• Dividends are great for investors as decent dividends augur well for earnings growth, they provide a degree of security in uncertain and volatile times, they are likely to comprise a relatively high proportion of returns going forward and they provide a relatively stable and attractive source of income.
• If dividends are allowed for the value of an investment in Australian shares has surpassed its 2007 record high.
• It’s important that dividend imputation is retained in Australia to ensure dividends are not taxed twice and companies continue to pay out decent dividends.

Introduction

Up until the 1950s most share investors were long term investors who bought stocks for their dividend income. This changed in the 1960s as bond yields rose on the back of inflation and investors started to shift focus to capital growth. However, thanks to the volatility seen over the last decade or so, and an increased focus on investment income as baby boomers retire, interest in dividends has been on the rise. Investor demand for dividends is clearly evident in Australia with even the big resource stocks starting to heed the call. This is a good thing because dividends are good for investors in more ways than just the income they provide.

It’s well-known Australian companies pay out a high proportion of earnings as dividends. This is currently 75%, and it’s averaged around this since the late 1980s. Banks, telcos, consumer stocks and utilities are the big dividend payers. By contrast in the major global markets dividend payout ratios range from 31% in Japan to 49% in the UK.

However, some argue that dividends are irrelevant and simply don’t matter – as investors should be indifferent as to whether an investment pays a dividend, or whether the company retains earnings that are reinvested to drive earnings growth. Or worse still, some argue that high dividend pay outs are a sign of poor long term growth prospects or that they are not sustainable.  And of course, some just see dividends as boring relative to the excitement that can come from speculating on moves in share values. My assessment is far more favourable.

Dividends are cool

There are lots of reasons to love dividends and here they are. First, dividends do matter in terms of returns from shares. For the US share market it has been found that higher dividend pay outs lead to higher (not lower) earnings growth.[1] This is illustrated in the next chart which shows that for the period since 1946 whenever US companies have paid out a high proportion of earnings as dividends (the horizontal axis) this has tended to be associated with higher growth in corporate profits (after inflation) over the subsequent 10 years (vertical axis).

And of course higher growth in company profits contributes to higher returns from shares over the long term. This all suggests dividends do matter & the higher the better (within reason). There are several reasons why this is the case:

• when companies retain a high proportion of earnings there is a tendency for poor investments which subsequently leads to poor earnings growth;
• high dividend pay outs are indicative of corporate confidence about future earnings (otherwise companies would not feel comfortable in paying them);
• high dividend pay outs are a positive sign as they indicate earnings are real, ie backed by cash flow.

The bottom line is that strong dividend pay outs are more likely to be consistent with strong, not weak, earnings growth. The higher dividend yield and pay out ratios for Australian companies, compared to mainstream global share markets, is a positive sign for relative returns from the Australian share market on a medium term basis – particularly at a time when the boost to national income from the terms of trade is going in reverse.

Secondly, concerns about the sustainability of dividends fly in the face of all the evidence that companies like to manage dividend expectations smoothly. They rarely raise the level of dividends if they think it will be unsustainable. As can be seen below, dividends move roughly in line with earnings but are a bit smoother. For an investor this means the flow of dividend income is relatively smooth.

Thirdly, decent dividend yields provide security during uncertain times. As can be seen in the next chart dividends provide a stable contribution to the total return from shares over time, compared to the year-t­o-year volatility in capital gains. Of the 11.8% pa total return from Australian shares since 1900, just over half has been from dividends.

Fourthly, investor demand for stocks paying decent dividends will be supported over the years ahead as more baby boomers retire and focus on income generation.

Fifthly, with the scope for capital growth from shares diminished thanks to relatively high price to earnings ratios compared to 30 years ago, dividends will comprise a much higher proportion of total equity returns than was the case in the 1980s and 1990s globally and in Australian shares up until 2007. Around half of the total return from Australian shares over the next 5 to 10 years is likely to come from dividends, once allowance is made for franking credits.

Finally, and for some most importantly, dividends provide good income. Grossed up for franking credits the annual income flow from dividends on Australian shares is currently around 5.7%. That’s $5700 a year on a $100,000 investment in shares compared to $3500 a year on the same investment in term deposits (assuming a term deposit rate of 3.5%).

Another angle on dividend income

The next chart illustrates just how powerful investing for dividend income (without even really trying) can be relative to investing for income from bank term deposits. It compares initial $100,000 investments in Australian shares and one year term deposits in December 1979. The term deposit would still be worth $100,000 (red line) and last year would have paid $4,150 in interest (red bars). By contrast the $100,000 invested in shares would have grown to $1,054,000 (blue line) and would have paid $45,000 in dividends before franking credits (blue bars). This would translate to around $59,650 if franking credits are allowed for. The reason for the difference is over time an investment in shares tends to rise in value, whereas an investment in term deposits is fixed.

New highs

Finally, while we all bemoan the fact that Australian shares are still trading around 20% below their 2007 all-time high, once reinvested dividends are allowed for (ie looking at the ASX 200 accumulation index) the Australian share market is now above its all-time high. In other words an investor who (god forbid) put all their money into the market at the peak in 2007 would now be in the black if they had reinvested dividends along the way.

Why dividend imputation is important

Which brings us to the topic of dividend imputation. This arrangement was introduced in the 1980s and allows Australians to claim a credit for tax already paid on their dividends in the hands of companies as corporate earnings and effectively boosts the average dividend yield on Australian shares by around 1.5 percentage points. However, in recent times it has been subject to some questioning with the interim report of the Financial System Inquiry questioning whether dividend imputation was creating a bias to invest in domestic equities and adversely affecting the development of the corporate bond market. Meanwhile, some such as Treasury argue that it along with other tax concessions (like negative gearing) primarily benefit the rich.

The trouble is that dividend imputation actually corrects a bias by removing the double taxation of earnings – once in the hands of companies and again in the hands of investors. It also encourages corporates to give decent dividends to shareholders as opposed to irrationally hoarding earnings. Interest on corporate debt never suffered from double taxation as it is paid out of pre-tax corporate earnings. And all such concessions encourage savings in the face of Australia’s relatively high marginal tax rates. The removal of dividend imputation would not only reintroduce a bias against equities but substantially cut into the retirement savings and income of Australian investors, discourage savings and lead to lower returns from Australian shares. So hopefully common sense will prevail and dividend imputation will not be tampered with.

Concluding comments

Dividends are often overlooked. But they provide a great contribution to returns, a degree of protection during bear markets and a great income flow. Investors should always allow for them in their investment decisions.

By Dr Shane Oliver, Head of Investment Strategy and Chief Economist, AMP Capital

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[1] See R.D.Arnott and C.S.Asness, “Surprise! Higher Dividends = Higher Earnings Growth”, Financial Analysts Journal, Jan/Feb 2003. Of course it’s become a bit complicated for US shares in recent times as the tax system effectively encourages companies to return capital to investors as buy backs as opposed to dividends, which might be argued to be the same thing.

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Looking beyond dividends may increase opportunities.

The demand for yield has stretched valuations of traditional high-yielding stocks. Malcolm Whitten, Portfolio Manager at Tyndall AM explains that looking at the total return to shareholders, not just the dividend, may help investors find better opportunities.

Record low bond yields and low interest rates on term deposits have been enticing investors into higher-yielding stocks.

Banks and telecommunications stocks have been major beneficiaries of this trend. In the process these sectors have become expensive with 12-month forward PEs now running at around the top-end of their ten-year average at 15 times. Where can investors find that much-needed income stream but not risk overpaying for it?

Non-traditional sectors also offer attractive yields

In an investment portfolio that is actively managed, diversification and risk management are paramount. In a share income portfolio, banking, telecommunications services and utilities companies will tend to have a large representation. Other sectors can also offer sustainable income opportunities.

Tyndall’s intrinsic value investment process identified a number of quality companies, beyond the traditional high-income sectors, which made a strong contribution to the Tyndall Australian Share Income Fund’s (‘Fund’) performance over the past year, both in respect of dividend yield and total return. These included holdings in such diverse names as Dulux Group, Woolworths, Woodside Petroleum, Henderson Group, Wotif.com and IAG.

Since its inception in November 2008, the Fund has delivered a total return of 10.7% p.a. (after fees), comprising a growth return of 5.8% p.a. and a distribution return of 4.9% p.a. (as at 31 August 2013). When including franking credits, the Fund’s holdings produced a grossed up dividend yield of 8.6% p.a. over the same period. Past performance is not an indicator of future performance.

Looking beyond the headline number

In achieving these returns, Tyndall doesn’t just focus on the headline dividend yield. It focuses on sustainable yields, earnings growth and potential capital appreciation using an intrinsic value process. The strength of a company’s balance sheet, particularly gearing levels, as well as franking levels and pay-out ratios are important indicators of the sustainability of a company’s earnings and dividend stream.

Understanding a company’s future operating cashflow and capital expenditure plans are a good way to ascertain the company’s capacity to return money to shareholders.

The most notable feature over the past five years has been an increase in returns to shareholders at the expense of future investment. This has been achieved through increasing dividend payouts as a proportion of earnings, as well as greater use of share buy-backs.

The challenge for portfolio managers is to find companies with future growth in operating cashflow, healthy balance sheets and the confidence to increase returns to shareholders.

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Disclaimer: This article was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (“TIML”). The information contained in this document is of a general nature only and does not constitute personal advice. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual. The Tyndall Australian Share Income Fund ARSN 133 980 819 is issued by Tyndall Asset Management Limited ABN 34 002 542 038 AFSL No: 229664 (“TAML”). Investors should consult a financial adviser and the information contained in the current Product Disclosure Statement available at www.tyndall.com.au before deciding to invest. TIML and TAML are part of the Nikko AM Group.

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FY2013 results flat as expected.

Brad Potter, Portfolio Manager and Senior Analyst, Tyndall AM provides his key take-outs from the August company reporting season.

Weak consumer demand, a slowdown in China and a high Australian dollar are just a few issues challenging Australian businesses. To maintain or improve their profit margins companies have needed to cut costs, reduce capital expenditure and improving efficiencies. Is it working?

Benign reporting season – no great surprises

Overall, the company reporting season was benign with earnings coming in close to market expectations.  Around 56% of companies beat expectations. Earnings overall in FY2013 were flat, but up 7% when excluding resource companies, which have fallen substantially because of the decline in commodity prices over the year.

FY2014 earnings forecasts have been lowered as expected in the current environment. Prior to reporting season the expectation was 8% to 10% earnings per share (EPS) growth in FY2014. Those expectations have now been reduced by about 1% or 2% (this is likely to be revised as analysts fine tune their numbers).

Many of the rallies during reporting season were based on ‘no further bad news’ or that the news wasn’t as bad as priced in going into the result – rather than good results. Stocks such as Qantas, Arrium, Origin Energy and UGL were typical of these stocks which had acceptable to probably slightly down results, but were not as bad as what the market was expecting.

Top line growth continues to be weak

The key takeaways from reporting season were very similar to last reporting season. Top line revenue growth continues to be poor. This was expected. Companies suggested things were not getting any worse, which is a positive.

When there is no top line growth companies cut costs. Cost outs were again a major thematic this reporting season across the market. Companies as diverse as BHP, Rio Tinto, AMP, Boral, Coca-Cola Amatil, Fairfax, Toll, Downer and all the banks have cost out and efficiency drives in place in a bid to keep margins flat or improving.

In the case of resources companies, such as Rio and BHP, their large cost-out programs are only just beginning. They’ve slashed their exploration programs, which has saved them between $500 million to $1 billion per annum.  Miners have seen substantial cost inflation over the last decade during this mining boom and they need to pare that back substantially because commodity prices have arguably peaked. They need to cut costs as there are a number of mines in a range of commodities that are now looking unprofitable. This is likely to be an ongoing theme, which provides a poor backdrop for the mining services industry.

Dividends still the flavour of the month

Dividends surprised on the upside again, like they did last reporting season. Payout ratios continued to rise, which reflects a combination of investor appetite for yield in a low interest rate environment, strong company balance sheets, a lack of investment opportunities and/or risk appetite to invest their money. In this environment, the easiest thing for companies to do is pay back excess capital as dividends, especially when they’re being rewarded for it. Therefore dividends again outstripped EPS growth quite substantially this reporting period.

Company outlook statements were guarded

Company outlook statements were quite guarded or non-existent. That’s understandable given the problematic economic environment, exacerbated by the uncertainty of the September Federal election.

Post the Federal election consumer and business confidence, currently at very low levels, should rebound. Companies are not investing at the moment because of this low confidence.  This was clearly illustrated by the low levels of capital expenditure (outside of mining projects that are already in construction) that we saw during the reporting season.

Profit downgrades were quite modest and many CEOs suggested that business conditions haven’t deteriorated further. This reflected a combination of interest rate cuts finally starting to have an impact and the recent decline in the Australian dollar.  Although, that hasn’t had a full impact yet given that the Australian dollar only tumbled in May.

All the banks stated that provisioning levels, while very low, they couldn’t see any issues currently.  That was quite positive, given that investors worry about that on an ongoing basis.

Housing was a strong theme during reporting season. Lend Lease commented that their residential property sales in July were two times higher than March levels and they also had increasing apartment commitments.  Stockland made similar comments about residential land sales, with the run rate in the second half of the financial year the best since 2010. The positive signs have continued with long queues for residential land sales on weekends. The first release of the Barangaroo apartments in Sydney was sold out in three hours and they were all $1 million plus apartments.

James Hardie commented that they’re seeing rising building activity in Australia and New Zealand, which was interesting given we saw more comments from other building materials companies. The company was very positive on the US environment with profit margins over the 20% level, and they’re suggesting that housing is continuing to pick up in the US.

Iluka also made the point that they sold more zircon in the first half of 2013 than they did in the entire 2012, so they are starting to see green shoots in the zircon market. I expect, given the recent positive news out of Europe (one of the biggest consumers of zircon), that may continue. They also commented that the titanium dioxide market, which tends to be primarily used in painting, is turning.

Seven West Media suggested that advertising spending appears to have stabilised. This is a grey area at the moment due to the election period because there is extra advertising spending by the political parties.  A lot of companies peel back their spending during the election period and start after the election. They are now suggesting they’re seeing good interest for commitments post the election, so that’s quite positive.

Companies that provided negative comments included Toll, which suggested activity levels had yet to show any signs of improvement. Fletcher Building also pointed out ongoing weakness in Australia, but commented that New Zealand was going full steam ahead.  At Wesfarmers, Target was quite disappointing, with no signs of improvement, which the market disliked. Echo commented that the weak consumer environment was driving soft conditions on the main gaming floor. Tabcorp made similar comments about the weak consumer environment.

Boral disclosed that activity in Australia remains broadly flat in FY2014, so similar to Toll.  BlueScope had a solid result but their outlook statement suggested that the first half of this year would be flat on the last half, but over the year would be up, thus indicating the second half would be strong. The market was initially disappointed with that, and the stock was punished severely on the day and subsequent days. It has however subsequently recovered. This was a classic example of where market expectations for the stock were very high and when the company didn’t meet those expectations, the stock was sold off heavily.

Mining boom is over

The reporting season didn’t provide any further clarity on the mining boom. My views pre the reporting season haven’t changed. The mining boom is effectively over in the sense that we’re close to the peak of capex.  Commodity prices have also peaked so if that’s the definition of a mining boom then it is finished.  I don’t expect commodity prices to fall in a hole though. I expect them to remain at reasonably elevated levels for the next few years at least, given demand from China is still reasonably strong and so I expect mining companies to do quite well in certain commodities. Rio & BHP for example are making great margins in iron ore.  On the flip side of that, coal companies are really struggling because coal prices have fallen substantially. A number of coal mines have shut down because margins are just not good enough, and there are a number of them really struggling given the low margins.

Gold is another commodity whereby a number of mines have become marginal, even at current prices, just because cost inflation has been so great. Reserve decreases are the likely next shoe to fall.

Highlights for the Tyndall share portfolios?

In our flagship fund, the Tyndall Australian Share Wholesale Portfolio, Twenty-First Century Fox, our largest overweight, was a highlight. They had an in line but quite messy result given the recent split from their publishing assets. Two days later however they had a strategy day where, for the first time, they laid out quite detailed information on their strategy and all their new revenue streams. The market upgraded substantially on that view.  The market, particularly in the USA, has been reluctant to price in these new earnings streams.  The share buyback continues at a meaningful pace and there’s an expectation that once this buyback finishes they’ll start another one.  The stock was up about 5% over the month.

Downer, which is our only exposure to mining services (albeit it’s not entirely mining services as it represents only about 30% of the business), had a solid result, slightly ahead of guidance, which is very credible given the negative sentiment in the sector due to the peaking in mining capex. The company’s mining segment was down but that was offset by other divisions.  It’s been hurt over the last six months because of the ongoing downgrades from other mining services companies, despite the fact that Downer has continually maintained their guidance, which they delivered.  The dividend was ahead of expectations and their cash flow was very strong.  The cost-out program has doubled to $500 million given that they achieved $250 million two years ahead of forecast.  The stock rallied substantially to be up nearly 15% during the month.

Qantas had a strange result in the sense that it was one of those stocks that rallied on the fact the news wasn’t as bad as what the market was factoring in.  Transformational initiatives delivered $428 million to EBIT during the year. They started up the small buyback, it’s continuing and the stock rallied 11% over the month.

Sims Metal’s result was also close to what the market was expecting. All divisions had good results, other than the European division which has been problematic over the last year or so due to governance issues. Operating cash flow was strong. No guidance was given, but Sims is leveraged to the US economy and in particular the housing market and scrapping of automobiles as people trade up cars and white goods as the economy improves. So the stock actually responded very favourably; again I think it was a relief rally with the expectations that it was going to be ugly. The stock was up about 11% for the month as well.

Portfolio positioning

Banks have run hard over the past 12 months or so. We’re underweight banks because we believe they’re expensive despite the attraction for yield.  We have selective exposures in domestic cyclicals, tilted towards housing and residential as we think that’s a reasonable area given the interest rate cuts and hopefully we’re seeing some green shoots at the moment so that’s quite positive.  We also have reasonable exposure to the USA, both from a growing US economy perspective and also a falling Australian dollar.

Conclusion

It was a by and large a non-eventful reporting season, due mainly to many companies confessing or reducing earnings guidance prior. Companies are adapting to the structural changes occurring in the Australian economy as evidenced by the various cost cutting and efficiency programs in place. These initiatives are having a positive impact on company bottom lines, but we now need to see a recovery in top line growth. Lower cash rates, a weaker Australian dollar and resolution of the Federal election, together with signs of stabilisation in the Chinese economy should assist this.

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Disclaimer: This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (“TIML”). The information contained in this document is of a general nature only and does not constitute personal advice. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual. The Tyndall Australian Share Wholesale Portfolio ARSN 090 089 562 is issued by Tyndall Asset Management Limited ABN 34 002 542 038 AFSL No: 229664 (“TAML”).  Investors should consult a financial adviser and the information contained in the current Product Disclosure Statement available at www.tyndall.com.au before deciding to invest.  TIML and TAML are wholly-owned subsidiaries of Nikko Asset Management Co., Ltd.

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However, bank term deposit rates have fallen and are likely to fall further, possibly to around 4%, as the RBA continues to reduce the cash rate to help the economy. So it makes sense to look elsewhere.

Our view is that the RBA will cut official interest rates from 3.5% currently to 3% or just below over the next six months on the back of sub-par business and consumer confidence, disappointing growth and benign inflation. While the RBA is currently putting out a relaxed and comfortable message it should be noted that it put out a similar message earlier this year only to commence cutting interest rates again in May.

To read more about investments that might deliver a decent yield, click here.

30 July 2012

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But how do you determine how sustainable dividend yields are?

“It is a straightforward process to screen for high-yielding stocks and build a portfolio around them,” says Tom Stevenson, Investment Director at Fidelity Worldwide Investment.

“However, this simple quantitative approach fails to recognise that the high yields available on certain shares can be the result of deteriorating fundamentals and collapsing share prices. It also fails to give any consideration to the fact that some high-yielding companies could subsequently cut their dividend. A high yield does not always imply value.

“The only way to determine whether there is value in a high yielding share is via fundamental research,” says Mr Stevenson.

“It’s a matter of historical fact that dividends and dividend growth are the key drivers of total return over time. Companies that have a track record of consistently growing their dividends tend to be rewarded with higher share prices. Long-term investigations of investment returns bear this out.  They also support the idea that dividend payouts provide a valuable, positive signal for future earnings growth. Finance directors typically pay out larger shares of earnings when they are optimistic that the dividend can be sustained. Moreover, high payout ratios are typically consistent with more carefully chosen capital spending projects that are also supportive of the share price.”

Mr Stevenson says “we believe that the dividend policies of companies contain predictive power which can be revealed via thorough fundamental analysis. While earnings can be manipulated by a variety of sophisticated accounting treatments, dividends cannot. In this way, they provide an accurate picture of a company’s financial health.

“Moreover, companies that can grow their dividend consistently are invariably healthy businesses with stable earnings growth and high free-cash flows; all factors that are rewarded by the stock market in the fullness of time. The link is clear: a company’s dividend policy can be a key indicator of earnings growth, which is in turn a key indicator of share price performance.”

He adds “owing to their generally defensive qualities, it’s not surprising that dividend-paying stocks tend to outperform in bear markets (as they did in 2011). What is surprising is the evidence that suggests that over the long run, this is also true in bull markets.

“In the past 10 bull markets, US dividend-paying stocks outperformed their non-dividend paying counterparts by over 3% a year, on average. The implication of this is that over the long-run, across all market cycles, dividend-payers tend to be better performers than non-dividend payers.

“One plausible explanation for the general outperformance of dividend-payers is that they are less likely to be overvalued than non-dividend payers, which are often ‘growth’ stocks that are more prone to excessive levels of investor optimism. Conversely, high dividend-paying stocks often fall into the ‘value’ or unloved stock category, which may be susceptible to excessive or unwarranted investor pessimism.”

Source: Ned Davis Research. Bull and bear markets as defined by Ned Davis Research. Based on equal-weighted geometric average of total returns (including dividends) of dividend paying and non-dividend-paying historical S&P 500 stocks. Bull markets from 1/31/72-12/31/10, as defined by Ned Davis Research, are: 1/31/72-1/11/73; 12/6/74-9/21/76; 2/28/78-9/8/78; 4/21/80-4/27/81; 8/12/82-11/29/83; 7/24/84-8/25/87; 10/19/87-7/16/90; 10/11/90-7/17/98; 8/31/98-1/14/00; 9/21/01-3/19/02; 10/9/02-10/9/07; and 3/9/09-12/31/10. Bear markets from 1/31/72-12/31/10, as defined by Ned Davis Research, are: 1/11/73-12/6/74; 9/21/76-2/28/78; 9/8/78-4/21/80; 4/27/81-8/12/82; 11/29/83-7/24/84; 8/25/87-10/19/87; 7/16/90-10/11/90; 7/17/98-8/31/98; 1/14/00-9/21/01; 3/19/02-10/9/02; and 10/9/07-3/9/09.

This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment. This document is intended for use by advisers and wholesale investors. Retail investors should not rely on any information in this document without first seeking advice from their financial adviser. This document has been prepared without taking into account your objectives, financial situation or needs.  You should consider these matters before acting on the information.  You also should consider the Product Disclosure Statements (“PDS”) for respective Fidelity products before making a decision whether to acquire or hold the product.  The relevant PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Details about Fidelity Australia’s provision of financial services to retail clients are set out in our Financial Services Guide, a copy of which can be downloaded from our website at www.fidelity.com.au. © 2012 FIL Responsible Entity (Australia) Limited. Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.      

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Real assets can be useful tool to produce stable income

Legg Mason launches funds to fill gap for retiree tailored products

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A new paper released by Legg Mason today argues the burning issue of longevity risk needs to fuel a rethink of portfolio construction for retirees with a greater emphasis on income producing alternatives and equities.
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The paper argues the traditional method of allocating 70% of a portfolio to defensive assets in retirement will not be sufficient to sustain an income in retirement. Instead it suggests a number of alternatives including real assets like property, utilities and infrastructure and income-generating equities.
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“Retirees will require the bulk of their investment return to come from yields to sustain them through retirement,” said the paper’s co-author Reece Birtles, chief investment officer for Legg Mason Australian Equities.
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Solving the income conundrum

While it’s important for retirees to target yields, the exact type of yields needs to be carefully considered.
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“Overly defensive strategies like fixed income don’t provide the necessary growth in line with inflation to continue to meet rising costs and sustain income. However retirees need a lower level of risk, which includes investment, foreign currency and liquidity risk. Therefore some higher yield assets could be too risky for their purposes,” said Mr Birtles.
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A solution to the income conundrum could be real assets, he argues. Utilities, property and infrastructure provide a good middle ground between defensive assets like fixed income and growth assets like equity. They have strong yields but their income stream is not reliant on the cycle, meaning lower volatility.
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High income Australian equities also provide a solution as they boast unique income characteristics in the form of franking credits, according to Mr Birtles. Often ignored, franking credits can boost overall returns by 1% for those on a 0% tax rate (such as retirees). The key with equity income for retirees is to manage risk by picking equities with the power to sustain good dividends through characteristics including strong cash flow and low capex requirements.
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“For instance, mining is very capital intensive whereas non-bank financials with sustainable earnings such as AMP and Perpetual are favourable as are stocks like Woolworths or Metcash,” said Mr Birtles.
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New Legg Mason funds help fill gap for retiree tailored products

For the past 20 years, the industry has focused on accumulating assets with little focus on retirement, leaving a gap for specifically tailored products.
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“In the same way as many product innovations were driven by baby boomers as they moved through their working life, we are bound to see new products and ideas as boomers enter retirement,” said Mr Birtles.
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The newly launched Legg Mason Real Income Fund builds a portfolio of listed hard assets including A-REITs, utilities and other infrastructure such as electricity and gas grids, toll roads, ports, airports and hospitals. This delivers a good yield, inflation protection and is low risk.
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Meanwhile the Legg Mason Australian Equity Income Trust (due to be launched 1 June) will invest in companies listed on the ASX that have attractive, reliable dividends. It is designed to deliver an income yield higher than the market without relying on gearing, derivatives or other complex structures.
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“We think it is the right time to be targeting specific solutions for retirees. As more people reach retirement they need to make sure they have the right portfolio to make their savings last the distance,” Mr Birtles concluded.

cNTA

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Dividends are on the rise with the average dividend across the equity market growing 6.4% over the last six months, according to recent data from Russell Investments, provider of the Russell Australia High Dividend Index (the index).

“This reporting season has shown companies are increasingly confident about their prospects and as a result are more inclined to return capital to shareholders, either via dividends or buy-backs,” said Scott Bennett, portfolio manager for Russell Investments.

The index, which forms the basis for Russell’s High Dividend Australian Shares ETF (RDV), comprises Australian blue-chip companies with a bias towards those that have a high expected dividend yield but also meet other characteristics including: a history of paying dividends; dividend growth and consistent earnings.

Russell has recently completed the semi-annual reconstitution of the index, which involves incorporating the latest reporting season data to rebalance the weightings of stocks within the index according to certain dividend and earnings factors.

Commenting on the outlook for dividends, Mr Bennett said: “The dash to dividends is likely to become an even stronger theme in the year ahead with more companies looking to return cash to shareholders, along the lines of BHP’s buy-back.”

According to Mr Bennett, dividend yields are now looking as attractive as term deposits. The average term deposit is now yielding 6.1% while the average dividend yield across the ASX is now 5.8% grossed up for franking credits, with the index yielding 7.3% grossed up for franking credits.

“The main advantage over term deposits is with Australian equities you get long term growth in dividends and also your capital,” Mr Bennett said. “The recent correction in equity markets has presented a good buying opportunity for longer term investors.”

Strong yielders

The index has seen a number of movements this half including Harvey Norman which has entered the index at a weight of 1.8%. This reflects its attractive 6.7% gross yield and solid dividend growth, although Mr Bennett says Russell index methodology has also taken into account the cyclical nature of its business.

Defensive companies such as Fosters and Coca Cola Amatil have also increased their weighting, as did the banking sector after three of the top four banks posted double digit dividend growth in the past 12 months. “The proprietary Russell index methodology does favour those companies with more defensive earnings characteristics,” Mr Bennett said.

“This half has really shown investors that dividends are on a steady growth path and as a result dividends are going to be a really competitive source of income compared to other investments,” Mr Bennett concluded.

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Since its launch in May 2010, the Russell High Dividend Australian Shares ETF (ASX code RDV) has grown faster by assets under management than any other ETF launched in Australia, reaching $142 million in the first nine months, Russell Investments announced today.

RDV has experienced significant demand from investors hungry for income, particularly from the SMSF sector. Since launch, RDV’s assets under management have grown at an average of around 35% each month.

RDV is based on a specially formulated index, the Russell Australia High Dividend Index, which seeks to deliver a dividend stream 1% higher than the broader market from a portfolio of around 50 Australian blue chip shares. The Russell index has a bias towards those companies that have a high but sustainable expected dividend yield and also demonstrate a history of paying dividends; dividend growth and consistent earnings.

“We developed RDV with SMSFs in mind so it’s pleasing to see such strong demand from these investors who love their share investing but also want sustainable income without sacrificing growth opportunities,” said Amanda Skelly, director Australia ETF business at Russell Investments. “ETFs are a good tool for SMSFs to diversify their portfolios and can be used as a complement to their own stock picks,” she added.

Ms Skelly said Russell has also seen growing institutional take up, particularly among investors with an income focus, or who are looking for alternative ways to manage short-medium term cash. Russell is planning to launch a number of new products this year with a focus on this growing institutional interest.  “We think there are numerous ways institutions can use ETFs, including portfolio tilting and as a plug for an active manager,” said Ms Skelly.

“We are focused on creating ETFs that deliver a specific, targeted exposure and we are working on a number this year, including one we plan to release shortly, which we hope will replicate our success with RDV,” Ms Skelly concluded.

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Income-seeking investors will increasingly turn to global equities in 2011, with leading international asset manager Threadneedle forecasting that key international markets will experience double-digit aggregate earnings growth and increasing dividends in 2011.

“For the last two decades investors have traditionally turned to bond markets for income and to equity markets for growth. This is no longer the case. Low interest rates in the Western world and unappealing bond yields are leading investors to turn to equities as a source of income,” Threadneedle Head of Global Equities Jeremy Podger said.

“Corporate profits have recovered strongly over the past 18 months, magnified by operating leverage as a result of cost-cutting undertaken during the downturn.

“Threadneedle forecasts that the UK, European, US and Asian markets will all generate double-digit aggregate earnings growth in 2011. This, in turn, is likely to feed through to a recovery in dividends. Our estimates are for dividend growth of 11 per cent in the UK, 10 per cent in Asia ex Japan and 8 per cent in Europe ex UK in 2011.”

Mr Podger said the broadly-based dividend growth enabled equity income investors to take an increasingly global approach to their portfolios and this had a number of advantages over regional income portfolios.

“Firstly, broadening the investment universe allows investment in best-of-breed companies from across the globe. It also provides the opportunity to gain exposure to fast-growing markets in areas such as Asia, where a number of highly profitable companies are generating robust levels of dividend growth,” Mr Podger said.

Global investing also allows better access to dividend-paying companies in sectors that may not be well represented in regional indices.

“For example, the Australian market offers 119 companies with a market capitalisation in excess of US$500m and a dividend yield of more than 4 per cent, whereas the global market offers 1512 such opportunities,” Mr Podger said.

“This deeper pool of income stocks offers superior scope for outperformance and diversification.”

Threadneedle said the financial crisis affected companies’ ability to pay dividends, with a number forced to cut or suspend their dividends during the recession as profits came under downward pressure.

At the same time the financial sector, which has been an important source of income over the long term in most equity markets, saw many companies forced to stop paying dividends as a condition of government support packages.

“This situation was an exception to the long-term pattern whereby, unlike deposits and most bonds, the income generated by equity investments has the capacity to grow over time. The short-term factors that disturbed this long-term trend have now begun to reverse and we are entering a new dividend cycle,” Mr Podger said.

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With Rio Tinto upping its payout to shareholders and JB Hi-Fi, Cochlear and OZ Minerals following suit this reporting season, it may be tempting for investors to buy up dividend paying stocks. However, according to Russell Investments’ latest paper, Dividends are the new black – Why the classics always come back in fashion, it is important for investors to consider more than just yields and know which companies are worth buying and which companies have unsustainable dividends.

The theme of income investing has experienced a surge in popularity recently owing to the attractiveness of dividends as a consistent source of positive returns and having less volatility in lower growth environments. On this, Russell’s new paper provides a ‘how to guide’ for getting the most out of dividends by indentifying companies whose dividends are likely to grow over time. This includes assessing multiple characteristics such as historical dividend yield, forward looking dividend yield, historical dividend trajectory and earnings variability over multiple time periods.

Russell’s ETF product specialist, Bronwyn Yates says the paper has given consideration to the role after-tax strategies play in the income investing theme, with the paper explaining how to make the most out of franking credits to achieve an alternative source of return for investors.

The Russell paper also looks at using different dividend strategies for different investment stages by highlighting the importance for those in the accumulation stage to think of dividends as a way to supplement growth in a volatile market. Those in decumulation should use dividends to supplement income to avoid drawing on capital.

Click here to read the full report.

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