Investment Matters

Dividend reality

The Australian market is widely known for producing strong dividends, which are a significant component of the overall market return. This week, we dig a bit deeper.

Australia's high income return component (4.6% pre-franking benefits) compares to the US market, which doesn't have a franking/ imputation arrangement and provides a dividend return of 2.1% pa.

Without the Big-4 Banks

The following chart depicts the dividend return of the market (being in this case the ASX200) - as a whole, the Big-4 banks, and the market without the Big-4 and other financial companies. This difference might not seem that significant, but compounding it over time does make it meaningful.

Banks dividends

Note: to simplify the analysis, data in the graph is based on market cap and share prices as at 31-Dec-15, with dividends earned through CY-15 (i.e. paid ~Aug-15 and ~Feb-16). Although a slight simplification, the underlying thesis remains valid.

In conclusion, whilst the Australian market still provides a strong dividend return without the Big-4 banks - they do certainly bolster it.

Dividend outlook

The above analysis is based on historical data. From H1FY-16 (the second dividend payment included above), resource companies slashed their dividends. Therefore, we expect the Big-4 banks to provide a higher portion of the market dividend return in the short term.

In the medium term, as we have discussed in the past, we expect pressure to increase on bank dividends.  This is because of factors such as the increased capital requirements and the earnings' peak/ impairment's trough.

Thus, over the medium term, we would expect bank dividends (which currently make up 34% of dividends paid in the ASX 200 and 36.5% if including franking) to become a lower component of the overall market return (but still meaningful nevertheless).

The other component of investment return

We love the dividends that are generated by the companies in which we invest.  Dividends not only provide a tax-effective and meaningful component of the overall equity portfolio return, but they also provide opportunity to reinvest: taking the proceeds of the dividends and using them to increase existing investments, or buy new investments, thereby compounding future returns.

However, we have highlighted specific instances in the past where companies in which you are invested have ceased dividends, in order to invest the proceeds - usually into expansion of their operations (and sometimes into acquisitions).

Specific instances that come to mind are Energy Developments (for a period of time after Pacific Equity Partners became the major shareholder), and Tassal (when it was expanding its hatchery and other operations).

In the current target equity portfolio, Heemskirk is currently another non-dividend payer.  It is investing in a frac-sand plant, and when it is producing strong cash flows we expect the current patience of investors to be rewarded - including via dividends.

So low or no dividends are not always a bad thing. In fact it is good when a company is reinvesting in itself such that the long-term return from the investment will be greater than the dividend that would have otherwise been paid.

However, dividend hungry investors, and companies/ management driven by TSR bonuses (total shareholder return, including dividends) have resulted in concern that management and boards are not placing adequate emphasis on reinvesting in their own companies.  Dividends can come at the expense of reinvestment, thereby reducing growth prospects for the future.

For your Australian share portfolios we are comfortable that the companies you are invested in provide the right mix of dividend (income return) and reinvestment / capital growth opportunity (as measured by the average 3-year EPS forecast increase).

What about the bank quasi-equity...

...also known as hybrids.

As an aside - many investors buy hybrids, to provide diversification and reduce risk. But are their goals going to be achieved?

In relation to the former - the banks have issued a staggering two-thirds (67.2% to be exact) of all the hybrids trading on the ASX (weighted by issue size).

In relation to the latter - no. It actually compounds risk by increasing exposure to the Big-4 banks (assuming the investor owns banks shares, which majority of retail and industry super and retail super / managed funds do. This especially applies to any of the newer generation (post-GFC) hybrids, with conversion-to-equity-at-APRA-discretion clauses (APRA is Australia's financial regulator).

Back to the matter in hand: the yield to maturity of the Big-4 bank hybrids (weighted by issue size) is 5.8%. This compares to the hybrids not issued by the Big-4 banks, which provide an 8.6% yield to maturity.

The lower yield compared to the non-bank hybrids (and the underlying bank equity including franking), implies a lower risk. Most of the time the market get things right - perhaps not in this case!

Conclusion

Australia's market provides a high income/ dividend return to investors, driven (at least significantly) by the franking arrangements. Sometimes dividends come at the expense of future growth.  Dividends from the Big-4 banks bolster the market's overall dividend return.