In today’s ageing environment where super funds are collectively an enormous participant in the stock market, the hunt for yield can be unrelenting. Dividend stocks are highly sought after because they offer a consistent revenue stream of cash that is generally higher than both bonds and term deposits.
Compounding this desire is the availability of franking credits, whereby investors will receive a refund of the tax that has already been paid on the earnings related to the dividend. This is a unique tax law found only in Australia and a few other nations, but it increases the attractiveness of dividends as this tax refund effectively increases the yield of the dividend.
Management can often be reluctant to pay out big dividends as they might prefer to keep the cash to reinvest in growth initiatives, whilst shareholders, as they owners prefer the regular payout. Peter Lynch in his famous book One Up on Wall Street likens the conflict between management wanting to retain profits and shareholders wanting it paid out to parents and their trust fund. The “parents” want control of the money and think (often rightly so) that they can invest it better, but the “children” just want a payout sooner rather than later.
Not all dividend payers are created equal, and the ultimate dividend payer might actually be rarer than you think.
When should a company pay a dividend?
A company should pay a dividend when they believe that shareholders can receive a better return on these earnings themselves, rather than it being reinvested back into the business.
If the company thinks they can make more than $1 of earnings for every dollar they reinvest back in the business (via retained profits) then they should not pay a dividend. Instead, they should return funds to shareholders through capital appreciation and earnings growth. This applies to companies who are in the start-up or growth phase of the business.
However, if the company is very mature and there are few prospects for significant growth in their market, then retaining the earnings may be a wasted investment. In this case it would therefore be more prudent to pay out the earnings as a dividend so that the shareholders can reinvest it elsewhere.
What else could management do with the earnings?
If management believes that the shares are currently undervalued, they could return capital to investors through a share buyback. This is beneficial to shareholders because it reduces the number of shares available, giving all shareholders a higher percentage of future earnings, i.e. increasing earnings per share (EPS). This is assuming that the business does not need these funds to continuing growing and increasing EPS.
So when should you invest in a dividend stock?
The most important factor when considering a stock for the dividend is whether the dividend is continually increasing or not. For example, if a company pays a $0.50 dividend in 2007, 10,000 shares will entitle you to a $5,000 dividend. If in 2017 the company still pays a $0.50 dividend, you will still receive $5,000, but in 2017, $5,000 can buy a lot less than in 2007 due to the eroding impact inflation has on buying power.
As well as the dividend, it is important that earnings also continually increase at a rate higher than inflation. In the same vein, if the company is able to increase their earnings, they will have a better capacity to pay out increasing dividends from these earnings.
If over 10 years the earnings and dividends are both flat, then the real rate of return (after the impact of inflation) on your investment will be negative.
Further, if EPS doesn’t grow and the dividend per share (DPS) doesn’t grow, what basis is there for share price appreciation? The market increases the value of a company based on current and expectations of future earnings, so if earnings aren’t growing, the share price won’t either.
The share price chart might look something like this:
This is a snapshot of Telstra’s share price chart (ASX: TLS). Telstra is one of Australia’s “blue chip” stocks, a quasi-bond that pays out a regular dividend each year without fail. It is a good company that has been market leader in the telecommunications industry for decades.
Telstra’s dividend in 2006 was $0.34 per share and in 2016 was $0.31. So if you owned 10,000 shares, your $3,400 dividend in 2006 has become a $3,100 dividend in 2016.
In 2006, the EPS was $0.26 and in 2016 it has actually grown to $0.35; growth, but not stellar growth. This has been reflected in the share price, moving largely sideways with a slight increase over the last 10 years.
Let’s look another famous dividend payer, BHP Billiton (ASX: BHP). For a time BHP actually had in place a progressive dividend policy, meaning they pledged the dividend would increase every 6 months regardless of earnings. They were able to maintain this for about 4 years, taking the payout from $0.94 in 2011 to $1.62 in 2015. Meanwhile, earnings per share (after abnormals) in the same 4 years went from $3.645 to $1.807. See a problem?
Eventually, in 2016 when the company posted a net loss after abnormals of $1.62 EPS, the dividend was cut to $0.40. For shareholders relying on this dividend as income, this would have been a big blow.
In comparison, let’s look at Real Estate Australia (ASX: REA), a market darling of the ASX. REA paid its first dividend in 2009 at $0.10 per share. In 2016, the dividend was $0.815 per share; a 7 fold increase in 7 years!
EPS was $0.07 in 2006 and $1.92 in 2016 and the share price followed suit, increasing from the $5 mark in 2007 to now comfortably over $50.
Granted, the dividend yield is lower for REA Group, but the payout ratio is also much lower than TLS and BHP, meaning they left much more in the tank to help the company grow. This is a key point that Jeeva Ramaswamy points out in Creating a Portfolio Like Warren Buffett a lower payout ratio creates an earnings buffer in the event of a market downturn.
To help me summarise, I’ll go back to a point that Lynch makes in One Up On Wall Street again.
Dividend stocks can be great if they have a history of increasing this dividend year after year and it is paid from a strong balance sheet with low or manageable debt. Further, ensuring that the payout ratio is sustainable and the dividend was maintained through the last recession will help you decide if the stock is worth purchasing.
The dividend yield is just one of many factors we look for in a value stock.
This document has been prepared by Farnam Investment Management Pty Ltd (Farnam) ABN 15 149 971 808 AFS Licence 430574. Australian Unity Funds Management Limited ABN 60 071 497 115 AFS Licence 234454 is the responsible entity of Farnam Managed Accounts. While every care has been taken in the preparation of this document it does not contain any recommendations to buy or sell any particular stock(s) noted. Farnam makes no representation or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. The information in this document is general information only and is not based on the objectives, financial situation and needs of any particular investor. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek their own professional advice. Past performance is not a reliable indicator of future performance. The information provided in the document is current as the time of publication.