Just as different countries around the globe exude different fashions, cuisines and languages, investors too seem to portray different traits and preferences depending on nationality. Compared with similar OECD nations the likes of the USA, UK, Japan, Germany and Canada, here in Australia investors appear to have a fixation with income and dividend yields.

Admittedly there are the frequently cited benefits for preferring dividend-yielding companies, such as periodic income generation and the tax benefits stemming from franking credits and imputation credits. 

Investors Confronted with a COVID-19 induced conundrum

Let us not forget that at present these retirees are essentially earning nothing in real terms on term deposits and struggling to fund their retirements in an era of unendingly low rates which brings us to a COVID-19 induced conundrum.

Australia’s largest companies are expected to slash dividend payouts at the upcoming August reporting season by the most since the global financial crisis as the coronavirus pandemic ravages the balance sheets of some of the countries most established and relied upon names. Large hits to corporate earnings and cash flows together with cautious management teams have seen an enormous chunk of the market’s dividends evaporate almost overnight.

Australia’s largest companies are expected to slash dividend

It is somewhat a moving feast at the moment but according to Bloomberg dividend payments from firms on the S&P/ASX 200 index may plunge by as much as 40% in 2020, before declining another 11% in 2021. As such forward dividend yields are expected to decline from approximately 4.6% as of May 2019 to 3.5% for the year ahead as of May 2020. To give it some perspective the 20-year average sits at 4.5%.

A third of S&P/ASX 100 stocks have reduced, deferred, suspended, or cancelled dividends since the February reporting season with the worst affected sector being the Banks where dividend expectations have fallen approx. 60%. The Consumer Discretionary has also been heavily impacted (down 45% compared to a year ago) given the many of the constitutes exposure to a devastated retail, tourism, and hospitality sectors.

The most robust dividend segment at this stage appears to have been the healthcare, where dividend estimates have only declined by approximately 4%.

Bank Dividends Disappear Almost Overnight

Confronted with wide-ranging shutdowns and joblessness, the banks, who in 2019 contributed approximately 30% of the overall dividends paid out on the ASX 200, have been forced to offer borrowers deferrals on mortgage repayments. In response, the NAB in April sliced its shareholder payment by two-thirds to 30 cents, its lowest since 1993. Following that decision, ANZ and Westpac both deferred its interim payout causing a real conundrum for countless retirees reliant, perhaps over-reliant, on bank dividends to support themselves through retirement.

Many of these retirees will be praying the cyclical Iron ore producers Fortescue Metals, BHP Group and Rio Tinto can come to the rescue and surprise on the upside with their dividend distributions to help at least partially offset the income cliff created by the market-wide cuts to dividends.

Recent events do beg the question, is the Australian investor’s adoration for dividend yield justified? Should we be chasing dividend yields, or high-quality businesses that reinvest in future growth?

Many investors and financial advisers believe the best way to approach investing in the stock market is to identify the ever-ambiguous ‘blue-chip’ company that pays out a large portion of its earnings to shareholders as a dividend yield.

A Focus on Dividend Yields can be Counterproductive to long term Investment Performance

This tendency in our view often causes the investor to neglect or miss out entirely on high-quality prospects, to instead favour companies for little real reason other than they being large organisations that pay high dividends. Such a habitual preference for dividends although simplistic and marketable, can be superfluous and counterproductive to long term investment performance.

As a general rule, the most benefit to shareholder equity is achieved when management chose to reinvest the company earnings back into the business. Earnings that then go onto earn the high return on equity rate, effectively compounding growth year after year. Investors need to remain conscious of the fact that dividend payments are in essence sacrificing future company growth for immediate gains in the form of income.

After all, Investors always have the option to raise cash by selling down their holdings or locking in a portion of profits, in effect creating a dividend, leaving the company free to reinvest profits into new ventures that will increase the value of the business into the future.

Looking at 3 Real-World Examples

Moving forward let us take a look at a real-world example to determine whether a pure dividend focus is justified when compared with a focus on top-quality businesses that are reinvesting in growth.

In the tables below we have a dividend snapshot of three ASX 200 constituents, Telstra Corporation (ASX: TLS), National Australia Bank (ASX: NAB) and Fisher & Paykel Healthcare (ASX: FPH) looking at the last 20 dividend periods back to 2010. I acknowledge that this is an extreme example comparing different businesses from different sectors, however, I think the explanatory power is of value.

Assuming an initial hypothetical investment of $10,000 the table compares the following over a 10-year period excluding franking credits and Foreign Tax offset which can differ considerably depending on the investor type: