It's a trap! How to avoid this common investing mistake

To be a successful equity investor, there are a few very simple tenets to follow if you want to get a head-start – and these include avoiding underperformers and not getting sucked into yield traps, Plato Investment Management managing director, Dr Don Hamson, said in a recent presentation.

Hamson also had some further sage advice for the investing audience, especially as it pertained to freeing themselves of the shackles of home bias and venturing forth into the wider world in search of income, pointing out that global dividends rose by 13 per cent over 2018.

This compared to Australia, which only grew dividends by 8 per cent – or about 5 per cent less than the global average.

So, what has held Australia back?

Firstly, Hamson said Australia's problem is that it is a market dominated by the big banks and Telstra, and that the biggest six stocks which used to represent more than half the dividend payments now represent slightly less than half of the income of the Australian marketplace.

It is this concentration that has caused problems for those in search of income over the past couple of years.

Telstra's ordinary dividend is now 68 per cent lower than it was two years ago, and Hamson said while the telco's total dividends don't look as bad if you include the special dividend resulting from compensation payments from the NBN rollout, these payments won't be around forever, and the special dividend will soon cease.

"I think in a couple of years' time the ordinary dividend of Telstra will be 68 per cent or even lower than what it was two years ago – and there'll be no special. And Telstra will have cut its dividends by about 70 per cent," Hamson said.

"So, I don't think it's too much hope there."

Moving on to the big banks, it's not a surprise that they have been "doing it pretty tough" in a post Royal Commission Australia, and while they may not have cut their dividends, they simply haven't raised them.

Therefore, the stocks representing nearly half the Aussie market haven't increased their dividends.

It's a wide, wide world

But all hope is not lost, as Hamson pointed out, given that the rest of the globe paints a very different picture when it comes to dividend payments. When looking at the MSCI World ex-Australia index, that massive concentration one observes in Australia is palpably lacking.

"They're not all banks – there's only one bank. There's actually two IT stocks, Apple and Microsoft. They don't pay huge dividends, but there's such huge companies that their dividends still get in the top six," he said.

"And you've got AT&T and Verizon … they don't have NBN problems … So, it's chalk and cheese when you compare them, and global dividends are growing very strongly, particularly in Australian dollar terms."

Hamson also pointed out the sheer number of dividend-paying companies available in the global universe to Australia, which he said, in reality, only has "about 200 decent dividend payers".

"We track about 6,000 stocks globally, and in some months like March, about 2000 stocks go ex-dividend. There's a huge choice compared to the number that we have in the opportunity set here in Australia," he said.

"So, there's plenty of dividends globally. A lot of them are low yielders, but if we look for income, which we do, we can actually deliver good income."

It's a trap!

Hamson also has no hesitation in professing his shop's love of buybacks, attributing some of Plato's recent outperformance to participation in the resources sector where BHP returned $7.3 billion to shareholders plus around $3 billion in franking on top of that.

"Rio did another one. There's a couple more on the horizon. Caltex have already announced one … That looks pretty juicy. And we expect Woolworths to do one as it sells its petrol assets," he said.

But while opportunities such as these are always on Plato's radar, Hamson said there is another way in which the manager makes money.

He calls it "winning by not losing". If you can avoid the underperformers, you've got a head-start in winning, he said. And the key to this approach is to avoid falling headlong into a yield trap.

Hamson used AMP to illustrate his point to the audience. "The trick about yield investing is to not always get sucked into the highest-yielding stock, because as AMP's share price fell over the course of the last 18 months, its yield on a historic basis – and we've grossed it up for franking because we don't just look at the cash yield … the gross yield actually went up."

"It went up from a fairly nice 8 per cent to where you could buy it a month or two back at a 15 per cent gross yield, which looks fantastic, doesn't it? Until it came out with its results and cut its dividend.

"And that is where you see that the yield rose until it fell, which is when AMP announced that it was going to cut its dividend and doesn't look nearly as great."

Hamson also held up department store retailer Myer as another cautionary tale of a yield trap: "There was a time early last year when … if you were a yield investor you could get at one stage about a 20 per cent gross yield."

"Now if you're looking for income, 20 per cent looks fantastic until, 'Bang,' – they cut their dividend and then they cut it again."

Hamson's message is crystal clear: If you're an income investor, you must have discipline to not get sucked into the dividend trap.

"Avoiding these stocks is pretty key and we have refined our process to try and avoid these. It seems, though, that some income managers and some simple passive strategies just say, 'Buy me the highest-yielding stock.'"

"And they're going to buy the AMPs, they're going to buy the Myers, until they cut their dividends and then they have to sell them at a loss."

Plato Investment Management is an Australian owned boutique equities fund manager specialising in maximising retirement income for pension phase investors and SMSFs. To find out more visit their website.