How to fire up the dividend machine
Dr Don Hamson, Plato Investment Management
Based on Plato's analysis, 2020 was the worst year for dividends in Australia over the past forty years, with the 35% cut in dividends surpassing the falls seen over three years in the recession we had to have and the GFC.
For investors holding just bank shares, the outcome was even worse, with big four bank dividends falling roughly 60% in calendar 2020. Self-funded retirees also took a huge hit on their interest income, with term deposit rates plunging to near zero.
But that was last year. We faced nationwide lockdowns, no one knew how bad things may get, many assumed the worse, the Reserve Bank of Australia slashed rates to an all-time low of 0.1%, APRA initially discouraged banks from paying any dividends at all, and the Federal Government literally threw money at COVID with its Jobkeeper and Jobseeker payments. As we have seen, Australia's island quarantine strategy has proved relatively successful, in fact very successful on a global context. Our economy has bounced back quicker than anyone thought, and our GDP has now surpassed its pre-COVID levels. For most companies, too, the outlook is bright, apart from those still directly affected by international travel bans and local lockdowns. On our analysis, 2021 has emerged as very strong year for dividend income and with the August reporting season ahead we expect the good news for dividend investors to continue into the remainder of the year.
The picture for income from ASX-listed equities is stark when compared to other asset classes. Below we've charted the real earnings on $1,000,000 from the overnight cash rate, 1-year term deposits and 10-year bond yields. These so-called safe assets are producing negative real rates of return.
So, in a world where real returns on cash-backed assets are in the red, and will likely remain there for the foreseeable future, how can investors ensure they don't miss out on a piece of the dividend pie?
The dividend outlook looks good
We model expected dividends for S&P/ASX300 companies and our expectations for future dividends is looking very bright. We also forecast the likelihood of companies potentially cutting their future dividends. This helps us avoid dividend traps, which we think is key for income investors.
We can use our dividend cut model to get a picture of the market as a whole, by calculating the average probability of a dividend cut across all stocks. The following chart shows how the probability has varied over time. The GFC in 2008/9 and the COVID pandemic in 2020 are very clear to see. The global pandemic set a new high for market wide probability of dividend cuts, but what is very interesting is how quickly the cut probability has fallen from its peak in April 2020 to a below average level. This underpins our positive outlook for dividends in 2021.
Source: Plato Global Dividend Cut Model
Diversify, but don't set and forget
We manage the portfolio of our Listed Investment Company, the Plato Income Maximiser (ASX:PL8), with the aim of paying monthly dividends and delivering investors above-market levels of income annually. It may come as a surprise that the majority of our top yielding holdings aren't what many consider to be Australia's traditional dividend-paying stocks.
Consider the miners. 3 of the top 6 dividend payers in Australia today are mining companies - Fortescue Metals (ASX: FMG), Rio Tinto (ASX: RIO) and BHP (ASX: BHP). For many investors this would have been inconceivable just a few years ago.
We've held a very positive view on the sector for a number of years, comfortable with the global supply/demand equation for iron ore. Over the past three years, FMG, RIO and BHP alone have delivered our portfolio 3.4% p.a. gross income.
The question we now face is how long will the mining stock dividend boom continue?
We still maintain a positive outlook on mining stock dividends for the foreseeable future. Our experience in active equity management has taught us things always take longer to play out than markets would indicate.
Samarco (the massive Brazilian Iron Ore miner owned by BHP and Vale) is only just coming back to full production five years after a devastating dam disaster. We often see miners forecast swift production resumption after major issues, but the reality is it usually takes longer. The COVID situation in Brazil is also another impediment.
Even when this Brazilian supply comes back on, steel production is on the rise with historical levels of infrastructure stimulus leaving the supply and demand fundamentals intact. Should Iron Ore prices for come off $100-$150 per tonne from the current highs, Fortescue, Rio Tinto and BHP will still be very profitable businesses.
Mining stocks do go through cycles, and this fact shouldn't be ignored. It's why a 'set and forget' approach isn't optimal for dividend investing. We like miners for the short-medium term, but our view is likely to evolve in the future as conditions change.
The same applies to retailers- again not a traditional area for dividends in the eyes of income investors - however it's a sector that has produced exceptional income in recent times for investors who have actively added the right names to their portfolios.
In the consumer discretionary space in particular, leading retailers including JB Hi-Fi (ASX: JBH), Super Retail (ASX: SUL) and Harvey Norman (HVN) have been thriving and delivering income far superior than most other asset classes.
These consumer discretionary businesses (and others) experienced a COVID-19 sugar-hit has consumers stocked up on products needed for working from home and increased domestic tourism, and we expect this to continue until borders are opened.
So, like the miners, as active managers we must consider if this will continue into the short-medium term.
It remains to be seen when full-scale international travel will resume. Australians love to travel and spend a lot of money abroad. A large chunk of that money is likely to continue flowing into domestic discretionary spending. There was evidence of this recently.
When it comes to the big 4 banks, they've traditionally been a major focus for income investors but in 2020 the outlook appeared dire as dividends were slashed across the board amongst the financials.
There has, however, been a remarkable turnaround, for three reasons. First, APRA have taken off all restrictions on bank and financial institution dividends in late 2020. Second, bad debts have proven much lower than expected, and finally, banks are seeing good loan growth fuelled by low interest rates.
In May we saw half-year results from Westpac (ASX: WBC), ANZ (ASX: ANZ) and National Australian Bank (ASX: NAB).
Across the board, there has been a significant write-back of provisions and strong increases in cash earnings, resulting from improving economic conditions.
Outside of the big 4, dividend strength is also evident. Bendigo and Adelaide Bank's half-year result earlier this year came in at almost 30% above expectations, Macquarie's FY21 net profit revealed in May, was up 10% on FY20.
While bank dividends aren't fully back to pre-COVID levels we believe the outlook is very positive for the sector and think Financial are once again an important element of a diverse equity income portfolio.
Individual dividend investors who set and forget can see their income plunge when the typical dividend stocks go through tough patches - such as the banks during the royal commission or the peak of the COVID crisis.
On the flip-side we're able to take a dynamic approach to generating high yield, moving around the market at any point in time to find the strong dividends and capital returns.
Dividend income to make ends meet
In our low-rate world, effective dividend investing has been a shining light for income-seeking investors. With Australia seemingly through the worst of the COVID-19 crisis the outlook for dividends is on the improve.
Looking forward to the remainder of 2021 and into 2022, we think there's a positive outlook for dividends, particularly from ASX iron ore miners, select consumer discretionary and the banks.
Diversification, active management, and tax-effective investing can help fire up the dividend machine and ensure investors, who rely on their capital for income, don't miss out.
Dr Don Hamson is the managing director of Plato Investment Management - a Sydney-based fund manager dedicated to maximising income for retirees, SMSFs and other low-tax investors.
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