In Search Of The Dividend Sweet Spot

Always an independent thinker, Rudi has not shied away from making big out-of-consensus predictions that proved accurate later on. When Rio Tinto shares surged above $120 he wrote investors should sell. In mid-2008 he warned investors not to hold on to equities in oil producers. In August 2008 he predicted the largest sell-off in commodities stocks was about to follow. In 2009 he suggested Australian banks were an excellent buy. Between 2011 and 2015 Rudi consistently maintained investors were better off avoiding exposure to commodities and to commodities stocks. Post GFC, he dedicated his research to finding All-Weather Performers. See also "All-Weather Performers" on this website, as well as the Special Reports section.

Rudi's View | May 21 2020

Dear time-poor investor: new research by Morgan Stanley has identified ASX sweet spots for dividend-oriented investors

In Search Of The Dividend Sweet Spot

By Rudi Filapek-Vandyck, Editor FNArena

This is the third, and final, instalment in a three parts series on dividends and investing in the Australian share market.

History shows dividends make up 50% of total return from equities, or more depending on how far we go back in time, but the subjugation of bond yields globally has made income-hungry investors increasingly dependent on dividends paid out by listed companies.

With many strategies centred around buying and holding high yielding stocks, the fall-out from the covid-19 pandemic for Australian investors is proving exceptionally damaging with high yielding share prices falling deeper and recovering less, only to be followed up with dividend cuts and deferrals, if not a fresh equity raising on top.

The first installment explains why your garden variety dividend/income strategy of only buying high yielding stocks with extra franking credits essentially amounts to high risk. Such portfolios have been hit the hardest in 2020.

The second installment identifies where investors can find dependable and sustainable yield/dividends in a market environment that is dominated by uncertainty, capital raisings, and dividend reductions.

The third installment predominantly leans on research done by analysts at Morgan Stanley which led to an in-depth 31-page report, released at the end of April under the title “We’re Going on a Yield Hunt”.


Bigger picture, Morgan Stanley’s research highlights the two sides that make up the conundrum for income-hungry investors eyeing the Australian share market for future income.

On one hand, Australian equities remain among the highest yielding in the world. Even with all the deferrals and cuts happening, the report still estimates average yield remains above 4%, and is forecasted to remain above 4% for the years ahead.

This settles the ASX firmly among global leaders in terms of yield/income available for investors, even without any franking (which doesn’t apply for foreign investors). Very few offshore markets do better, but the UK and Singapore do.

Of course, in many cases the higher yielding stocks are carried by little, if anything, in investments while boards have substantially lifted payout ratios in years gone by to keep the party going for loyal and appreciative shareholders.

This story has now broken down. Economic growth in Australia has been trending down for a while, and the lack of investments by these companies is one major driver as to why. By late last year cash profits increasingly could no longer sustain the prior year’s dividend.

Less than six months later, the global covid-19 pandemic and subsequent government ordered lockdowns have ensured this year’s losses in dividends in Australia will be much larger. Morgan Stanley has joined other experts, including peers at UBS, in suggesting total damage will be the largest post-GFC and in many respects 2020/21 will mimic what happened during calendar years 2008/09.

We are already witnessing fresh capital raisings on a large scale by companies whose balance sheet and cash generation no longer support paying out a dividend. In addition, Morgan Stanley suggests boards will use this year’s emergency settings to scale back unsustainably high payout ratios.

The impact from lowering the payout ratio to what might be a more sustainable level, potentially around the long-term average of 65% in Australia, will inflict more pain for investors loyal to their beloved champions from times gone by.

It means, explains the report, not only will dividends take a dive in 2020, but the recovery in the years ahead on lower payout ratios will be noticeably slower.

Banks Under Scrutiny

Within this context, the sector that immediately springs to mind are Australian banks. All will be facing the additional restraint of having to rebuild capital buffers, point out the analysts.

Investors relying on history repeating with bank dividends rebounding sharply in 2010/11 will have to scale back their expectations.

In concrete numbers: Morgan Stanley sees dividends from banks remaining well below FY19 payouts for multiple years into the future (the report only looks out as far as FY22).

The analysts agree CommBank ((CBA)) will prove most resilient in the sector locally, but they are not in favour of CBA shares retaining their rather large valuation premium vis-à-vis its more vulnerable peers.

Others, such as sector analysts at CLSA, have no such restraints. On Monday, CLSA repeated its Outperform rating for CBA in a report titled “The Safe Play”, with a slightly raised price target of $65.02.

CLSA’s comment: “…while CBA’s valuation looks stretched relative to the other majors, we believe it is justified given the strength of its capital position, likely ability to pay above-peer dividends, provision levels above peers, and likely continued mortgage market share growth.

Market strategists at JP Morgan note the Australian share market has underperformed other developed markets by quite the margin over the past three months; the MSCI Developed Markets outperformed by 670 basis points.

Apart from Australian banks representing such a prominent index weight, JP Morgan also suggests the veracity with which companies here have started to raise fresh capital, plus the big dividend reductions this early in the downturn are likely co-responsible.

Year-to-date dividends from ASX200 companies have already been scaled back by -27%; by far the largest reduction across the globe, on JP Morgan’s numbers.

JP Morgan research suggests there is a high correlation between index performance on a three-month assessment and the gravity of dividend downgrades.

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