Why yield is vital when share prices fall

BRW, September 2008

The fall in stock market prices, while miserable, has a more edifying side-effect: yields are going up. A stock’s yield – what it pays out in dividends, relative to the cost of owning the stock – is sometimes overlooked as an investment consideration, but it’s never more important than in a market like this.

According to Craig James, chief equities economist at Commsec, the Australian stock market today is paying its highest yield for 17 years (see chart). Many blue chip stocks are paying as much as 6 or 7% in dividends – the banks in particular are offering a generous payout. And in a choppy environment, the dividend provides more predictable income than the prospect of share price growth. “Cheap stocks plus companies maintaining dividends creates a powerful combination,” says James.

Australia is one of the most high-yielding major stock markets in the world. Stocks in places like Japan and Hong Kong in particular generally pay a much lower yield, and consequently the dividend is considered an afterthought in investment decisions in those markets. In Australia, canny investors have long considered the dividend to be a key part – perhaps the most important – in deciding whether to buy a stock.

“When you’re looking at total return on investment, and particularly in flat or down markets, the contribution from your dividends can be quite meaningful,” says Mark Robertson, portfolio manager for international equities at ING Investment Management, whose products include the ING Global High Dividend fund. “If you look at the long run history of the US equity market as an example you’re talking about an 8% annualised return over the last 200 years of data. 5% of that has come from the dividends. And in declining markets, we see that stocks paying dividends outperform those that don’t by about 10% per annum.”

But it’s not as simple as looking at a stock’s yield and deciding to buy in purely on the basis of that. “If you pick stocks that pay a good dividend, it’s got to be a sustainable dividend,” says Roy Chen at Global Value Investors in Sydney. “It’s no good having a stock with a 10% yield this year that drops to nothing next year because of some problem.”

A high yield at any given moment doesn’t necessarily mean an excellent buy. After all, one thing a very high yield often indicates is that the share price has collapsed, and it’s important to ask why. “Highly leveraged companies can have very high dividend yields, but sometimes they end up paying their dividend from borrowings,” Chen says.

Professional investors ask a number of questions about dividends: where do they come from? Are they paid from earnings or from other sources? How long have they been going for? How strong is a company’s coverage of that dividend and how likely is it that it can keep paying it in tougher times? In GVI’s case, for example, of the65 stocks in the portfolio, about one third of them much have either net cash, or interest cover of at least 30 times. “To be able to have confidence that they will be able to pay the dividend, the key thing we look for is free cash flow generation.” GVI’s portfolio has a roughly 4.5% yield.

Different sectors of the market have reacted in different ways, but one that is attracting increasing attention is the Australian listed property trust sector, which these days is referred to as the A-REIT market. Few areas of the Australian stock market have been hit as badly as this one: the trouble that the Centro, Allco and Rubicon groups have got themselves into have been part of the problem, as have broader falls in the overall market, concerns about gearing, and worries about the outlook for property in Australia.

Even at the best of times LPTs have always paid a good yield – traditionally it was the whole point of buying them, rather than for the prospects of capital growth – but in this environment the yields really have shot up. Stephen Hiscock at the property specialist fund managers SG Hiscock & Co says the forecast yield for the A-REIT market in 2009 is above 9%. If the behemoth stock Westfield is excluded, it’s 11%.

Hiscock says: “We are expecting further distribution cuts, but these will still leave the sector yield at extremely attractive levels, and importantly the yield will then be paid predominantly from underlying cashflow – a step which is necessary in order that confidence about the long term health of the sector is restored.”

The sector really has been a bloodbath. “It’s been incredible really,” says Andrew Saunders, CEO of Real Estate Capital Partners, a Sydney-based real estate fund manager. “The A-REIT sector was worth about A$145 billion in June [2007]. Now it stands at $70 to $75 billion.” The falls have created quite a divergence in yields: Westfield, which still trades at a premium to its net tangible assets (NTA), yields only 6.7%, but many trusts yield two or three times that. Saunders’s active A-REIT portfolio is yielding around 14%. “If you look at the pure A-REITs, the real rent collectors, they are trading at a 45% discount to NTA. That’s just incredible: they have real, hard, physical assets.” An example is Westpac Office Trust, which owns the Westpac head office on Sydney’s Kent Street. “Westpac can clearly afford to pay their bills,” Saunders say. “Yet it’s paying a 9.5% yield and trading at a more than 50% discount to NTA.”

Different managers find appeal in different sectors. Chen at GVI, looking globally, has favoured utilities and telecoms. Even some airlines are appearing in conservative portfolios: Singapore Airlines is yielding 6%, and GVI also holds several listed airports, including Frankfurt and Vienna. Robertson at ING says the high dividend fund also holds utilities and telcos, but is underweight financials, mining and industrials.

Another consequence of rising yields is increasing interest in structures that are built around the dividend.  Craig Keary at Westpac Institutional Bank notes an increase in self-funding instalment warrants, in which the investor buys a stock in more than one instalment but gets the benefits of the full dividend from the time of the first investment. Margin lending, too, is growing in popularity again as high dividends all but offset the cost of borrowing. “For customers looking at blue chip portfolios, investing for a long time, the after-tax costs are pretty good.” Setting the dividend off against the interest cost brings the after-tax cost down to a few per cent. One lesson of the credit crunch has been that gearing has its risks, but Keary says people are taking a conservative approach with careful diversification among leading blue chips.

BOX: DIVIDENDS AND TAX

Since 1987, Australia has allowed an approach called dividend imputation. This is like getting money tax-free: if companies pay dividends from earnings upon which they’ve already paid tax, then you don’t have to pay further tax on them. (There is a caveat, but we’ll get to that.)

The reason for this unlikely largesse from the government was that previously, profits paid by companies to shareholders as dividends were often taxed twice: once when the company paid tax on its profits, and again when the shareholders were taxed on the income they got from the dividends that came out of that profit.

An important term to understand is franking. Dividends may be fully franked, partially franked, or unfranked. Franking refers to a tax credit on the dividend – that is, tax that has already been paid.

A fully franked dividend is one where tax has already been paid on all of it, at the corporate tax rate of 30%. In some cases, only part of the dividend may be franked (an example would be if the company has enjoyed a big tax deduction, such as a previous loss). And some have no tax credit at all. On the unfranked parts, shareholders pay tax as usual. Any company sending you a dividend should spell out how much is franked or unfranked.

The impact dividend imputation has on you depends on your own tax rate. If you are a high earner and your marginal tax rate is higher than the 30% company tax rate, you will still have to pay some tax even on franked dividends – but only to make up the difference between your rate and the company rate. If your tax rate is lower than the company rate, you get an even better outcome: no tax paid on the dividend, and some credit left over to set against the tax bill on your other income.