Morningstar Guide to Income Investing

Introduction

At Morningstar we are all about independence for the individual investor. Independence from conflicted advice, independence from excessive fees and independence from the presumption that it is somebody else’s responsibility to give you the life you want.

Passive income is one of the pillars of independence. Which investor hasn’t dreamt of earning income while sitting on a white-sand beach sipping a cocktail? That’s nice but a Morningstar investor knows the difference between dream and reality. This dream isn’t going to come true by itself. It takes research to uncover investment opportunities. It takes patience to let compounding do its magical work. It takes conviction to resist chasing the crowd. And it takes foresight to realise that earning money is only the first step on the journey to financial independence.

Income investing has played a crucial role in my own financial freedom. I started investing for income in university. This may not be the age at which most people gravitate towards income investing but I found the concept of passive income so compelling that I couldn’t help myself. During my time as an income investor my approach has evolved. Initially, I used a dividend reinvestment program across my entire portfolio. This served me well, particularly when the global financial crisis hit. While certain stocks I owned cut their dividend, most did not, and my focus on sustainability worked well. The dividend reinvestment program allowed me to plough cash back into my holdings at what turned out to be extremely attractive valuations. As I get older my approach continues to evolve: I’ve set up a dedicated investment account that generates income, which I can use to spend on travelling. And this account brings with it a psychological inducement: the discipline to continue saving money while also generating some immediate gratification (yes, I know this is a trick; and no, I don’t care because it works for me). Eventually I hope to reach the point where the income I need to live will be generated by my portfolio—then I will have reached true financial independence.

But the life moment that really cemented my views on the merits of income investing came when my parents divorced. And with divorce comes solitude, which was understandably a great source of anxiety for my mother, especially since she was never one to pay attention to investing. With her retirement rapidly approaching she asked me to take over her portfolio, and before long concepts such as sustainability took on greater importance. Ten years later, my mother is retired and living off income generated by her portfolio. There will certainly be a time when she will have to start dipping into principal, but she is in a better situation than she may otherwise have been. And for me, being part of a real-world example of the type of financial freedom that income investing can provide is a source of relief and gratification.

The Morningstar Income Investing Guide is intended to help you become a better income investor whether you are just starting out or have been investing for years. The guide outlines basic income-investing concepts and points you towards Morningstar Investor features and tools that can help you navigate your own path to financial independence.

Earning income from stocks

“Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.” – John D. Rockefeller

Dividends: The truth about stocks

Let’s start with the basics: What is a dividend? A dividend is a payment made by a corporation to its shareholders, with each share receiving an equal amount of value. Dividends can be paid in additional shares of stock (stock dividends or stock splits), or shares of another corporation (a process known as a spin-off). Some are one-time affairs known as special dividends. However, the vast majority of dividends are regular cash dividends, paid at predictable intervals—usually twice a year in Australia.

Dividends are everywhere: 90% of the companies in the ASX 200 Index make regular distributions of cash to shareholders, and many smaller companies also pay dividends. The yield of the ASX 200 is ~2.92%, which means that for every $1000 invested $29.20 of income will be generated. The yield increases to 3.58% if you exclude the 10% of the ASX 200 companies that pay no dividend. Australian companies tend to pay higher dividends than foreign companies and Australia has a higher yield than other global markets.

Common stocks derive their value from the same source that bonds do: cash that is paid by the security issuer directly to the investor. With a bond, the investor knows exactly what he is supposed to get. Interest payments are scheduled in advance, as is the return of principal when the bond matures. The only question directly related to these cash flows is whether the issuer can pay on time and in full, and how much purchasing power these dollars will have when received. You could debate how much these cash flows are worth based on various scenarios for inflation, interest rates, credit spreads, economic conditions, and so on, but a bond that paid no interest and never matured would have a tough time finding buyers.

When one thinks beyond the “buy low, sell high” mentality that pervades the stock market, it turns out that common stocks are no different. Once you put some cash into a share of stock, there are only two ways you can recoup your cash. You could sell the stock on the open market, but then it has a new buyer, who would need another seller. Unless there is some other source of cash, this is the world’s biggest game of hot potato. The other source of cash is from the issuing corporation itself. It might take the form of a liquidating distribution (these are very rare), a cash buyout offer, or a dividend. The most useful payments for some investors—and the only practical ones for the largest companies—take the form of regular cash dividends.

The critical importance of dividends, as well as dividend growth, is easily observed in historic stock market returns. Since 2000, the ASX 200 has returned an average of 5.12% annually. The proportion of total return that comes from dividends is 60%.

So dividends are not just powerful in terms of delivering potential returns, they can also be practical in meeting investors’ real-world objectives. Dividends help give investors the ability to use corporate earnings as they see fit: to fund portfolio withdrawals during retirement, to meet other personal financial obligations, to reinvest in the company that paid it, or to invest in other areas of the market.

Dividends may not be the contractual obligations that a bond’s interest payments are, but once a dividend has been established, directors and managers have historically been reluctant to yank it away without good cause. An investor cannot take any dividend for granted, yet a dividend-paying company provides evidence, at least in part, that it has shareholders’ interests in mind.

S&P/ASX 200 – DS Dividend Yield

Source: Morningstar

Dividends and compounding

Seeking a decent income from stocks is a good start, but it’s not the final destination. It is critical for investors—even dividend-oriented investors—to think in terms of total return. Let’s say you find a $25 stock that pays annual dividends of $1 a share. That’s a 4% yield, which isn’t too shabby. But if that dividend never grows, your income return is fixed at 4%, and there’s probably no reason for the stock to go up over the long term, either. By contrast, an increasing stream of income is far more useful than a flat one in an inflationary world, and a growing dividend is also likely to result in capital appreciation over time.

Compounding is often compared to pushing a snowball down a hill. As it travels down the hill, the snowball gathers more snow. The bigger it gets the more snow it gains on each rotation. The “snowball effect” shows that small actions continued over the long term can have a big impact.

The same applies in investing. Compounding is simply the concept of earning a return on your previous returns. The full guide explores an in-depth example of return outcomes when investors reinvest dividends, opposed to receiving them as cash.

Using dividends to evaluate stocks

Dividends can be remarkably useful. Not only do they deliver income and drive total return, they can provide a framework for analysing companies. Dividend investors seek stocks whose dividends (1) will not be cut, (2) will grow at an acceptable rate over the long term, and (3) will provide a good total return profile. That’s why the analysis of a dividend paying stock can be thought of in terms of three questions, all of which are viewed from the standpoint of the dividend: Is the dividend safe? Will it grow? And what’s the potential return?

But first, let’s visit a concept that is central to Morningstar’s approach to all stocks, including those that pay dividends: economic moats.

Economic Moats and Dividends: An economic moat—a term we borrowed from Warren Buffett—is a sustainable competitive advantage (or combination of advantages) that allows a company to earn excess returns on capital for a long period. We assign every company in our coverage universe an economic moat rating of wide, narrow, or none, depending on our assessment of its competitive strengths and how long we expect these strengths to last. We say a company generates excess returns if its returns on capital (operating profits less taxes divided by the net assets used in the business) consistently exceed its cost of capital (the interest on its debt and the total returns required by shareholders, weighted by how a company’s assets are funded). However, it’s not enough to observe that a company earns excess returns; we also need to know why. Morningstar identifies five potential sources of an economic moat:

Intangible assets

Cost advantage

Switching costs

Network effect

Efficient scale

Read more about economic moats in the full guide on Morningstar Investor.

Sustainability: What factors can help create a reliable stream of dividends?

Some factors that can help create a reliable stream of dividends include economic moat ratings, strong finances and payout ratios. 

Find the full in-depth guide on Morningstar Investor.

Will the dividend grow?

Dividend growth is a sign of health that reflects dividend stability. You can’t require a dividend increase every year from every company, but most investors look for a decent average rate of dividend growth over three- to five-year periods.

A good place to start is with a stock’s dividend record, preferably including at least 10 years of history, which preferably includes a time where the company has undergone earnings pressure. If nothing else, this will signal the willingness of management to reward shareholders. This doesn’t mean candidates with shorter records should be dismissed out of hand, but additional scepticism should be applied.

The full guide looks at specific characteristics to look at for potential dividend growth.

International income investing

There are several reasons why Australians don’t invest overseas. Our own subscribers cite, for instance, a lack of knowledge about overseas markets, currency risk and uncertainty about how to access global investments. And when it comes to income investing, there are even more compelling reasons to stick with local equities. The dividend yield on Australian shares has consistently been among the highest in the world, not to mention the favourable tax treatment of franking credits. Together these two reasons alone leave many Australian investors wondering why they should look overseas for income.

The full guide explores the case for international income investing that all income investors should consider.

Glossary

Dividend (or dividend rate): We express most of our dividend data for individual stocks as an annualized amount based on the most recently declared amount per share multiplied by the frequency of dividends during a year.

Dividend yield (or current yield): A stock’s yield is the annual dividend rate divided by the stock’s current price.

Economic moat: Morningstar’s moat ratings reflect our assessment of a company’s competitive standing, with ratings of wide, narrow, or none. We expect the structural competitive advantages furnished by a wide moat to encourage excess returns on capital (defined as returns on capital less a company’s cost of capital) for at least 20 years. Narrow moats reflect an expectation of shorter-lived advantages and/or smaller excess returns. Wide and narrow moats help protect a company’s ability to pay and increase its dividend, so we strongly prefer stocks with Morningstar economic moat ratings of wide or narrow. To find out if a company has an economic moat and the source of the moat, enter the ticker and review the Analysis section on Morningstar Investor.

Payout ratio: This is the percentage of earnings being paid out as dividends by a corporation. For example, a company earning $2.00 a share on an annual basis and paying dividends at the rate of $1.20 a share annually has a payout ratio of 60%. Both the numerator (dividends) and the denominator (earnings) may reflect timing issues, adjustments for unusual dividend payments, and/or factors influencing reported earnings. To find the current and previous year’s payout ratio, enter the ticker and review the Dividends section.

Find the full Guide to Income Investing on Morningstar Investor.