44% and have a history of high dividend growth. Pronraj believes this will continue into the future and is forecasting the dividend to rise from $3.63 per share to $4.03 in fiscal 2024 and $4.81 in 2025. CSL is currently trading at a 24% discount to fair value.

For more on CSL please read my article on why I decided to purchase the shares.

Bapcor Ltd (ASX: BAP)

Bapcor is one of the largest automotive spare parts and accessories businesses in Australia and New Zealand. The firm principally distributes automotive spare parts and accessories to independent and chain mechanic workshops in Australia and New Zealand through Burson-branded stores. Bapcor also operates a retail automotive spare parts and accessories business in Australia, catering to the do-it-yourself customer, under the AutoPro and Autobarn brands.

Morningstar equity analyst Angus Hewitt awards Bapcor a a narrow economic moat, thanks to the brand intangible assets and cost advantage in its trade and retail businesses. Hewitt believes Bapcor's balance sheet is in sound condition. Leverage, measured by net debt/pro forma EBITDA was 1.1 at June 30, comfortably below the firm's covenant level of around 3.0.

The shares are currently yielding 3.23%. Hewitt is forecasting moderate dividend growth in fiscal 2024 and 2025. The shares are currently trading at a 15% discount to fair value and were included in the September edition of Morningstar’s Global Equity Best Ideas.

Please note that Bapcor is included in both indexes mentioned in this article. The only share to appear on both lists.