A hawkish RBA is a gift for dividend investors

In my last wire, I wrote about how the ‘magazine cover indicator’ pointed to now being a good time to buy stocks for dividends.

My Dad confirmed that view the other day. I manage his super and have had a good chunk of it in cash. It allows me to buy selectively in a market that is trending down. As you probably know, cash in a platform doesn’t earn a yield. This makes Dad uneasy. My talk of the ‘option value of cash’ falls on deaf ears (literally and figuratively).

So I relented and put some (but not too much!) in a six-month term deposit. At just under 5%, the return isn’t bad. But it’s still a lot less than what you should be able to earn from select Aussie equities over the next few years.

Which is the dilemma many investors have right now. Cash in the bank with a decent risk-free yield, or stock market risk where in many cases yields aren’t that much higher.

And with the RBA ignoring the fact that monetary policy acts with ‘long and variable lags’ (as per Milton Freidman) and forecast to raise rates more, it makes sense to seek the safety of cash.

But investing is rarely about what makes sense. In fact, the best investment outcomes result from doing things that actually don’t make sense at the time (at least to the majority). The RBA’s hawkishness is actually a gift for dividend investors.

That might not be apparent for another six months or so. But if you’re a long term investor, six months is nothing.

Which is why now is the time to look at yield-based opportunities. I explained why in my previous wire. In this wire, I want to provide a few basics about dividend investing. Because it’s not as easy as just buying traditional ‘dividend stocks’. Especially as the economy is slowing sharply.

Let me explain…

Dividends – the basics

Put simply, a dividend ‘yield’ is a function of price. If a company pays a 10-cent annual dividend and its share price is $2, its ‘yield’ is 5%. If the share price falls to $1 and the dividend remains at 10 cents, the yield increases to 10%.

Dividends are paid out of a company’s profits. Management must decide what it wants to do with these profits. Does it keep them and reinvest them back into the business for growth, or does it pay the profits out as a dividend?

Usually, for large cap stocks it is a combination of the two. That is, companies will reinvest a portion of their profits and pay the rest as a dividend. The proportion it pays as a dividend is called the ‘dividend payout ratio’.

This is how I think of it…

A company with a 50% payout ratio or less (meaning it reinvests at least half of its profits back into the business) is a growth company and will usually have a low dividend yield.

Growth companies also come with a higher P/E (price-to-earnings) multiple. That’s because they are compounding shareholder returns via the reinvestment process. Sometimes the market puts a high price on this compounding potential — sometimes it doesn’t.

The problem here is that you are at the whim of the market as to whether your portfolio gets rewarded for holding growth stocks. In a rising and high-interest rate environment, this part of the market can struggle.

A company with a dividend payout ratio between 50–70% is a combination of income and growth. This is where you can find some really attractive dividend yields PLUS the prospect of capital growth, especially where the stock price is potentially undervalued.

A dividend payout ratio of 80% or above is more of an income play. That is, it’s a mature business paying most of its profits out as a dividend. Think Telstra or property trusts.

Yields can be particularly attractive here, especially where stocks are undervalued. However, bear in mind that there is not a lot of genuine capital growth available from these stocks. Rather, any potential growth would come from it moving from undervalued to fair value, or from a fall in interest rates.

Regardless, it’s crucial to do valuation analysis before investing. Just rolling the dice on high yields — without considering the price you’re paying — is asking for trouble.

Another thing to consider when investing in dividends is to check the cash flow statement. Dividends come out of cash flow. You want to be sure that a business generates enough cashflows to cover the dividend as well as any capital expenditure required.

What yield are you looking at?

Finally – and this is really important – you need to know exactly what you’re looking at when considering yield stocks. By that I mean, is the yield you see in the financial pages accurate?

The answer is, probably not. Most dividend yield information is backward looking. When you look in the financial tables of a newspaper — or search online — a yield will most likely be based on the past two dividends paid (making up the annual dividend).

As a result, it’s backward-looking, and you shouldn’t rely on it. Instead, you need to look forward. That’s not easy for the individual investor. It involves finding consensus earnings forecasts for the next few years.

While only an estimate, it’s a better guide than looking at past dividends, which may reflect a cyclical earnings peak, or trough.

Companies that trade on very high forward dividend yields are both an opportunity and a risk. It’s usually a sign that the market doesn’t believe the forecasts. So if earnings and dividends do get cut in the future, you’ll be looking at capital losses as well as lower than expected dividends.

On the other hand, if the market turns out to be overly pessimistic, you’re looking at a juicy yield plus the prospect of healthy capital gains.

This is basically what I’m trying to achieve in my hunt for dividends. I’m looking for the income/growth sweet spot. Specifically, a juicy dividend yield with the potential for decent capital growth thrown in.

With many ASX200 stocks down significantly from their peaks (there’s a stealth bear market going on) there are plenty of opportunities right now. But with the RBA on a war path and potentially putting the economy into recession, you have to be selective and patient.

Banks – deposits or dividends?

What about the banks though, probably the most common sector to think of when it comes to dividends.

Are you better off lending to them (in the form of a term deposit) or being a shareholder?

Long term, the question is a no brainer.

But short term, there are a number of considerations. Bank earnings are cyclical. The yield curve in Australia just inverted for the first time since 2006, suggesting the economy is in trouble. That means bank earnings will be under pressure.

The charts confirm the weak fundamental outlook…they look horrible for all the banks.

I plan on doing a deep dive into the banks later today in our What’s not priced in weekly podcast. A slowdown is definitely NOT priced in to Australia’s biggest bank.

So feel free to head on over later this afternoon when the episode will be ready to watch. Or just search for it where you normally listen to your podcasts.

And don’t forget, as a valued Livewire reader, we're offering you an opportunity to gain immediate access to my Fat Tail Investment Advisory with an incredible discount of up to 70% when you join today.