Sweat the small stuff to safeguard returns
Australian shares hit a sweet spot last year, whipped up by investors with a taste for dividends.
Total returns from share-price rises and dividends was 20.7 per cent in the year to June 30, leading some observers to ask if the yield cookie is about to crumble.
"We think dividends will continue to be a theme this year because you can't get the returns and yields elsewhere," Elio D'Amato, chief executive Lincoln Indicators, says.
"The market has recently let the air out of the tyres a little bit, which provided the opportunity to pick up a substantial yield in good businesses."
In a low interest-rate environment, with yields on term deposits and Australian government bonds below 4 per cent, shares still offer attractive yields for investors seeking income.
The forecast dividend yield (for the 2014 financial year) for the overall market is currently 4 per cent, or 5.5 per cent grossed-up to include franking credits. And you can still find quality stocks paying more.
The grossed-up (after tax) dividend yields for the big banks range from 7.5 per cent for the Commonwealth and 7.9 per cent for ANZ to 9.1 per cent for Westpac and NAB.
The dividend yield on a share is the value of annual dividend payments divided by the current share price. This means rising share prices reduce the value of your dividend payments. But there are still attractive dividend yields on offer with one caveat. Focusing on price or high yields in isolation alone can be misleading.
Morningstar's head of equity research, Andrew Doherty, says it is important to buy quality stocks at a decent price so you don't expose yourself to the risk of capital loss. Take the example of mining-services companies Ausdrill and NRW Holdings. In the year to June 30 their share prices fell 75 per cent and 70 per cent respectively as the mining boom lost steam. Yet both recently had forecast dividend yields of more than 15 per cent.
On the surface these yields look tempting, but share prices often fall for a reason. As dividends are paid from after-tax income, investors need to be confident that a company's earnings are sustainable. If profits dry up, so may your dividends.
"A huge number of companies have had to cut their dividends because of the high cyclicality of their earnings or they were highly geared," David Buckland, chief executive Montgomery Investment Management, says.
Buckland says income investors should avoid companies in cyclical industries, such as mining with highly variable revenue streams. "If earnings are sustainable, predictable and recurring then dividends will be too," he says.
Buckland also filters out businesses with a high level of debt to equity. "If a business has low gearing and a high return on equity, that generally means it has got a good niche or moat," he says.
Return on equity (ROE) is a measure of profitability. Put simply, a high ROE means that for every dollar shareholders invest in a company, it tends to earn more than the market average. ROE above 15 per cent is considered desirable.
Buckland says a portfolio of Amcom, ANZ, CarSales.com, Credit Corp and Woolworths, bought in equal amounts, would deliver a prospective dividend yield of 4.25 per cent, a grossed-up yield of 6 per cent and average ROE of 28 per cent.
Doherty describes an economic moat as a sustainable advantage a company has over its competitors. For example, Woolworths and Coles (owned by Wesfarmers) enjoy a supermarket duopoly in Australia with cost advantages that come from their vast scale.
Even though their dividend yields are average, the strength of their moat and the highly repetitive nature of their earnings put them in his top five income stocks (see box).
D'Amato says Lincoln's preferred income stocks must have sustainable earnings and an ability to grow earnings in future. He also looks for dividend cover (the ratio of after-tax earnings to dividends) of more than one to ensure that a company can afford the dividends it is paying, and a grossed-up dividend yield that is better than the market average.
While Westpac is his pick of the banks, he also mentions Premier Investments, with a grossed up yield of 8.2 per cent, Woodside Petroleum (10.8 per cent), Spark Infrastructure (6.3 per cent) and Cromwell Property Group (7.6 per cent).
It is possible to have too much of a good thing, though. Paul Chin, senior research analyst, Vanguard Investments, says too many investors have a portfolio full of banks, leaving them exposed to too much volatility - especially if they are in or nearing retirement. Chin recommends diversifying sources of income not only across market sectors but also asset classes such as bonds and property.
Five stocks for income
David Buckland, Montgomery
Elio D'Amato, Lincoln
Cromwell Property Group
Andrew Doherty, Morningstar
Five stocks for income