Australia: Ten best investment ideas 2014 - Yield does not equal income

Last Updated: 14 March 2014

For those living from their personal investment wealth, record low interest rates are forcing investors to make decisions impacting lifestyles by taking risks they otherwise wouldn't, facing returns which are being eroded by higher prices of goods (inflation) or leading a lower standard of living. This is a global phenomenon.

At the time of preparing this report, the Reserve Bank of Australia set the official cash rate at 2.5% while 6-12 month term deposits are paying approximately 3.6%. These rates are less than compelling and put pressure on investors to seek other avenues of return.

Taking this into consideration, the chase for income has only intensified in the last couple of years, with highdividend stocks having emerged as the chief focus for many investors.

Australian companies are generally reporting modest results amid difficult operating conditions. Many are focused on driving out costs as sales growth remains weak. In the post GFC world, most sectors in the Australian stock market that have outperformed have been those which have larger dividend payments. In particular, banks and telecommunication companies have been major beneficiaries of the demand for higher-yielding stocks.

This is highlighted by the performance of the All Ordinaries Index which summarises the movement in share values of Australia's largest companies and the All Ordinaries Accumulation Index, which also incorporates dividends paid by the companies. As illustrated in the following chart, the All Ordinaries Accumulation Index (including dividends) has recovered to pre GFC levels whereas the All Ordinaries (prices only) has not.

Receiving a portion of your total return in the form of a dividend presents investors with two choices:

  1. It can be taken as cash and spent; or
  2. It can be reinvested for potential growth and further return generation.

It is important to recognise that yield is not a measure of income receipt. Yield merely compares the income generated from an asset through time. The dividend yield is a function of an investment's price. A high dividend yield could just indicate that the stock is cheap, and in some cases cheap for a reason.

A "yield trap" refers to companies that promise high dividends without the cash flow to support the payments over time. Sometimes the dividend yield gets so high it is the market's way of saying it does not believe the prospects for the company are sustainable. Using historic dividends can also distort yields; if a company is reducing rather than increasing dividends, yields can appear higher than what should be expected in future.

As an example, Telstra Corporation Limited (TLS) is referenced as a high yielding stock. The company has seen flat earnings per share growth, leading to a stagnant dividend payment since 2005. This is illustrated in Figure 11 (over page).

Strong cash profits to support dividend payments are what matters over the long-term. Dividends are proof that companies are making profits, with growth in profits protecting the sustainability of the dividend which should ideally grow over time too.

Companies that exhibit growing profits over time, generally exhibit increased in share price and are sometimes less volatile. Recurring earnings also allows a company to forward plan two or three years with reasonable transparency. The broad industrial sector has provided more favourable earnings per share certainty versus resources especially from businesses that operate staples franchises (supermarkets), healthcare and the large banks.

As a result of consistent earnings per share growth, Sonic Healthcare Limited (SHL) has been able to increase its dividend by 210% from 20 cents per share in 2002, to 62 cents per share current day. This is illustrated in Figure 9 (over page) – for those simply focusing on yield, these opportunities may be missed.

Sonic is an example of a good dividend growth company yielding in the order of 3.5% which might be low right now because the company's earnings are expected to grow in future.

Given dividends represent a reasonable portion of total returns and wealth creation, it is important to identify quality companies where there is a strong correlation between earnings per share growth and dividend growth.

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The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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