Delusionary yields? Will you be amongst the disappointed?

Chris Hall

Ellerston Capital

Projected dividend growth for the ASX 200 is negative for the first time since the GFC and equity income investors need to change their focus from yield to income. Many equity income dividend strategies place a high emphasis for stock inclusion on the absolute dividend yield level. I strongly believe that dividend yield for income strategies needs to be an output, not an input. The focus then shifts towards lower volatility superior income growth and its sustainability. Stocks that can deliver this outcome should receive stronger multiple valuation support by the market and deliver a superior total return offering.

Over the last 10 years, dividend cover from the traditional equity income providers has fallen from 1.8x to 1.3x, yet payout ratios have steadily risen from around 70% to around 90%.

I believe we are reaching an inflection point where continued earnings downgrades are resulting in dividend cuts from companies long viewed as high yielding dividend providers. The buffer between earnings and dividend payout has been effectively eroded away. A recent example of this is National Australia Bank (NAB). The company reported its 2019 interim result in May, accompanied by a 16% cut in their dividend as the weight of earnings decline and NAB’s capital requirements could no longer support holding the dividend. In effect, they have structurally rebased the income generation provided to shareholders (in the form of dividends) due to mounting structural pressure on their business model.

A critical consideration for equity income investors is the effect of income compounding. Again, a great case in point is looking at the banking sector. Let us consider the four major retail banks compared to Macquarie Group. As at December 2018, the 5 year dividend per share growth rate per annum for Macquarie Group has been in excess of 20% versus the major retail bank average of less than 1%. Yet 5 years ago, the dividend yield of the four major banks looked optically attractive at around 6.3% versus Macquarie Group at 4.2%. If you purchased Macquarie Group as at 30 June 2013, the running dividend yield on that investment is in excess of 12% per annum compared with the major bank average of still 6.3% p.a. A consequence of this is the share price of Macquarie Group has risen by 300% vs a broadly flat capital growth profile for the major banks. Going forward, the risk of further dividend cuts by the major banks is a real possibility whilst Macquarie Group should continue to deliver a very positive earnings and dividend trajectory.

This is the direct effect of dividend compounding and demonstrates the risk of solely focusing on optically high dividend yields as a key input in stock selection.

Running sustainable equity income strategies

Sustainable equity income strategies require a highly disciplined approach to identifying the right stock opportunities. I believe sustainability also means flexibility to invest across different income strategies to ensure continued outperformance throughout the economic cycle.

The three dividend strategies identified and utilised for our low volatility income fund are

  1. Dividend Champions
  2. Defensive Income
  3. Cyclical Income

Dividend Champion income stocks suit a steady bond yield / stable growth environment with consistent historical dividend growth of greater than 5% p.a. A good example is Aristocrat Leisure.

Defensive Income suits falling a bond yield / economic slowdown market, like the environment we are in today. Typically shareholdings are those with bond proxy characteristics who have dividend yields greater than 4% p.a. however lower earnings growth rates. Consumer staples, REITS and Utilities are good sector examples focused on with this strategy.

Cyclical Income stocks suit a rising bond yield / economic recovery market with a dividend yield greater than 3% but with an accelerating earnings profile. Typical sectors suiting this strategy are materials, consumer discretionary and financials.

Besides the right stock picking, the portfolio manager’s skill is to construct the right portfolio by getting the dividend strategy (outlined above) blends right that best suits the economic environment we are facing.

Low earnings and dividend volatility coupled with income growth greater than the benchmark is the key stock selection focus. This stock selection process also takes into account several earnings and balance sheet quality filters to weed out any undesirable stocks in the investment universe. Earnings quality warning signs include those companies showing capex indiscipline, rising working capital, rising intangibles and poor cash conversion. Balance sheet quality warnings signs include those companies with excessive leverage, frequent capital raisings, liquidity concerns and operational stress.

Coupled with an ESG overlay, this consistent criteria aims to identify the right stock opportunities whilst minimising risk.


When looking at FY20 and FY21 dividend growth for the ASX 200, it is negative for the first time since the GFC. Many stocks which look supposedly attractive on an optically high dividend yield basis are set to disappoint and be subject to potential dividend cuts based on their ever increasing payout ratio. By focusing on the low volatility income generator stocks, or dividend compounders, investors should expect a far more favourable total return experience as opposed to one of disappointing income outcomes based on delusionary yields.

Don't get caught in a trap

The Ellerston Low Vol Income Strategy (ELVIS) is made up of a portfolio of between 30 – 40 Australian mid-to large-cap stocks with a clear focus on delivering low volatility, sustainable income for investors through actively blending multiple, distinct dividend yield strategies throughout the market cycle. For further information use the contact button below, or visit our website

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Chris Hall
Chris Hall
Chief Investment Officer
Ellerston Capital

Chris is an industry veteran with over 28 years' experience including roles at Blackrock, Argo Investments and JB Were. He is passionate about providing investors with a strategy focused on sustainable and growing income generation.

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