CPD: The Australian Dividend Landscape versus Global Dividends

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The outlook for Australian companies looks susceptible to the market turbulence created by the COVID pandemic.

This paper will discuss the outlook for the Australian equity market with regards to dividends and the subsequent impact this will have on total returns. Despite having a history of consistent dividends and high payout ratios, and the added benefit of the imputation tax system, the outlook for Australian companies looks susceptible to the market turbulence created by the COVID pandemic, with many industries facing strong headwinds. This has exposed issues in the fundamentals of the Australian market, such as a lack of diversification by industry and market cap, which may present a case for increased global diversification in your clients’ portfolios.

2020 has seen a cutting or deferring of dividends in an effort to prioritize the survival of the business over distributing cash payments to shareholders. As global GDP contracted, companies with high levels of operational gearing feared a material impact on profitability and even solvency. The ability to cancel or delay dividends is an important source of funding to preserve balance sheets. Almost a quarter of Australian companies have cut or deferred their dividends since the Coronavirus fallout. These suspensions have been widespread across industries, including the major banks, who have often been relied upon for reliable dividends.

Among the hardest hit are self-funded retirees, many of whom rely heavily on dividends and franking credits from income-paying stocks to fund their retirement. Asset managers say this reliance has become acute in the past few years amid record low interest rates, with retirees loading up on financial sector stocks with the promise of high yields.

The Australian market has a reputation for high levels of dividends so the growing list of companies suspending dividends is a blow to income investors who rely on the payouts as a tax-effective cash flow source. In fact, companies listed on the ASX have seen the largest dividend downgrades across the globe in 2020, with Australian dividends-per-share (DPS) undercutting analyst expectations by over 20%. In the calendar year to 31st October, 2020.

Australia’s concentrated risk

The Australian market is heavily weighted towards a smaller number of industries, being heavily concentrated in financials and materials (see below). In the MSCI Australia index, the Financials sector is the largest and is almost 18% larger than in the MSCI ACWI. The Materials sector also has a relatively large sector position 15% higher than it’s global counterpart. On the other side, the largest sector in the global markets, IT, is higher than in MSCI Australia by almost 20%. Communication services and Consumer Discretionary sectors both have relative over-weights for ACWI in excess of 5%.

In addition, the top 50 Australian stocks have a high concentration in a small number of large-cap stocks  and then a very long tail of mid-to-small caps. It is generally not well diversified compared to the MSCI ACWI. Of the 2000+ stocks listed on the Australian Securities Exchange, the top 200 stocks account for 82% of the country’s total market capitalization. Of these 2000+ stocks, around one third are junior metal and mining stocks by number, yet the entire listed materials sector accounts for only 15% of the index’s market cap. In contrast, financials only account for 5% of listed companies by number but 36% of the index’s market cap.

In comparison, the MSCI ACWI offers greater diversification by volume of companies, with approximately 630,000 companies traded publicly throughout the world. The US still has one of the largest exchanges in the world, but many of the fastest growing exchanges now reside in Asia.

The MSCI ACWI is designed to represent the full opportunity set of large and mid-cap stocks across 23 developed and 26 emerging markets.

The MSCI ACWI has clear diversification benefits over the MSCI Australia, with significantly less concentration in its largest holdings, as well as a more even spread across sectors.

 

How has Australia performed?

Over the medium term, the global markets (MSCI ACWI) have outperformed the Australian market by a comfortable margin (see below).

The table below shows the risk-return comparison between various markets, which also confirms that over the long-term ( 10 years), global markets provide a higher return and lower risk than the Australian market. The reasons for this are to do with structural differences, opportunity set and diversification.

Evidently, the addition of global stocks into your clients’ portfolios can bring the benefit of increased diversification, access to growth sectors not easily or readily available in Australia and offers higher returns with lower risk.

What is the future dividend outlook in Australia compared to the rest of the world?

In many ways, the FY20 reporting season was one of the most closely watched in recent memory as investors attempted to understand the true impact of the COVID-19 pandemic on company fundamentals. Going into the end of the financial year, expectations for earnings had been slashed significantly across the globe due to the level of uncertainty that remained in the outlook for the economy. This had particular implications for Australian equity investors, whose portfolios are typically overweight in high dividend-paying stocks and rely heavily on companies distributing their earnings. With the unexpected market turbulence of 2020 exposing this fundamental flaw in the Australian equity market, the benefits of holding a globally-diversified portfolio will be increasingly apparent to your clients.

Australia has historically been a high dividend paying market. This is because of Australia’s almost unique franking credit tax breaks, which lead investors to favour higher dividend paying companies. These companies are rewarded with higher share prices in favour of companies that are reinvesting into their business. As a result, Australia is currently delivering a 3.5% dividend yield against the MSCI ACWI’s divided yield of around 2%, placing it second in the world behind only the UK.

Dividend yield is primarily driven by dividend payout ratio (shown below), which results in these two graphs closely mirroring each other in many markets across the globe.

The payout ratio is a financial metric showing the proportion of earnings a company pays shareholders in the form of dividends, expressed as a percentage of the company’s total earnings. The dividend payout ratio helps investors determine which companies align best with their investment goal. A high ratio may be attractive to income investors who prefer the assurance of a steady stream of income but forgo high potential for growth in the share price. A low ratio means that the company is reinvesting money back into expanding its business. By virtue of investing in business growth, the company will be more likely to generate higher levels of capital gains for investors in the future. Younger, more rapidly growing companies are likely to reinvest most of their earnings for future growth whereas more mature, established companies are likely to have a high pay out ratio.
The payout ratio may vary greatly from one industry to another. Many high-tech industries tend to distribute less in dividends, whereas a utility is likely to distribute a large portion of their earnings. The below chart confirms the Australian market as being a higher dividend, higher payout ratio market with 75% of all stocks paying out 50% or more of their revenues. 18% of companies have a higher retention rate and 7% having the highest reinvestment rate of the market.

The below chart shows the industries which supply the highest dividend yields. The highest paying sectors are unlikely to be companies growing at the faster rates into the future. Examples are utilities, real estate and financials. Often companies that are paying out high dividend yields are companies that have lower or stagnant growth and are considered to be cash cows. These could also be dividend traps. A dividend trap is a stock that lures investors in with a high yield only to result in a potential dividend cut or financial distress. Buying stocks with high yields can lead investors into troubled sectors. When a stock’s price declines, its yield will rise. In order for companies to have vibrant growth into the future, a good portion of their revenues need to be retained for future growth. There are some sectors in Australia that reinvest for future growth currently reinvesting with a payout ratio of 50-60% such as the healthcare and IT sectors. But for a broader diversified portfolio of these types of stocks there are richer pickings off shore.

The consequence of Australia’s high payout ratios, however, is that they entice companies to forego sufficient cash reserves in favour of distributions, forcing them to drastically cut dividends during down markets with no financial buffer in place. It should come as no surprise that this fundamental issue has been surfaced during the COVID pandemic.

Since May 2000, the ASX 200 has returned an average of 7 per cent annually. The proportion of total return that comes from dividends is around 60 per cent, leaving your Australian clients heavily exposed to dividend cuts.

Investing in companies with sustainable dividends

Dividend sustainability manager Dundas Global Investors maintains that although the pool of companies maintaining and growing their dividends is shrinking, there is still a significant number of suitable stocks for this style. Dundas pay careful attention to the sustainability of future dividends through careful management of the reinvestment of revenues first before rewarding shareholders. They look to industries that have good tailwinds, which during the COVID crisis, industries such as healthcare, IT and logistics have benefitted from this environment.

Although dividends may resume post COVID-19, there is no doubt the virus has hit all economies with high unemployment, as well as issues for the banking sector, shopping centres and retail, hospitality, tourism and many more. The additional benefit of the size and scope of global markets will be a better hunting ground for sustainable dividends than investing in the Australian market alone.

With record low interest rates spurring the hunt for yield, there may be more need for other sections of your clients’ portfolios to bridge the gap on income requirements. Finding revenues from stocks that are somewhat resistant to economic downturns with good future growth potential will be an important factor for client portfolios.  These may be used in conjunction with higher yielding stocks to bridge the gap of current income combined with future income. Avoiding industries with headwinds as a result of the new economic environment will require careful portfolio construction.

High growth stocks, particularly in the tech sector such as Facebook, Apple, Amazon, Netflix and Google comprise 20-25% of market capitalization of the S&P500 as at September. They account for nearly all of the gains in that index for the year to date. Technology stocks have received significant benefits from the lockdown as consumers made online purchases and watched streaming services. However, this is not the entire story and is not a representation of the broader market. In the past year to 30 September, the MSCI returned 4.3% in USD. In Australia, there were only 14 companies which outperformed the benchmark. On the other hand, the MSCI ACWI had 1,173 stocks which outperformed. This shows the greater scope from a broader universe to choose from. Interestingly, the USA contributed 265 stocks to the 1,173 outperformers. Although US stocks receive more than their fair share of news time, the rest of the world provides good long-term performing companies with sustainable dividend characteristics. For example, Europe’s exposure to financials and cyclically sensitive sectors in industrials and materials give it the potential to perform well when economic activity picks up.

The outlook for Australia shows some economic headwinds as a result of the lockdowns. Stretched household budgets and limited tourism will have an extended impact. The Reserve Bank of Australia has reduced interest rates to an all time low of 10 basis points.

Improving your clients’ risk-adjusted returns

Global equities are a key part of portfolio diversification. Asset allocation will be the core driver of total investment return and with the outlook for the economy and business profitability more uncertain, the Australian market alone may not meet diversification and income requirements.

Given the size of the Australian market relative to the MSCI, there are some key sectors and exposures that your clients will be missing out on. A home bias to Australia has been shown to be suboptimal for client portfolios over most timeframes. Given the equity markets broadly reflect the earnings of the underlying economy, it is important to look at the structure of the Australian market and the headwinds for the key sectors. The banking sector represents 27% of the market.  It has historically provided rich dividend hunting ground but the outlook is much poorer. With our shallower market by number of companies and sectors, the dividend shortfall may need to come from a global portfolio.

Exposure to global markets can be done through ETFs and there are also ETFs that focus on dividends. However, these are backward looking indices that do not focus on the future outlook for dividends by companies nor headwinds or tailwinds by industry. For an active portfolio which will look forward to future dividend capabilities by company, you can seek out managers such as Dundas Global Investors.

 

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Sources:
Bergmann, M. (2016). The Rise in Dividend Payments. Reserve Bank of Australia.
Bloomberg Finance L.P. (2020). Retrieved from Bloomberg database.
Dundas Global Investors. (2020). Apostle Dundas Global Equity Fund – In Search of Growth.
Lundberg, A. (2020). Australian Dividends Forecast to be Cut Most in the World. Montgomery Investment Management. Retrieved from: https://montinvest.com/investor-insights/insights/australian-dividends-forecast-to-be-cut-the-most-in-the-world/
MSCI, Inc. (2020). MSCI Index Solutions. Retrieved from: https://www.msci.com/index-solutions
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