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Where dividends might grow from here

Shani Jayamanne  |  05 Aug 2020Text size  Decrease  Increase  |  
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We are all grappling with a high degree of uncertainty related to the COVID crisis. Pre-COVID assumptions on the way we work, we socialise and live have been upended and none of us know what a post-COVID world will look like. This uncertainty extends to generating income from investments. Income streams used to support day to day lives have been upended as formerly reliable dividend generators halt their payouts (ANZ Bank (ASX:ANZ) missed its first schedule payment in almost four decades). This environment is testing investor agility, with many having to discard the former anchors of their income stream and look for companies that will grow their dividends going forward. This often means that many must accept lower yields than what has been traditionally earned.

Morningstar’s latest report on dividend opportunities calls out the most attractive sectors and investments that have strong dividend forecasts and are trading below their fair value. The report forecasts that median payout ratios will, for the short term, decline to around 60 per cent for fiscal 2020, compared with 71 per cent in fiscal 2019. Faced with this new reality, it’s worth knowing that an investor’s ability to understand a company’s balance sheet and its competitive advantages can provide insights into how to create a portfolio with sustainable income beyond the crisis.

Companies must be strong enough and properly prepared to weather the near-term storm. To do this, they must have strong balance sheets, robust cash generating capabilities and sustainable competitive advantages.

‘Economic moats’ is a term that was popularised by legendary US investor Warren Buffett, drawing on inspiration from medieval castles. A ‘moat’ is the ability of a business to pull up the drawbridge to defend long-term profit and market share, thus delivering excess returns above the cost of capital.

Companies with a sustainable competitive advantage are able to fend off the competition and sustain excess profits over a long period of time. However, in saying this, an economic moat does not just protect profitability; it also suggests that additional investments of retained earnings for expansion should earn a good return that may be reflected through enlarged dividend-paying power.

We view companies with economic moats as more likely to succeed in growing earnings and dividends when the economy recovers. In fact, companies which entered the crisis with a competitive advantage and the capacity to invest through the cycle could come out of it in a stronger position. For example, our analysis of the fortunes of the Australian retail sector during the last recession concludes retailers competing effectively on price and taking market share turned their short-term pain into long-term shareholder gain.

Next to moats, cash reigns supreme. Dividends can be paid to common stockholders only if all other financial obligations are satisfied first—banks, bondholders, suppliers, employees, pensions, the tax office, and even hybrid holders. Being last in the pay line, an investor would typically want to see that this line is not too long.

Companies likely to weather the storm better than others are those with no debt and cash on the balance sheet, or no net debt. If a company has debt it is important to understand when it needs to be paid back. There is a big difference between companies with debt that doesn’t mature for a while and companies that have debt maturing in the near future. Having debt mature in a bad capital market environment can be difficult to refinance. This is especially true if the cash flows are affected by lower levels of economic activity. In some cases, companies may not be able to cover their interest payments with current cashflows and can’t borrow more money to support them through the crisis.

Balance sheets can provide further indicators of the ability of a company to weather turbulent conditions and return to strength post-storm—strong finances are essential to ensuring a sustainable dividend.

This may be the single most important statistic in evaluating a dividend’s stability, but there’s always a bit of tension. A payout ratio is the proportion of earnings being paid out as dividends. All else being equal, a higher payout ratio will generate a higher dividend yield, but lower payout ratios are less risky than high ones. What you should seek is balance—current yield versus stability, as well as current yield versus future growth.

By sector, we see the greatest opportunity for rising payout ratios and near-term dividend growth in the utilities, industrials (including defensive infrastructure names), and consumer defensive sectors. We estimate a better-than-average 78 per cent of utilities and 65 per cent of industrials will grow their dividends in fiscal 2021 over fiscal 2020, while a still-solid 46 per cent of consumer defensive companies will also do so.

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. The value of a company is largely driven by the long-term outlook, but only if it can survive the current downturn. Therefore, a more cautious stance on returning capital to shareholders can be part of prudent liquidity management.

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is an investment specialist, Individual Investor, Morningstar Australia.

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