The Reserve Bank of Australia (RBA) has just slashed interest rates to a historic low of 0.10% and initiated $100 billion of quantitative easing, essentially ensuring low interest rates for the foreseeable future. Associated cash, term deposit and fixed interest investment products are not appealing.
In addition, the COVID-19 pandemic has resulted in Australian stockmarket (ASX 200) dividends to be cut 20% in calendar year 2020, with typical dividend-paying stocks like the banks down even more than this.
Despite this, we believe investors are currently being presented with a unique opportunity, one not seen for over a decade.
Dividends have rebased with upside potential as revenues and dividend payout ratio’s normalise over the coming years. Dividends are likely to recover quickly, with 2022 underlying dividends expected to be broadly in-line with 2019.
Consequently, the dividend yield on equities is very attractive, with dividend yields for 2021 and 2022 forecast to be 4% to 5%, compared to cash rates and fixed interest products below 1%. In addition, franking benefits are unique to the Australian market and provide a source of upside for domestic investors – particularly retirees.
Now more than ever, income-seeking investors need to look beyond any single asset class and specifically consider higher allocation to Australian equities with strategies focused on tax-advantaged, reliable and growing income generation.
WHAT IS THE IMPACT FROM THE COVID-19 PANDEMIC ON 2020 DIVIDENDS?
Since the beginning of the COVID-19 pandemic, 2020 calendar year dividend expectations for the ASX 200 have fallen from -$73 billion to -$58 billion, representing a decline of -20%. This is broadly the same level of dividends that were paid in 2013 (see Chart 1).
While partly driven by a ~20% fall in earnings, the reduction is also driven by a fall in payout ratio of Industrials to below 60%, as boards understandably exercise caution in the current uncertain environment.
WHAT IS THE OUTLOOK BEYOND 2020?
As earnings recover, dividend growth is projected to be around 15% in 2021, with a further +10% expected in 2022.
On a dollar income basis, we expect 2022 dividends will be back broadly in-line with 2019. Note, that this is on an underlying basis, ignoring special dividends that were elevated in 2019, ahead of a potential Labor government and proposed franking policy changes.
WHAT GIVES YOU THE CONFIDENCE IN THE DIVIDEND OUTLOOK?
Of course, the recovery path for economies remains uncertain. The COVID-19 pandemic is ongoing with various lockdown strategies offset by the potential of a vaccine and ongoing government stimulus. Overlay this with a deteriorating China relationship and Brexit, it is a very challenging time for investors.
Despite this, we still expect income from equities to be an important source of return for investors for several reasons.
Firstly, the yield on equities is still very attractive relative to alternatives. Equity yields of 4% to 5%, compare to cash rates and fixed interest products below 1%.
Secondly, dividends will continue to be a large contributor to market returns, having contributed approximately half the ASX 200 index returns since 1950. This remains a defensive investment plank in Australia’s investment case, relative to other markets.
Net dividend yields (excluding franking) have consistently averaged ~4% p.a. over the last ~30 years, whilst bond yields have declined from ~8% to less than 1% currently.
Fourth, franking benefits are unique to the Australian market and provide a source of upside for investors – particularly retirees. Each year the Australian market (ASX 200) typically receives dividends with ~75% to 80% franking attached.
Last and certainly not least, dividends have rebased with upside potential as revenues recover and dividend payout ratio’s normalise over the coming years.
STOCK-SPECIFIC DIVIDEND OPPORTUNITIES
There have been dividend winners and losers over the course of 2020, with financials hit hard due to recession headwinds and regulatory intervention, whilst resources companies have been faring well as high commodity prices help generate significant free cash.
This is a timely reminder for investors that sources of yield shift over time. Active portfolio management and stock selection can therefore have a significant impact on income generation.
We continue to position our portfolio in high-quality businesses that offer a combination of sustainable free cashflow generation, attractive dividend yields, growth, franking benefits and importantly, valuation support. Below are some examples:
IPH Limited: Provides intellectual property, patent and trademark services across Australia, New Zealand and Asia. Its defensive characteristics, robust patent filing volumes and strong progress on the synergies from recent acquisitions were key highlights from reporting season. The stock is expected to deliver a ~6% p.a. gross yield with high single digit growth and potential acquisitions should also serve as a catalyst.
Atlas Arteria: Following a significant decline in traffic earlier in the year, traffic quickly rebounded on the main asset in France. Escalating COVID-19 case numbers and new lockdown restrictions in France have stalled the traffic recovery. Inter-regional roads bounce back faster than the city roads, and therefore normalisation should occur relatively quickly. This implies free cashflow of up to ~40 cents per share (cps), which translates into a dividend yield of ~6% p.a. at current prices.
BHP: Offers ongoing earnings growth potential from its iron ore and copper exposure, with leverage to an eventual global economic recovery through coal and energy resources. In particular, iron ore prices continue to be robust given i) ongoing strong China demand; ii) Brazil supply constraints; and iii) contracting economic output in world-ex China. Dividend yields of mid-single digits are supported by free cash flow yields in the high single and double digits over the next two to three years.
Telstra: Has not been immune from COVID-19 disruption with some negative one-off impacts from lower international roaming charges, customer incentives and delayed synergies. The market appears to have focused on the risk to the 16cps dividend from a lowering of near-term return on invested capital targets. In our view, the competitive environment in mobile is rational and will see improving earnings over the next few years. As such, we think the 16cps is sustainable, and represents an attractive gross yield of ~8% p.a. at current prices.
FOCUS ON GROWING INCOME OVER TIME
We believe that a growing dollar income over time will deliver the best outcome for income seeking investors as they seek to offset inflation and look to maintain lifestyles in retirement.
The annual income received from ASX 200 dividends has increased materially compared to the annual income received from term deposits over the last 20 years.
To demonstrate further, let’s compare an investment in Commonwealth Bank (CBA) versus REA Group (REA) over the last decade. CBA’s annual dividend in 2020 is broadly the same as it was in 2010 at ~$3 p.a.
Whilst REA’s dividends have increased from 16cps to $1.10 p.a. over the same period. In other words, the yield on initial investment for REA Group is currently almost ~12% including franking benefits, whilst CBA’s remains around ~6%.
This is before we consider capital growth, where REA’s share price has increased ten-fold over the last decade, whilst CBA’s is now just ~30% higher.
Now more than ever, income investors need exposure to a diversified portfolio of quality companies at reasonable prices, with good visibility on long-term dividend sustainability and after-tax benefits.
Scott Kelly is portfolio manager at DNR Capital.