On average, companies in the top 10 per cent of expected dividend yield deliver negative earnings growth, negative dividend growth and underperform the market over time, our analysis suggests. To find the companies with genuinely sustainable dividends, you need to dig much deeper than these simple historical measures.
Low returns, volatile earnings, poor momentum, high payout ratios and the use of borrowing to finance dividends – these are all tell-tail signs a company’s dividends are unsustainable, but some of these factors aren’t immediately apparent until you scratch the surface.
See, listed company executives know there’s high demand for income, given the number of retirees investing in the share market at the moment looking to generate income. Historically low interest rates mean returns from cash holdings aren’t enough to ensure savers are keeping ahead of inflation. Some companies will give investors what they want because it attracts investors, stimulating demand for their shares. But without sufficient earnings to support high dividend payments this approach looks more like a short-term ploy as opposed to a long-term strategy.
Stretching the yield
A high pay-out ratio is often an early sign a company is stretching itself to deliver regular income to investors – this is a measure of the proportion of earnings that gets paid out.
Borrowing to finance dividends is another sign management is trying to make its shares more attractive to income hungry investors in a way that may not ultimately be sustainable.
Tracking companies closely and understanding their respective stories relating to the way they allocate capital to grow versus returning capital to shareholders is an important part of determining whether they have a narrative that supports a sustainable dividend.
Now, in the middle of the first earnings season for 2018, is a good time to separate companies with sustainable dividends from those we believe might struggle to maintain their dividends going forward.
One area we are seeing dividend pressure at the moment is in the media sector, in particular amongst broadcasters. This is a sector where there continues to be pressure on the business models – content delivery is changing, broadcasting is different than in the old days because they’ve lost their oligopoly on eyeballs with people turning to social media for their entertainment and they’re avoiding advertisers.
As a result, many of these companies have dropping earnings with legacy cost structures and high payout ratios. Investors in these types of companies should be careful not to fall into what we call a ‘yield trap’.
Beyond sustainable dividends
Finding companies with sustainable dividends is one thing, but it’s also important to avoid concentration risks and other risks that might come with thinking solely about dividends at the expense of thinking about anything else.
For one thing, high demand for income in the share market has led multiple expansion where a company share prices stretch well beyond where earnings might justify, making these companies risky and potentially more volatile for investors.
Beyond considering valuations, franking credits are extremely valuable, so we are always on the lookout for companies with the potential to conduct off-market buy-backs in the near future.
We are currently seeing some of the bulk miners in a position where they have strong earnings again and, because they’ve cut costs in the past couple of years, they’re now able to shift to profitable value. Add to this the fact they have been paying tax locally and banking franking credits along the way.
Investing for income alone can often lead to poorly diversified portfolios and sometimes investing with this lens on can lead to a concentration in certain traditional sectors such as financial services. Indeed, banks have been consistent dividend payers over the years, the question is whether they can continue to sustain their dividends in the face of regulatory pressures and a slowing domestic property market.
When it comes to diversifying an income portfolio, one thing I’d say is not to rule out areas of the share markets where dividends might be low but where free cash flow and earnings are generated and business conditions are picking up. Currently we’re looking closely at energy companies where dividends have been cut in the past but where fortunes are looking like they’re starting to turn around.
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Dermot is an Australian Equities portfolio manager for AMP Capital. He is responsible for stock coverage across the domestic resources industries and is particularly interested in delivering high post-tax returns for domestic Australian investors.