Good news: Signs of stronger dividend payouts on the horizon

As we approach reporting season, our income hunters are seeing signs of stronger payouts looming. It's good news for those who were wondering whether the February reporting season was a hopeful blip on the recovery trajectory or something more sustainable. 

I recently spoke with Michael Maughan, who co-manages the Nikko AM Australian Share Income Fund and an Institutional Share Income mandate to see what the upcoming reporting season is expected to bring and whether or not income investors are in for some headwinds. He also gave us his top three tips behind the fund's diversification strategy, which is critical for capital protection. 

"Income investing is a constant battle balance between generating the income loss protecting and growing the capital base. In reality, anyone can manufacture a yield. In the short term, you just have to steal it from the capital, said Maughan, suggesting you'd be mad to steal from yourself. 

Of course, no one wants to be eroding their capital away for the sake of yield. So, Maughan has given us some food for thought ahead of reporting season. 

Where we were: Dividend decline and recovery

Last year was one of the worst years for dividend payouts. Last year, dividend payout ratios fell from pre-COVID levels by about 30%. Some sectors have managed to recover better than others, but we're still not quite on a level playing field with pre-COVID payouts. 

"All we knew is that boards would be conservative in the short term, and that's how it played out," said Maughan. 

The February reporting season saw dividend recovery in some sectors, while others were left behind. Source: Rethinking Income, Tyndall AM. Source: Supplied.

"We're back now to kind of pre-COVID expectations on dividends. But underlying that it's made up of resources dividends that are nearly 40% higher than they were pre-COVID, and Bellwether sectors, like banks, still being 10% below expectations," said Maughan.

But Maughan thinks that it will be a fairly quick recovery for the banks, which were dealing with COVID-19 impacts compounded by APRA restrictions on its capital requirements. 

"We expect that bank payout ratios will return to kind of 70 to 80% payout ratios (just below their pre-COVID levels). But also banks are going to be returning capital to shareholders here because they are over-provisioned and over-capitalised. CBA and ANZ are the most flush with cash, and they could announce buybacks any day now," said Maughan. 

Maughan is cautious that recent lockdowns could dim the reporting season ahead and throw out a few "surprises" to the outlook for FY22. 

Who will be the big dividend players this reporting season? 

So if the banks aren't quite ready to deliver, who will? 

There are a few sectors that Maughan is keeping an eye on, such as insurance, which he said has a strong environment for premiums ahead and upcoming M&A activity, such as IOOF. 

"We'd be looking for news from companies like IOOF, where they can show progress on their acquisitions of ANZ and MLC, to give the market confidence that that's all on track," he said. 

Maughan also believes a number of the Aussie dividend kings will announce buybacks or special dividends with their results, including CBA, BHP, Rio Tinto, Woolworths and Telstra. 

Telstra is in fact Maughan's #1 pick for a reliable, defensive dividend stock. 

"I think one traditional yield stock that's been out of favour has been Telstra, and we see its fortunes turning," said Maughan.  

"The key here is the mobile business which has returned to growth as they launch their 5G services ... And that should drive earnings growth at the group level for the next couple of years," he said. 

"Helped by the fact that we're past the drag of the NBN rollout," he added. 

What to watch out for: inflation

Inflation is still the word on everyone's lips (read: Twitter) and it is a beast that will hit income stocks once interest rates go up. But Maughan said, don't fire until you see the whites in the eyes of inflation. We're not quite there yet.  

"I think the first issue is that right now bond yields are 1 to 2%, making dividends a very attractive source of income. The ASX 200 is forecast to generate a grossed-up dividend yield of about 5%. In FY22 we plan to continue to create a 12-year track record of delivering 2% higher than that," he said. 

The other issue Maughan is watching out for is yield-curve steepening, but he can't see the gap between bonds and equities closing enough to be a problem. 

"Equities still look like a great place and a great source of income for investors, he said. 

"Where rates might be more relevant I think in sector exposures in asset allocation ... if I had all of my dividend exposure in bond proxy type companies and rates and infrastructure stocks. We're big believers in having diversified portfolios for generating this income," said Maughan. 

Diversification: the name of the game 

Maughan insists on the importance of diversification in an income portfolio. He said the dual objectives of an income fund must be yield and capital protection. 

Source: Rethinking Income, Tyndall AM. Source: Supplied. 

Here's how they do it: 

#1 Have a specific yield objective

The fund Maughan operates has a yield target of 2% higher than that of the ASX200. This means not just owning income stocks, but making a commitment to a high yield outcome. 

#2 Have stock and sector limits  

Maughan uses stock and sector limits to ensure the fund isn't overweight or overexposed to any one sector, particularly those exposed to cyclical or structural factors. 

For this particular fund, this means not holding more than 8% in any one stock within the market. And, with the exception of financials, not holding more than 20% in any one sector.

#3 Have an intrinsic value assessment

Maughan said he and his team are focused on "picking the eyes out of the market and making sure that we're not falling into traps that the market sets for us". 

One of the categories of stocks Maughan looks at is "uncorrelated businesses", which as you can see above includes Tassel, which he said works to its own supply and demand cycle. 

"We're obviously balancing out the income and value opportunities there as well. But then we're also looking at the overall risk of the portfolio so when we're making that change, we're going to make sure that we've got the best risk reward in the portfolio that we can get.

"The reality is that portfolios are living things. We're always balancing," he said. 

A front-row seat to income and growth

Michael invests in 40-70 stocks, designed to provide tax-effective income and also the potential for capital growth. To learn more, click here.