Where to find sustainable income and 2 traps to avoid

Throw your double-shot coffee in the trash and turn those eyes to some news sure to jolt you awake on your Monday morning. Dividend payments are back, baby, or slightly more sustainable dividends at that. 

And with research from UBS finding dividends and franking credits accounted for 87% of returns from the ASX200 over the past decade, it couldn't have come any sooner.

Income investors suffered a bashing in 2020, with COVID-19 slashing any semblance of yield from the once-trusty banks and now grounded travel stocks. While a one-off special dividend may have boosted spirits, investors have been left high and dry, hungry for a more sustainable source of yield. 

Well, there is no better time than the present. In this episode of Buy Hold Sell, Michael O'Neill from Investors Mutual and Peter Gardner from Plato Investment Management take you through their favourite sustainable sources of income in 2021, as well as two alluring yield dividend traps to avoid as if your life depended upon it.  

Enjoy.

Note: Watch, read or listen to the discussion below. This episode was filmed on 3 February 2021.

Edited Transcript

James Marlay: Welcome to this thematic discussion brought to you by Livewire Markets. My name's James Marlay, and today, we are talking income and specifically income from dividends and if we can find it, some fully franked ones. I'm joined by two gentlemen that know all about income and dividends, Dr Peter Gardner from Plato Investment Management and Michael O'Neill from Investors Mutual.

Michael O'Neill: Dr Michael O'Neill.

James Marlay: Are you doctor as well? There we go, two doctors, so we're in good hands. Dividends have been an important source of income over the past decade. More than 80% of the return from the market has come from dividends, but in 2020, there were a few wobbles. We had deferments. We had industries under pressure, and the outlook moving forward is for a slightly more subdued return from dividends. We're going to need the two doctors to help us find out and sniff out a few specials. Michael, we'll start with you. One word to describe the outlook for income in 2021. What is it?

Michael O'Neill: Compelling.

James Marlay: Okay. Same question for you, Pete. One word?

Peter Gardner: Improving, for me.

James Marlay: Okay, so we've got two bulls. Pete, we'll start with you. Let's talk about that improving outlook. Give us a few stats, convince us why the outlook is improving.

Peter Gardner: If we break the market down into a few different areas, there are some stocks that have big cuts in dividends in 2020, and most of them are still in the doldrums in 2021. Unfortunately, those kind of COVID related trends have continued, such as the travel stocks. We've had other stocks that have done really well out of COVID, such as the retailers and the iron ore miners and the tailwinds are still behind them. We're expecting strong dividends from them in 2021 as well, and potentially even increasing. 

The real swing factor for us, and the reason I said improving, was because of the banks. We expect the banks' payout ratios were maintained at 50% given APRA rules, but now that's been taken off. We expect the payout ratios to go back up to 70% and so expect improvement there. In the longer term, potentially as things return to normal, you'll see some of those stocks in the doldrums coming back, but not for the short term.

James Marlay: Okay. Compelling. It's a bit more bullish than improving. Why is the dividend outlook so compelling?

Michael O'Neill: Well, if I can just take one component of the market Peter's not described, which is the non-bank industrial sector, the defensive part of the market that's been left behind. I think as well as the sectors Peter's pointed to, this is the really exciting hunting ground for yield investors. You don't have to chase some of the cyclical sectors or the sectors that have benefited from COVID to get an improving yield. 

Fair to say a lot of industrial companies have been conservative in the past year, holding back capital in some cases, raising capital and their yields are quite compelling when you compare them to fixed interest, cash and property. If you can take these as a building block, perhaps get some diversification in income through shares, whether it's through franking and also simple option strategies, defensive equities do prove to be quite a compelling proposition for investors.

James Marlay: Okay. We heard about it from Peter. It's hard to have a conversation about dividends without talking about the banks. I think I've seen some research from Plato, which found that at one stage, nearly 50% of the income from the market was coming from the banks. Of course, that got put on hold last year. Is that an obvious source of income in 2021? What do you expect from the banks?

Michael O'Neill: Well, look, we do expect improving yields from the banks. And I think it's fair to say yields are improving faster than we would have expected both because strong, unprecedented stimulus measures and also deferral measures have largely worked. The federal books of the banks are shrinking rapidly. We've seen bad debts in the second half reduce. We've seen the outlet for house prices be buoyed by the stimulus measures and dividend restrictions are being taken off. 

Now the yields do look tempting. However, we do caution investors from overconcentrating in bank shares. Their returns are structurally challenged, both by the record low cash rates we have, but also the fact that the majors are losing share in mortgages. Our focus is on generating income with a better risk-return outcome from the non-bank industrial sector.

James Marlay: So some of those pressures that were there pre-COVID remain for the banks. All right, Peter, you were pretty upbeat; you thought there was a bit of an opportunity in the banks. Can I get you to be a bit more specific? Is there going to be catch-up on the dividends that were deferred? What sort of yields are you expecting to get out of there? Have you got one that you prefer over the other?

Peter Gardner: Yeah. We're not expecting catch-up initially. We definitely agree with Michael that in terms of the banks, they're still kind of under a fair bit of pressure at the moment. But in saying that, their capital ratios are extremely high, well above unquestionably strong. We don't think it will happen initially; if you look at an APRA statement, they still say banks need to be conservative. But potentially after job keeper ends, if things don't go too bad after that, if we don't see a lot of bad debts or businesses going broke at that time, then we expect the banks to increase their payout ratios. Potentially, you could even see a few banks do some capital returns in the form of off-market buybacks. That's definitely the potential. Some of them like CBA were announcing they were going to do one before COVID and that obviously got put on ice. Potentially as things stabilise, then they could do that again.

James Marlay: Okay. Did you have a preference or are they kind of all the same?

Peter Gardner: There is a slight preference for CBA at the moment. It's a bit more defensive and it's got a bit more capital that it can return to investors, but they are fairly similar in the current market.

James Marlay: So if we wind back the clock to 2020 March rolls through everyone kind of takes a deep breath. We don't know how it's going to play out, but there were definitely some surprise winners. The resource companies had a stellar year, commodity prices, record highs. You've got Fortescue Metals spewing out cash. Some of the retailers did really, really well. I guess if you've talked about some of those slightly surprising alternatives or non-traditional sources of income, the question is, is it sustainable? Do the tailwinds that have fanned their dividend payouts continue over the year ahead?

Peter Gardner: We think they will continue over the year ahead. So the tailwinds are still there. Retail sales are up 20% for most of those stocks or more from what they were at this time last year. It's very strong right now for the retailers. The iron ore price is obviously up around US$150 which is very strong at the moment. We think the tailwinds are there, but obviously, in the medium to long term, we're not expecting retail sales to stay at where they are. As people start spending again on travel and on services, then we expect retail sales to come back down. 

We expect the iron ore price to gradually come back down as well. But as with most things in life, they take longer than you expect. We think that's the case with cycles as well. We think this cycle still has a fair way to play out and we're expecting high dividends from those companies for sure.

James Marlay: Okay. Same question for you, Michael. A few surprising winners from 2020, you've called out those defensive industrials. What else caught your eye as being a surprising source of income that people could turn their eye to?

Michael O'Neill: When it comes to opportunities in the income space, our focus is very much on those companies with sustainable dividends based on recurring cash flows, who don't overpay against their long-term earnings prospects. So opportunities and winners for us in 2020, I'll give you two examples. Metcash and also Nine Entertainment. 

In Metcash's case, strong performance across all three divisions, supermarkets, liquor, and hardware. It's fair to say I don't think the local shop is going away anytime soon. It's not a COVID phenomenon. Their earnings are sustainable. They're reinvesting back into the stores. 

In the case of Nine, that presented an opportunity because the stock sold off strongly against what was a fallen ad budget at the start of COVID for traditional media, such as free-to-air. But in the meantime, COVID has accelerated that trend towards digital, whether it's Nine's Stan or Nine Now, and also their online newspapers. Digital is becoming a growing proportion of their recurring revenues and also if you add in the stake in Domain, it's the vast majority of their valuation. That's another sustainable opportunity that we benefited from.

James Marlay: So a change in quality in the business? Sustainability is a word we've touched on a few times there, and that's what everyone wants in dividends. Was there a company you could call out or a particular part of the market that just really surprised you or impressed you with how sustainable and resilient it was last year?

Michael O'Neill: If you're looking for impressively resilient dividends AusNet is a great start. It pays over five and a half percent yield, underpinned by their essential energy infrastructure. Their returns are locked-in in five-year intervals with some smoothing with the energy regulator. They do get some growth in that distribution because over time we're seeing billions of dollars invested in renewables, which need to be connected into the grid. 

I guess another area of very resilient dividends is the supermarkets. We've gone from a period where we've had heightened competition, a lot of price deflation, and now we're coming into food inflation, improving margins and predictably growing earnings. Again, quite a resilient dividend stream.

James Marlay: Okay. Peter, same question for you. I mean, the Plato style is a bit more about harvesting. You're really looking to cherry-pick some of those dividends. But is there something that stood out as a company or a sector that still stood out as being impressively resilient last year?

Peter Gardner: For us, it was actually the iron ore miners, which would not be a normally resilient area. People think of them as cyclical stocks that should suffer during a downturn, but we've seen the opposite in the last two downturns, both in the GFC and in the global pandemic. Instead, what has happened is that China, the way that they get out of these global downturns, is that they increase their spending on infrastructure. Now, infrastructure requires steel, and that requires Australian iron ore at the moment and you actually saw the iron ore price during the GFC stay fairly resilient and will bounce back quite quickly. The same during this pandemic; it actually rose during this time and so we think they're surprisingly resilient dividends for cyclical companies. We think the market's kind of underappreciated that.

James Marlay: Okay, we've been talking like bulls about all the upside in dividends, let's go the other tact. What are some of the potholes? There are some big looking yields out there, there are double-digit yields on a few stocks, maybe help our readers understand some areas where you think it's maybe not so sustainable and they could be heading towards one of those fabled dividend traps.

Peter Gardner: Yeah. Well, the electricity market at the moment is very under pressure for us. If you look at wholesale electricity margins, they've come down very significantly during the pandemic. Afterwards, as people instal more and more solar panels on their roof, that's putting more and more pressure on the market. That's putting incredible pressure on AGL and to a lesser extent, Origin Energy. AGL is a big dividend trap for us. We actually think that they've got enough cashflow in the business, their balance sheet is quite strong, so it's not that that will drive a dividend cut. But we think as earnings start dropping management will have no choice but to cut their dividends. So that's the one we're highlighting.

James Marlay: Michael, same question to you, something out there where the yield doesn't look sustainable and you're a bit concerned about it.

Michael O'Neill: Well, I have to agree with Peter on AGL. For me, front of mind is Dexus. Dexus is paying over five and a half percent yield, which is attractive, but the trick is they're paying out a hundred percent of earnings if you include maintenance, CapEx, and also lease incentives. This is at a time when CBD rents are at record highs. If you walk around Sydney, you'll see plenty of construction sites. 

A lot of supply will come in over the next two years and big corporates like Telstra and ANZ have said they're going to move the majority of their workforce to flexible arrangements, maybe two to three days in the office a week. Now on our numbers, a 1% change in vacancy rates can translate to a 6% fall in net effective rents. The problem is, and where the trap might lie, is that the dividends are leveraged to any increase in office vacancies.

James Marlay: Well, there you have it. According to our two doctors, if you've gone a little bit cold on dividends in 2020, things should be looking a bit better and you'll be feeling good soon in 2021.

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