Buy Hold Sell: How to maximise your income on the ASX

Ally Selby: Hello and welcome to Livewire's Buy Hold Sell. I'm Ally Selby, and today it's all about income. You are going to be learning how to make your money work harder for you on the ASX. And to do that, we're joined by Reece Birtles from Martin Currie and Michael Price from Ausbil. Reece, I'm going to start with you today. We've just come out of reporting season. It was quite mixed. What trends emerged in terms of income?

Income Trends

Reece Birtles: So the big thing would be that the payout ratio on the Australian market has fallen. Pre-Covid, it was about 62%. The typical payout ratio today is about 53%. So companies are conserving more cash. They're not paying out as much in dividends. They're also being conservative in terms of their debt ratios. You did have a few good companies in terms of paying special dividends and buybacks. JB Hi-Fi (ASX: JBH), Super Retail Group (ASX: SUL), Lottery Corporation (ASX: TLC) and Brambles (ASX: BXB) did a buyback and then CBA lifted the payout ratio. So there are some good examples of companies returning capital to shareholders, but there's also a general conservatism going on.

Ally Selby: Okay. Are there any other trends you want to point out, Michael?

Michael Price: It was a bit of a disappointing reporting season. The commodity prices in particular meant that the dividends on the resource companies went backwards. So dividends for the market overall did go backwards. Interestingly, because the price went up over the reporting period, the dividend yield dropped further. So the dividend yield when we look forward is probably as low as it has been for quite some time. And yeah, definitely special dividends are interesting. They've replaced the old off-market buybacks, and companies are using them to get rid of any excess franking credits they might have.

Sustainable Yield

Ally Selby: Okay. It's easy for investors to be mesmerised by high yields. Why can that sometimes be a trap? And in your view, what is a sustainable dividend yield?

Michael Price: A high dividend yield normally means there's very low growth for the company. It can also mean the company is distressed or highly geared. That means it's often particularly risky as well. So, there are probably a few reasons to avoid. Once the dividend yield gets above, say 8%, we see that as a bit of a red flag.

Ally Selby: Okay. Over to you, Reece.

Reece Birtles: Yeah, I'd probably agree - 8% is probably a cut-off where you'd really have to start questioning the sustainability of the dividend. It may be a company with cyclically high earnings on commodity prices, or it might be a signal of distress or a pending equity issue. The dividend yield alone is not the signal, but it's probably something to watch out for.

Ally Selby: Is there ever a case where there's a dividend yield of perhaps 20% where it may be attractive?

Reece Birtles: Probably not. I would've said if it's a 20%, the market's just not believing that that dividend is sustainable in any way. So it could be that it's leveraged to a commodity price that could fall 50 or 80%, could be that they're in denial that they need to do an equity raising.

Factors for Income Stocks

Ally Selby: I want to get into your investment process now. What are some of the factors that are important to you when identifying the income stocks that make their way into your portfolio?

Reece Birtles: For us, the most important things is what we call a sustainable dividend. So we look at a level of dividend per share that a company can pay eight years out of 10. So that's with below average commodity prices, below average economic conditions, not using debt to pay the dividend. It's considering the moat of the business and the defensive characteristics it has against threats. So we are really looking for that sustainable dividend that a company can maintain, and that's the most important thing.

And when it comes to portfolios, we'd really think diversity is what matters in terms of income. You don't want your concentration from one source. You may have some companies that are paying lower dividends that you expect to grow. You might have some higher dividends that you're looking more to flatline, but it's really about getting that right portfolio mix.

Ally Selby: Okay, Michael, over to you. What factors are important in your process?

Michael Price: Well, for us, the first thing we start with is total return. No stock gets into the portfolio just on the back of the dividend income. But once we're satisfied with the total return, we include the stocks in the portfolio that have higher dividend yields or also if they've got an upcoming dividend. What we're trying to look for is maybe the total of the dividend yield plus earnings growth over the next year to be at least 10% and a little bit of valuation upside as well.

So if we construct a portfolio with a range of stocks on that basis, we should be able to get a decent total return and actually get a better outcome from the total portfolio than we can get from any one individual stock.

Portfolio Turnover

Ally Selby: Okay. How often do you turn over the portfolio and is that important when it comes to income?

Michael Price: Well, because of that process, we do turn over some of the portfolio quite a bit. Most of the companies we hold, we're happy to hold for the long term, but we change the weights based on when the upcoming dividends are coming through. So we're aiming to get 50% more dividends than the market, and we actually mean more dividends than the market rather than higher dividends. So what we do is we start up with a portfolio we're quite happy with, and when we see upcoming dividends, we change the weights in our securities in order to capture those dividends and that way we can achieve a good total return and also 50% more dividends than the market.

Ally Selby: How often are you turning over your portfolio?

Reece Birtles: We are probably a low turnover strategy. We tend to be more 20-25% per annum turnover. We're really looking to buy companies that have a solid income and are going to grow that income per share over time on the back of their profit growth and sustainability of their business model, because we're really looking to have a high and growing dollar income stream for a retiree. So for us, it's less about trading. We really don't want to turn capital into income. We want a genuine income stream that is part of a good total return.

Franking, Frankly

Ally Selby: What is franking? Why is it important and does that impact your final decision when investing in a company?

Reece Birtles: For sure. For us, it's critical. We build our income funds for 0% taxpayers. So a franking credit is when an Australian company has paid tax, and in order for the end investor not to have double taxation, they get a tax credit for the tax the company's already paid. So it can be very important. On a 5% dividend yield, you might get an extra 2% yield from the franking credit. For a 0% taxpayer that is a free lunch. There's not many free lunches in finance, but it is certainly one of them because the market may value the first dividend at about a 10% tax rate on average, but it ignores all the future dividend stream. And when you gross that up over time, a fully franked dividend company is worth 20% more to a 0% taxpayer than one that is not paying franking credits.

Ally Selby: How important is franking when you're deciding whether or not a stock makes its way into your portfolio?

Michael Price: It's also very important for us. We're also designed for the 0% taxpayer, although one thing about franking credits is that a dollar of franking credit is worth the same as a dollar of cash to all Australian investors, because that's not really fully appreciated, I don't think that's valued correctly by the market, as Reece said. So yeah, we definitely are looking for franking credits, and in fact, we might even prefer it to a dollar of cash because we think it's undervalued by the market.

Ally Selby: What do you mean by all taxpayers?

Michael Price: So, as Reece said, the franking credit is pre-payment of tax, and that applies to all taxpayers, whether you're on the highest tax rate or a retiree. As long as you're not an offshore investor, you're able to get the value of the franking credit back from your tax. So if you are on the top rate, you've still got to pay some more tax on top of the franking credit. If you're a retiree, you get the full amount back in the form of cash, but everybody does get some benefit from the franking credit.

Top Income Stock for the Year Ahead

Ally Selby: Okay. Last question for today. What's your top income stock for the next 12 months?

Origin Energy (ASX: ORG)

Michael Price: For us, it's Origin Energy. It pays a 6% fully franked dividend yield or pretty close to that right now, which is a good start. It's got three parts to the business, and all of them we think are reasonably attractive. So the gas business is doing well. We think gas is going to be an important transition fuel. Their electricity business, a bit disappointing on costs at the last result, but we think the cost will come back next year - probably more than the market expects - which is going to be good. They also will benefit from volatility in electricity markets, which we think might take place. And they also have a software business, which has got some really good long-term growth prospects, and we don't think it's really valued very well by the market. So good yield already and good growth prospects from across the business.

Ally Selby: Okay. Over to you, Reece. What's your top income stock for the next 12 months?

Medibank Private (ASX: MPL)

Reece Birtles: Ours is Medibank. The dividend yield is about 5% fully franked. It's the type of company where it's earning a 24% return on equity. It's a very strong market position. It's doing a lot for consumers and society in terms of lowering the cost of healthcare. It's growing, its customer numbers in its business. Market perceptions are that it's probably growing about 5% per annum. I's actually been growing more like 10% per annum, given their investments in medical services and healthcare solutions on top of the standard insurance business. So we think it's a type of company that can pay that dividend and grow it over time, without being an economic cyclical. So it's a real reliable dividend payer.

Ally Selby: Well, I hope you enjoyed that episode of Buy Hold Sell as much as I did. If you did, why not give it a like? Remember to subscribe to our YouTube and podcast channels. We're adding so much great content just like this every single week.