Investing for yield
23 May 2016
By Shadforth Financial Group
Global interest rates are now near zero or negative in some cases. In this environment, investors, particularly retirees who are in need of income, have moved away from traditional fixed income towards using dividends from shares to provide income. Unfortunately, some investors may have started to assume that dividends always grow and are ‘guaranteed’ into the future and are pricing dividend paying shares as if they are bonds.
Ultimately, this is based on flawed assumptions, as dividends are not guaranteed but in fact completely discretionary. Furthermore, there is certainly risk to both the dividend and the dividend growth rates given the cyclicality of earnings.
Total return, not dividend yield
The expected dividend yield is the expected dividend for the year ahead divided by the current share price. The risk to investing in shares based on this yield is flawed on many levels, as both dividends and share prices change regularly. Using the dividend yield as a motivator for investing ignores the fact that the dividend yield is not a bond coupon payment where the payment is known and regular.
The other issue is that trying to put a capital value on a share price in three or five years’ time is exceptionally difficult, unlike a bond where the maturity date and final value are known. This means that investors are faced with the uncertainty of the dividend and the capital value, including the volatility experienced over the time period. Pricing shares solely based on their dividend yield is an extremely risky method of investing. It is imperative that investors take total return (that is, capital appreciation and dividends) into account when assessing shares and, more importantly, focus on the risk of capital loss.
Issues when considering stocks for dividends
There are also a number of issues to consider when reviewing shares from a dividend perspective – does a company have the cash flow, income and growth to justify both paying the dividend and growing this dividend in the future? If a company is borrowing to pay dividends or paying dividends from non-cash flow items there is a risk to both future dividends and the business itself. Quite simply, dividend increases at the very least need to be justified by growing earnings.
There seems to be a sense within Australia that companies do not change or reduce dividend payout ratios. Company management can also often view maintaining dividends paid as one of their primary objectives. However, this is a dangerous assumption as we have recently seen BHP Billiton cut their dividend and back away from their progressive dividend policy, while ANZ also cut their dividend. This highlights the fact that dividends are a discretionary payment and management make the best decisions in terms of utilisation of capital and in the best interests of the company to generate value creation for shareholders over the long term.
Are companies contributing to the dividend desire?
Companies have often been guilty of using dividends to satisfy investors’ desire for yield at the expense of the company and arguably not in the interests of shareholders. In reality, dividends should only be paid if the shareholder can get a better return on that capital relative to the company.
Before the global financial crisis, we regularly saw Real Estate Investment Trusts (REITs) acquire assets, revalue them higher and borrow against the inflated asset values to pay dividends. The REITs were guilty of paying dividends in excess of free cash flow. Furthermore, a few years ago Macquarie increased their dividend to satisfy investor demand. Arguably, if an investment bank is increasing the dividend payout ratio, it implies that they do not have a better use for the capital and that shareholders can achieve a greater return on capital than the investment bank. This was a clear case of Macquarie surrendering to demand for dividend yield as opposed to investing for future growth in the investment bank.
A further example to review is the Commonwealth Bank (CBA) chart below, which has been adjusted for dividends paid in August 2015 and February 2016, including the rights issue in August 2015. If we assume investors have a focus on dividend yield as opposed to capital at risk, then an investor who bought CBA at $85 in January 2015 would be receiving an annualised dividend yield of 4.9 per cent as opposed to the cash rate of 2 per cent. Approximately one and a half years later in May 2016, the investor has received the dividend yield but has also experienced a 9.5 per cent capital loss. The attractive dividend yield has become more attractive for a new investor but the original investor is now worse off from both a yield and capital perspective. In January 2015, CBA was trading at over three times book value and expensive. It may take a number of years before the investors’ dividends manage to recoup the capital value lost. This highlights the importance of thinking about total return and the capital value at risk – not just about the dividend yield.
Source: Bloombergs, IOOF Research