A new way to think about dividends

Just as different countries around the globe exude different fashions, cuisines and languages, investors too seem to portray different traits and preferences depending on nationality. Compared with similar OECD nations the likes of the USA, UK, Japan, Germany and Canada, here in Australia investors appear to have a fixation with income and dividend yields.

Admittedly there are the frequently cited benefits for preferring dividend-yielding companies, such as periodic income generation and the tax benefits stemming from franking credits and imputation credits. 

Investors Confronted with a COVID-19 induced conundrum

Let us not forget that at present these retirees are essentially earning nothing in real terms on term deposits and struggling to fund their retirements in an era of unendingly low rates which brings us to a COVID-19 induced conundrum.

Australia’s largest companies are expected to slash dividend payouts at the upcoming August reporting season by the most since the global financial crisis as the coronavirus pandemic ravages the balance sheets of some of the countries most established and relied upon names. Large hits to corporate earnings and cash flows together with cautious management teams have seen an enormous chunk of the market’s dividends evaporate almost overnight.

Australia’s largest companies are expected to slash dividend

It is somewhat a moving feast at the moment but according to Bloomberg dividend payments from firms on the S&P/ASX 200 index may plunge by as much as 40% in 2020, before declining another 11% in 2021. As such forward dividend yields are expected to decline from approximately 4.6% as of May 2019 to 3.5% for the year ahead as of May 2020. To give it some perspective the 20-year average sits at 4.5%.

A third of S&P/ASX 100 stocks have reduced, deferred, suspended, or cancelled dividends since the February reporting season with the worst affected sector being the Banks where dividend expectations have fallen approx. 60%. The Consumer Discretionary has also been heavily impacted (down 45% compared to a year ago) given the many of the constitutes exposure to a devastated retail, tourism, and hospitality sectors.

The most robust dividend segment at this stage appears to have been the healthcare, where dividend estimates have only declined by approximately 4%.

Bank Dividends Disappear Almost Overnight

Confronted with wide-ranging shutdowns and joblessness, the banks, who in 2019 contributed approximately 30% of the overall dividends paid out on the ASX 200, have been forced to offer borrowers deferrals on mortgage repayments. In response, the NAB in April sliced its shareholder payment by two-thirds to 30 cents, its lowest since 1993. Following that decision, ANZ and Westpac both deferred its interim payout causing a real conundrum for countless retirees reliant, perhaps over-reliant, on bank dividends to support themselves through retirement.

Many of these retirees will be praying the cyclical Iron ore producers Fortescue Metals, BHP Group and Rio Tinto can come to the rescue and surprise on the upside with their dividend distributions to help at least partially offset the income cliff created by the market-wide cuts to dividends.

Recent events do beg the question, is the Australian investor’s adoration for dividend yield justified? Should we be chasing dividend yields, or high-quality businesses that reinvest in future growth?

Many investors and financial advisers believe the best way to approach investing in the stock market is to identify the ever-ambiguous ‘blue-chip’ company that pays out a large portion of its earnings to shareholders as a dividend yield.

A Focus on Dividend Yields can be Counterproductive to long term Investment Performance

This tendency in our view often causes the investor to neglect or miss out entirely on high-quality prospects, to instead favour companies for little real reason other than they being large organisations that pay high dividends. Such a habitual preference for dividends although simplistic and marketable, can be superfluous and counterproductive to long term investment performance.

As a general rule, the most benefit to shareholder equity is achieved when management chose to reinvest the company earnings back into the business. Earnings that then go onto earn the high return on equity rate, effectively compounding growth year after year. Investors need to remain conscious of the fact that dividend payments are in essence sacrificing future company growth for immediate gains in the form of income.

After all, Investors always have the option to raise cash by selling down their holdings or locking in a portion of profits, in effect creating a dividend, leaving the company free to reinvest profits into new ventures that will increase the value of the business into the future.

Looking at 3 Real-World Examples

Moving forward let us take a look at a real-world example to determine whether a pure dividend focus is justified when compared with a focus on top-quality businesses that are reinvesting in growth.

In the tables below we have a dividend snapshot of three ASX 200 constituents, Telstra Corporation (ASX: TLS), National Australia Bank (ASX: NAB) and Fisher & Paykel Healthcare (ASX: FPH) looking at the last 20 dividend periods back to 2010. I acknowledge that this is an extreme example comparing different businesses from different sectors, however, I think the explanatory power is of value.

Assuming an initial hypothetical investment of $10,000 the table compares the following over a 10-year period excluding franking credits and Foreign Tax offset which can differ considerably depending on the investor type:

Dividend Return on Investment (10 yr)	Total dividend return earned on investment over 10 years
Dividend Income (Current)	Current Dividend Income received as of last financial year
Dividend Income Growth (10 yr)	Growth in Dividend per share over 10 years highlights the change in dividend income received by the investor over the period
Dividend Yield on Initial Investment	Dividend Yield on Initial Investment highlights the income return the investor receives today on their initial investment of $10,000

In monetary terms a hypothetical $10,000 investment in FPH would today be worth considerably more than TLS and the NAB, however, I have intentionally chosen not to look capital gains in order to focus on the dividend characteristics of each company alone. In terms of capital gains, there is no doubt about which of these three investments has produced the superior return but that’s not the premise of this article.

Headline Dividend Vs Growth in Dividend p/sh

Overtime most market observers would have noted that both TLS and the NAB have always maintained a higher ‘headline’ dividend yield than FPH but take special note of the dividend income per share over the last decade.

What we can see is that the dividend income for a TLS shareholder has in fact fallen from -47.54% over the last 10 years. In essence, what that means is that the income received on the investment has fallen from $866.88 to $495.36 on an annual basis..

Looking at the NAB and the figures don’t fare much better. Over 10 years the NAB dividend per share decreased -24.62% in total, meaning that an investor receiving $631.08 10 years ago, would now be receiving $475.73 on an annual basis..

Let us now compare these figures with those of FPH. FPH dividend income on the same $10,000 investment has risen substantially over the same period from only $393.94 to approximately $1,130.22 today on an annual basis.

What is most noteworthy is that the income an investor receives today on an FPH investment made 10 years ago, would be greater than the income that the same investor would be receiving on the equivalent investment made in TLS or NAB.

That is to say, the Dividend Yield on an Initial $10,000 Investment (or effective yield) in FPH of 11.30% compares favourably with the 4.95% yield on TLS and 4.76% yield on NAB. 

Dividend and Growth: Enjoying the best of Both Worlds

The purpose of this article is to highlight is that despite TLS and NAB having substantially superior dividend yield or ‘headline yield’ over the years, a sound investment decision made several years ago can ensure that an investor can reap both greater income and capital gains despite markedly different dividend yields. In effect this enables the investor to enjoy the best of both worlds by receiving superior capital growth and growing income over the medium to long term.

Earlier I asked the question, “Should we be chasing dividend yields, or quality businesses?” Based on the above example there is a strong argument investors should focus on investing in quality businesses that are delivering strong growth in earnings, cashflows and subsequently dividends per share, rather than just one-dimensionally pursuing dividend yields

At Medallion we choose to follow the simple approach of identifying sectors of the economy that are booming, before going a step further and selecting established businesses within those sectors that are financially sound. We believe quality businesses in growing sectors have a better probability of delivering reliable revenue, earnings, & dividend income growth over time. From that point forward both capital growth and dividend incomes tend to look after themselves.

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