Investment Matters

Dividend delusion?

How sustainable are dividends in the current market?  

Dividends versus buybacks

Companies can provide their earnings to shareholders via dividends or share buybacks (or they can be retained).  Dividends are distributions of a company's net profit to shareholders.  A buyback is the purchase by the company of its own shares (usually from profit, but increasingly using debt in this low-interest-rate world).

Share buybacks reduce the number of outstanding shares that a company has on issue.  Remaining shareholders receive a higher proportion of future earnings and dividends. 

Australia's dividend imputation (franking) systems provides incentive for companies to provide returns via dividends.  Dividend imputation essentially means that the shareholder gets back the company tax already paid.

Australia's dividend payout ratio (the percentage of profit a company pays out to shareholders as dividends) has been steadily increasing post GFC, as shown in the following graph from the RBA.  The RBA report concludes that the banks and major miners were the primary driver of the increase in the average payout ratio.

(Source: RBA Report - The Rise in Dividend Payments by Michelle Bergmann, Bulletin March Quarter 2016, utilising Morningstar data.)

By comparison, other countries have a greater tendency to provide returns to shareholders via buybacks. The USA is a case in point, as is depicted in the graph below.  As a percentage of operating earnings, spending on buy-backs is now above 80%.  These buybacks have been boosting profit on a per share basis, during a time when revenue and profit growth has been benign.  And, on top of buy-backs, companies have also been paying out dividends.

Germany, Switzerland and Canada are also fans of buy-backs.   The extensive use of buybacks is, in some ways, surprising - given the elevated share prices of many companies (more on this below).

US share buy backs 2

Drivers of Australia's high payout ratio

Investment Matters has often referred to the 'chase for yield' being experienced in the current market, especially in the property sector and large-cap stocks.  In the current low-interest-rate-world, many investors have moved at least part of their investments from cash/term deposits to shares (and property securities), in order to earn a higher income.

Companies, in particular the largest ones, have been keen to meet that demand and their share prices have benefited, along with their TSR (Total Shareholder Return = dividends plus capital growth.  TSR often forms a part of the criteria for setting management and director bonuses).  Companies also fear a negative signal would be sent to the market if they cut dividends.

Returns vs future growth

A company needs to balance paying out earnings (i.e. profits) either as dividends (or by conducting a share buy-back) with retaining them to re-investment in the business.  Re-investment can take various forms - from buying new equipment,  purchasing new assets or upgrading assets, or even acquiring other businesses.  Such investment should contribute to growing the future earnings of the company.

Therefore, concern is often expressed that high payout ratios today will compromise future earnings growth, and thus are not in the longer term interest of shareholders.  

A recent Goldman Sachs report on this (Divided on Dividends, 27-Jul-16) contained an interesting analysis on this.  Simply, their analysis finds that companies are choosing high dividends over re-investment not just because of the demand for yield, but also because of the weak revenue environment and the spare capacity that exists in many industries. 

The average age of companies' fixed assets has increased quite significantly over the last five years, as companies utilise assets at a lower rate in the current lower sales growth environment. Capital expenditure is running lower than depreciation (after a period of high capital investment), and thus companies have higher free cash flow.  In the short to medium term dividends and buybacks may therefore not be as unsustainable as they first might appear. 

However, in the longer term, future growth prospects will still be harmed.

Banks

Australia's big-4 banks are of particular interest in relation to dividend sustainability.   This became particularly apparent when in FY-15 ANZ pre-paid FY-16 tax to ensure it had adequate franking credits to pay the FY-15 final dividend as fully-franked.

More recently, the big-4 are keeping their dividends pretty much constant in absolute dollar terms (thus the payout ratio is decreasing as earnings increase).  We expect this to continue as pressure on capital requirements further increases (BASEL IV).  And, as we have seen with the announcements from CBA and Westpac this week, bad debts and funding costs are moving in an adverse direction (though not in a substantial way).  If there is a more meaningful deterioration in these trends, or the BASEL IV reforms have a greater impact than expected, dividends could come under pressure - in absolute terms.

An aside: dividends and your portfolio

Each investment in your Australian equity portfolio is individually assessed.  Expected profit growth, valuation, as well as other quantitative and qualitative factors are considered.   We consider the sustainability of dividends, and the company's ability to grow them. 

The level of dividends is also assessed at portfolio level.  Some investments may provide a high dividend; some may be more capital growth oriented and have a low dividend or no dividend at all.   So we consider the overall dividend stream for the portfolio, with the aim of obtaining meaningful income - cash which we can reinvest for future growth. 

Additionally, because your investments are individually managed (rather than being in a managed fund for instance), franking benefits accrue in full to you.  This in an important post-tax component of your investment return.

Conclusion

Dividend payout ratios are at high levels in Australia - they certainly can't increase much from here, and they may come down for some companies.  Some companies are already adopting a constant absolute dividend (in $ terms) with the aim of bringing payout ratios down over time, without upsetting the market (banks are in this basket, along with some property trusts). 

However, in the short to medium term dividends may not be as unsustainable as they first appear given the low level of capital investment and high free cash flows that many companies are experiencing in the low sales growth world.