Be Wary of Income Stocks

Investors are demanding yield. That’s understandable. With bank deposit rates at record lows, investors have turned to the stock market for income. And companies have stepped up to the crease.

The last reporting season revealed that Australia’s largest companies — those in the ASX 200 — raised their dividend payments by 5%, paying out more than $90 billion. Surely that’s got to be good for investors desperate for income?

Well, yes, maybe in the short term. But this is not a good sign of things to come. The problem is that company earnings grew by just 2% in that time.

This is the fourth straight year that dividend payments have outstripped company earnings.

With bank deposit rates at record lows and limited opportunities for companies to reinvest earnings, many companies are paying out those profits to shareholders. And it’s likely that dividend payments will keep growing at a faster pace than earnings. That’s until they no longer can.

Term deposit rates are still falling — even though the RBA decided to keep interest rates on hold at its last two monthly meetings. Company boards are feeling pressure from shareholders who are desperate for dividends.

But a look at companies’ payout ratios suggests there isn’t much room left to keep raising dividends.

The market’s price to earnings ratio (PE) has been pushed to 16x, up from around 14.5x a year and half ago. The PE ratio compares share prices to company earnings. A higher ratio suggests the company, or market, is more expensive.

In the past, a high PE often reflected the expectation of strong earnings growth. However, this is no longer the case with many high dividend paying stocks. By distributing so much of their earnings, growth isn’t possible.

Companies paying high yields are often unable to generate the same level of earnings growth as those paying lower dividends. So high PE stocks can no longer be viewed as growth stocks, as was historically the case. This low interest rate environment has warped the market.

In the search for income, simply shifting your money into any high yielding stocks isn’t the answer. You have to be discerning. When buying dividend stocks here are a few things you should consider.

1) Don’t be misled by high yields
Be careful that you don’t simply buy stocks paying the highest yields. This doesn’t mean just avoiding weak businesses that pay high yields. Even when comparing quality stocks, there’s a good chance that the one with the higher yield today won’t pay the most over time.

Yields can be misleading. A company could be trading on a high yield, not because it lifted its dividend, but because its share price fell. If there was a good reason for that fall, you can also expect a lower dividend or find it cut altogether down the road.

Don’t view yields in isolation. Yield is a function of both the dividend payment and the share price. If dividend payments rise, yield rises. But a falling share price will also result in higher yields.

2) Low but rising payout ratios
A company’s payout ratio is different from its dividend yield. Yield is the dividends paid divided by the company’s share price, whereas payout ratios are the proportion of profit that a company pays to shareholders as dividends.

Historically, payout ratios have averaged 60–70% in the Australian share market. They’re now up around 80%.

High dividend payout ratios are often favoured by investors. But higher isn’t always better. If operating conditions worsen, there’s not much room to smooth dividends. And a fall in earnings is likely to equal a cut to dividends.

Companies with lower payout ratios are generally better able to maintain dividends. And the lower the payout ratio, the more room there is to raise them.

Small to average sized payout ratios are ideal. If you’re investing for dividends, aim for companies with lower payout ratios — below 70% is best. This reassures you that dividend growth can continue and that dividends won’t be crushed if earnings dip.

There’s a good chance a dividend isn’t sustainable if more than 85% of profits are paid out. For example, a company with a 90% payout ratio distributes $0.90 of each dollar of earnings to shareholders. That doesn’t leave much room to raise dividends, let alone reinvest into growing the business.

3) Rising dividends
In the long term, dividend growth trumps dividend yield. Stocks with the highest yield today are the least likely to grow in value.

At the Australian Investors Club, we invest in companies that raise dividends often. We seek out stocks with a long track record of raising dividends and the ability to grow them.

But you have to make sure these dividends are supported by rising earnings. Higher dividends in the face of falling profits aren’t sustainable. You want investments that will continue to pay distributions over the long term.

Paying a $2 dividend when your earnings per share are $1 is not sustainable.

4) Low debt
Only consider companies with low or manageable debt levels. Higher dividends are fantastic. But not if they come at the expense of safety. Too much debt is dangerous. It overextends the business. The company can find itself in a bad spot if the market suffers a downturn, or project funding falls through.

Also, be aware that debt holders receive their interest payments before shareholders receive any dividends. If things turn sour, debt holders will drain the company’s cash reserves. This means, as a shareholder, you may not get your dividend. Always closely check a company’s debt and its cash flows.

Make sure that dividend payments aren’t maintained by higher debt levels. And that company earnings are also increasing.

Lower profits alongside higher dividends are not sustainable.

There are great opportunities out there
The rush to dividend paying stocks means there are some excellent quality investments being ignored. I’ve recommended a number of these to members of the Australian Investors Clubcompanies that are selling cheap because the market is so focussed on dividends.

It’s important to have discipline and not get carried away with the market. I have eight criteria that each company must pass before even considering it for one of our portfolios. Follow your investment principles, and have the discipline to stick to them.

Buy the best companies available that will perform for years to come, not the hottest ones today that have been bid up because dividends are in demand.

If you’d like to know more about the Club, click here.


Meagan Evans,
Investment Analyst, Australian Investors Club

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Markets and Money offers an independent and critical perspective on the Australian and global investment markets. Slightly offbeat and far from institutional, Markets and Money delivers you straight-forward, humorous, and useful investment insights from a world wide network of analysts, contrarians, and successful investors.

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