In a world where returns on cash are effectively negative after taxes and inflation, bond yields are record lows and equity markets are at all time highs creates a real dilemma for the income focused investor.
Historically, a portfolio that consisted of 60% Equities and 40% Bonds/Fixed interest would be able to provide investors with a reliable income stream whilst enabling some capital growth. In fact, over time for many investors this simple strategy was able to provide outstanding long term returns, preserved wealth in real terms and reduced the volatility experienced by the investor.
Today, many investors are being forced along the risk curve into investments such as Equities and Real Estate in order to generate the income required to maintain their lifestyle without drawing down upon their corpus (or capital).
One strategy for clients in this position that we like to use involves leaving up to 2.5 years worth of living expenses in cash (to cover short term expenses and market volatility) and utilising investment in equities to supplement the cash reserves.
When a strategy like this is utilised the underlying investment portfolio is going to contain a very different mixture of equities to an investor that is focused on achieving maximum capital growth.
Building an equities portfolio with the goal of deriving income involves evaluating investments with a different eye to the growth focused investor. While investors who purchased early and were able to hold onto market darlings such as Afterpay and Xero have achieved phenomenal returns on their capital, these types of opportunity are incredibly unlikely to have been in or a large percentage of an income focused investors portfolio.
Understanding Dividends
A dividend in essence is a payment that a company makes to owners (shareholders) from the companies profits. Typically, this is considered to be apart of the capital allocation decision from management. To keep it fairly simple, a profit making company has two options for what they should do with this profit. They can keep the money in the business in order to reinvest with the goal of increasing growth or future profits. The other alternative they have is to pay back money to shareholders via either a share buy back (the company uses funds to reduce the amount of shares on issue) or they can pay the cash back to owners via a dividend.
Dividends are typically paid by mature businesses that are not able to use their excess cash to create high levels of internal growth. For example, some of the businesses in Australia that have been famous for their high dividend payments have included the Big Banks (there is a natural limit to how many higher quality borrowers are out there and it does not make great business sense to loan large sums of money to borrowers unlikely to pay it back) and the big miners (in this case unless the company is looking to do further exploration or acquiring other mines, there is only so much required for ongoing operations so it makes sense to return the cash to shareholders).
Companies that pay dividends have a policy in place that determines the amount that they will return to shareholders in this manner.
Investing In Dividend Stocks
The first thing a potential dividend focused investor needs to look at is the current profitability and stability of the underlying business. Generally, it is a very good sign to see a business that has been able to consistently grow dividends in the past. However, this does come with a caveat for cyclical businesses. During a bull market these companies are able to pay high levels of dividends but in the future should business conditions and profitability decline these dividends streams are unlikely to continue at the previous rate and in some cases may stop in their entirety.
As a solid rule of thumb, share prices tend to move in the direction that earnings go. This is particularly relevant for income focused investors as increased earnings, with a consistent dividend policy is likely to result in not only solid price appreciation of the underlying share but also growth within the dividend as well.
For example, one of my favourite companies on the ASX Computershare (the relatively boring and stable share registry business) has increased it’s full year dividend from $0.28 a share in 2011 up to $0.46 a share in 2020 and the share price has grown from $7.80 to todays price of $16.90. The yield has increased from 3.50% to 5.80% for investors that have held through out this time.
Utilising this strategy means an investor may have to sacrifice a higher yield today to achieve future growth and appreciation on their dividend growth.
In the Australian market our miners and financials have been great dividend payers over the years, however this does not mean that are always good investments to make. For example, in May 2008 Rio Tinto was trading at a share price of $97 and yet today 13 years later with Iron Ore at record prices the share price is $126.21. When looking to invest in businesses that are cyclical by nature, it is often a better approach to look to invest when they are unloved. Coincidently, December 2008 would have been a great time to buy RIO as the share price dropped to $28.00.
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A long term favourite of Australian dividend investors has been the CBA. If we exclude last year from the banks dividend’s (they were mandated by the regulator to slash dividends and preserve cash in the event that covid caused economic chaos) from an initial purchase at float of $5.40 a share, the total dividend for the 2020 was $4.31, a yield on purchase of 79.80% (plus a share price that has increased nearly 20x to boot!)
Investing in stable businesses, that offer reliable cashflows are a must of the investor focused on generating an income stream from their equity portfolios. It is essential to understand what future catalysts there are for the business and how they are going to impact upon the ability of the company to pay and grow future dividends.
While CSL is not typically considered to be a favourite of dividend investors, considered more to be a growth stock, it might surprise to you learn that in July 2011 the stock was trading at $32.80 with a dividend of $0.80 for the year. An acceptable but not fantastic yield of 2.43%, however if you were to have held the stock the dividend last year had grown to $2.82 or 8.59% on a purchase basis. Once again ignoring the spectacular growth in the stock price as well.
It is of crucial importance for the dividend focused investor to understand the balance sheet and debt of a potential investment. If a company has high levels of debt, a stretched balance sheet or large impairments likely to occur it becomes very unlikely that dividends will continue to be paid at the same rate into the future (if at all).
One thing that dividend focused investors should be aware of is the dividend trap. Typically, this occurs when a company is offering a dividend yield on the current share price that is not sustainable for the long term. For example, a cursory screen might reveal that last year’s dividend was 10% of today’s stock price but it could be because of factors such as; a special dividend following the sale of an asset or business line, the company has downgraded earnings significantly resulting in the fall of the share price or the business simply had a remarkable year last year that is unlikely to be repeated.
In order to avoid the dividend trap, the investor must understand the reason why the stock is selling so cheap in relation to the dividend. Often, the market will be correct about the business and the issues they face. However, on occasion, the market will be overly pessimistic about the outlook for what at its core is a fantastic business and will temporarily allow an astute investor to purchase the stock on the cheap. One thing you would notice about all of the charts above is that every one of them have suffered periods where the stock price has performed poorly, as mentioned above these would all have a offered a dividend focused investor a chance to buy high quality assets at a discount.
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