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10 stocks for Australian income investors: Morningstar Special Report

Gareth James  |  11 Aug 2021Text size  Decrease  Increase  |  
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This is a snippet from Morningstar's Special Income Report: 10 franked income-stock ideas for Australian investors. Morningstar Premium subscribers can view the report here.

Australian income investors face a challenging environment. Repeated interest rate cuts have crushed interest rates on deposit accounts and caused asset yield to compress. RBA indications that the target cash rate won't increase until at least 2024 has caused some investors to claim "there is no alternative" to equities as a source of yield.

Dividend payout ratios among Australian companies are high due to the dividend imputation system. This returns corporate tax to Australian resident taxpayers via franking credits with dividends, creating an additional source of income.

Morningstar's fair value estimates exclude the value of franking credits because they only have value to Australian resident taxpayers. However, franking credits can materially increase the income earned from Australian equities by Australian resident taxpayers. Notably, franking credits, like dividends, are received equally by all Australian taxpayers irrespective of their personal marginal taxation rate and are equivalent to other sources of gross income, such as bank interest and dividends on shares.

We've identified 10 franked income stock ideas from our coverage list of 189 stocks. The additional income from franking credits highlights several companies with 3-star ratings which appear more valuable when the value of franking credits is incorporated into our analysis.

Our shortlist is based not only on the short-term dividend yield, but also on the gross yield including franking credits and other indicators of dividend sustainability, such as our Economic Moat rating.

Australian dividend imputation encourages dividend payments

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The Australian dividend imputation system was introduced in 1987 to avoid the double taxation of Australian resident taxpayers whereby dividends were effectively subject to both corporate and personal income tax. The payment of franking credits with dividends enables Australian resident taxpayers to reduce their personal tax liability but, since 2002, franking credits are also refundable, meaning taxpayers with a low or zero marginal tax rate can generate additional gross income from franking credits.

The dividend imputation system encourages Australian companies to return capital to shareholders via dividends and leads to relatively high payout ratios, as illustrated below. This happens despite the existence of the capital gains tax discount, or CGT. It also reduces the appeal of directing capital to other potential uses, such as reinvestments in the business, growth by acquisitions, or on-market share buybacks.

Payout ratios are relatively high in Australia

Dividend payout ratio

Source: 'A History of Australian Equities 2019' Reserve Bank of Australia, Morningstar

Income is important in Australia, but the equity market is concentrated and domestically focused

Dividends and franking credits comprised around 70% of the total return of the S&P/ASX 200 Index over the past decade, which highlights the importance of income to long-term Australian equity investment returns. However, the Australian market is relatively concentrated across financial and resources stocks, and arguably domestically focused. This means that a portfolio of Australian equities may be more highly correlated, or less diversified, than investors perceive. The Australian market's large exposure to resources companies also arguably increases environmental social and governance, or ESG, risks and resource companies' earnings volatility can increase dividend volatility.

Franking credits increase the long-term total return of Australian resident taxpayers

S&P/ASX 200 Total Return

Source: www.spglobal.com, Morningstar

Traditional sources of income have declined in recent years

Australian income investors have been impacted by falling interest rates in recent years, which has crushed interest rates on deposit accounts and compressed yields on residential real estate. However, with most Western central bank interest rates close to zero, it's understandable that investors seeking income are concerned about interest rates and income stock yields moving higher, potentially causing capital losses from income stocks.

Traditional sources of income are in decline

Identifying dividend sustainability and avoiding the yield traps

Income investing is about more than simply buying companies with high short-term dividend yields. This could signal future earnings and dividend weakness rather than relatively high returns, a situation known as a yield trap. In addition to Morningstar's star ratings and price/fair value estimates, we recommend investors consider Morningstar's proprietary ratings when evaluating income stocks. Income investors can also assess dividend sustainability via financial statement and earnings forecasts analysis, such as the following metrics:

Morningstar Economic Moat Rating: The Morningstar economic moat rating measures a company's ability to protect its profits from competition. Narrow- and wide-moat-rated companies are more likely to sustain profits and therefore dividends than companies with no economic moat. Organic revenue growth: Organic revenue growth is arguably a more sustainable source of revenue growth than acquisitions or cost cutting. Income investors should therefore assess the extent to which revenue growth is organic and sustainable and if acquisitions are masking a weak core business which could threaten dividend sustainability.

Customer concentration: High customer concentration can pose a significant threat to revenue, earnings, and dividends. The loss of a large client or contract could significantly impact revenue and be exacerbated by operating leverage, causing profits and dividends to fall. Income investors should therefore assess the degree of customer concentration in addition to key contract terms and expiry dates.

Recurring revenue: Companies with a high proportion of recurring revenue should experience more sustainable dividends and resilience to economic downturns.

Margin compression: Strong businesses with economic moats should demonstrate resilient profit margins. Falling profit margins imply competition is eroding profits and may lead to future dividend cuts.

Dividend payout ratio: Dividend payout ratios should be sustainable. Morningstar analysts assess the suitability of dividends within their Capital Allocation analysis. However, paying dividends while increasing debt or raising equity, or a dividend payout ratio of over 90% may indicate unsustainable dividends.

10 franked income-stock ideas for Australian investors

We have screened our coverage list of 189 stocks for attractive income stock ideas, including franking credits, for Australian investors. Factoring in the additional income from franking credits into our analysis, our screen highlights several companies with 3-star ratings which have significant forecast franked income streams.

Our shortlist is based not only on the short-term dividend yield, but also on the gross yield including franking credits and other indicators of dividend sustainability, such as the Economic Moat and Capital Allocation ratings.

For more details on our valuation and outlook for each firm, please see the full report

10 franked income-stock ideas for Australian investors

Source: 10 franked income-stock ideas for Australian investors; Every cent counts if 'there is no alternative' to equities (Morningstar)

Securities mentioned: APA Group (APA), Aurizon Holdings Ltd (AZJ), Dexus (DXS), GWA Group Ltd (GWA), Link Administration Holdings Ltd (LNK), Magellan Financial Group Ltd (MFG), Medibank Private Ltd (MPL), Perpetual Ltd (PPT), Telstra Corp Ltd (TLS), Westpac Banking Corp (WBC)

is a senior equities analyst at Morningstar Australasia

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