Float on a decent return

Getting a 23 per cent return from a stock in a market like this is something to write home about. Especially when it has nothing to do with mining and, more amazing, comes entirely from dividends.

Seven West Media is one of many high-yielding stocks that are going begging. But surely there's a catch? Too right.

The dividend yield, which includes the 30 per cent tax credit for being fully franked, has been wiped out and then some by a slump in the share price. What you gained on the swing you would have lost on the, er, big dipper.

As with most of the top-dividend-paying stocks in the table based on the two most recent payouts, Seven West Media isn't all that generous to begin with. No, the high yield mostly comes from a very low price.

Getting 50? when you paid $3 for a share yields 17 per cent. Pay only $1, though, and the yield becomes 50 per cent without the payout rising a single cent. Not much help, of course, if you'd already paid the $3.

In Seven West Media's case it can only mean the dividend is going to be slashed, or the market has completely misread it and marked down the share price way too far. The prices of the best-yielding stocks have collapsed in the past year. They might only be paper losses until you sell, which wouldn't matter to longer-term investors, but don't imagine their shareholders are too thrilled.

Yet relying more on dividends is something all shareholders are going to have to get used to.

Luckily, most of the top-200 stocks have been increasing their dividends during the past three years, most spectacularly, the banks. In this market you need all the help you can get the days of easy capital gains are over. For now the only reliable source of an income from the market is from dividends. "A share portfolio now needs a high degree of yield," the portfolio manager at Platypus Asset Management, Simon Bonouvrie, says. "Capital growth will be tough to come by."

Although "on valuations, the market is extremely attractive", he says this is a bear market that started in 2008 and which is far from over. "[The sharemarket] may re-test the lows of the GFC - that is, the mid-3000s."

It closed at 3928 on Friday.

Income rules

The market gyrated 700 points in August alone, finally settling down by 232 points.

At least a dividend is some protection against all that volatility. The market can do what it likes but business goes on. Besides, dividends have always been more important than price gains over time.

Going back to 1900, they've accounted for just over half the return from the sharemarket, fund manager Perpetual says.

That's been even more pronounced during the past 10 years. Of the 8.2 per cent a year the market returned, only 2.7 per cent came from rising share prices, according to Russell Investment Group, which sells an exchange-traded fund of 50 high-franked dividend-paying stocks.

Even so, there's a chicken-and-egg argument among the experts about whether you should pick a stock just because it pays a high dividend.

Notice the list of the 25 top payers is dominated by media companies, retailers and manufacturers. Analysts are wary of these businesses because they rely on household spending and a weak dollar. The same goes for the banks, which face a borrowers' strike.

As the panel top right shows, the banks are a special case. With yields on their dividends in double digits and likely to rise again this year, even with another 5 per cent price drop they'd still be better to have than most other stocks - and certainly preferable to a term deposit after tax.

"The banks are better positioned than other industrial stocks," says Leanne Pan, joint chief investment officer at top-performing fund manager Prime Value.

When good yields go bad

A problem in only going for the dividend is that some companies - including, until recently, Telstra - borrow to pay it. The worst offenders were real estate investment trusts (REITs), then known as listed property trusts. They borrowed to the hilt and, for a while, were paying more in dividends than they earned.

Although they've since got their act together - only, it must be said, after massive shareholder-value destroying rights issues and slashed distributions - they're trading for less than their properties are worth. One reason is that the best-known REITs, such as Westfield, depend on shoppers spending. Yet that's only true up to a point. Usually leases with large retailers are inflation-linked, not based on turnover. In fact, REITs offer an inflation-proof yield with the prospect of capital growth.

There are also some regarded ones outside retailing such as Commonwealth Property Office Fund and the Charter Hall Office Fund.

Their marked-down prices have pushed the yields on the distributions they pay above 6 per cent. Although they don't pay franking credits there is some deferred tax benefit. Better still, buying them at 20 per cent discounts or more to their underlying value makes for potential capital gains when the market comes to its senses.

REITs such as Dexus, GPT, Mirvac and even Stockland are also possible takeover targets.

Still, if you think interest rates are going to rise they're probably best avoided. Anyway, when a company is paying a dividend it must be confident about its future. But a lot of experts argue that paying out a big dividend proves its prospects can't be too crash hot if it's handing the money back rather than investing in the business. It's not an argument you'd want to push too far, though, because the only thing worse than a company reluctant to reinvest in itself is one that will use the spare cash to embark on a takeover just for the sake of it. But don't write off a stock because it doesn't have a high yield.

The best stock to own is one where both the price and the dividend increase over time. Take BHP Billiton. It could never be regarded as a high-yielding stock, yet if you'd bought it 10 years ago you'd have earned twice as much from dividends than from supposedly high-yielding Telstra shares. Oh, and made 600 per cent on your money.

Nothing but the dividends

There's one kind of stock where yield is everything. A converting preference share, or hybrid, is a cross between bonds and shares and the return is roughly halfway between the two. They pay dividends quarterly, unlike most ordinary shares which pay once or twice a year, and are usually franked.

Most popular are the two versions of the Commonwealth Bank's PERLS, which come with the bonus that when they eventually convert to ordinary shares you get a few extra thrown in.

Series four pays 1.05 per cent above the bank bill rate, or about 5.8 per cent after taking the franking credits into account. They're trading at a 1.5 per cent discount, so if you bought them at their last price and hung on to them until their maturity they'd yield about 7.3 per cent. The latest series is more generous, paying 3.4 per cent above the bank bill rate, but the market has seen to that.

Instead of getting a yield of 8.2 per cent, you'd get closer to 6.6 per cent over time because you have to pay another 1.6 per cent over their face value. So even though the previous series was less generous, it produces a bigger yield thanks to a quirk in the market. Remember, the interest rate is floating, not fixed.

You'll do even better if rates rise and could be hit by a double whammy if they drop because both the price and dividend could fall. Then again, if all rates drop, they may more than hold their value because the extra margin you get can't change.

If you want a fixed dividend there's always Macquarie's convertible preference securities, which pay 11.1 per cent a year. They have another 21 months to run but are trading at a 1.8 per cent premium.

Double-digit

dividend returns

Greece's long shadow

FUND managers buying bank stocks for the dividend income for the fund, that is, not them must know how their clients feel.

Forget capital gains, just a decent income will do for most pensioners and self-funded retirees. Yet the banks were the wonder stocks, leading the charge to new records right up until the GFC.

Nobody's predicting those days will return.

Sure, the banks are still profit powerhouses but they're breaking records by less than they were during the great borrowing binges of the '90s and noughties. And that's one problem. Credit is growing at only a bit more than 2 per cent a year, which is below the inflation rate.

The banks are caught up in what's happening, or rather not happening, in Europe over the Greek sovereign debt crisis.

The market expects Greece, and perhaps the other so-called periphery countries, will default and the European banks that lent to it will take a big hit. Not only will that cast a shadow on all banks wherever they are, as the GFC showed, but ours could have trouble raising offshore funds again.

The banks' low share prices mean the yield from their dividends expected to go on rising, if at a slower rate is more than 10 per cent when you take the 30 per cent tax break from franking into account.

If the Commonwealth is any guide, the other three big banks, which report in early November, will lift their dividends. Great yields but what's to stop their prices falling further?

The last thing you want is to fall into the Telstra trap of all yield and no capital.

Nobody knows what will happen although you'd think the more they drop, the less they can drop further.

After all, the banks are trading at unusually low price/earnings ratios, making them pretty cheap to begin with.

Even Telstra could fall only so far. And two things have improved greatly since the GFC, which suggests the worst of their price plunge may be over.

Their balance sheets are much stronger to the point where they'll be under pressure to return some capital to shareholders since nobody seems to want to borrow it and they rely less on offshore funds than before.

"This time the market is wrong on Australian banks. We believe bank share prices are currently significantly mis- [that is, under] priced," Morningstar says in a research report. But it points out that as the European debt woes spread, the share prices of other banks are dropping so, along with what is still a high dollar, it's profitable for speculators to switch from ours to theirs.

How long you intend holding the shares is critical. If it's only a few weeks, more falls are possible. For a few years, though, it's more likely their value will have risen.

What the banks

are worth