Maximising dividend payments
Earning income by receiving a share of the profits, paid as dividends by companies listed on the stock exchange, remains a central pillar to any retirement income investment strategy. But not all approaches to investing for higher dividend income are the same. It is possible to maximise income using forecasts of future dividends and stock selection insights to generate improved income and total return outcomes.
This is a better approach than simply focusing on historical dividend data alone which - despite understanding that past returns are not an indicator of future performance - is a method than many employ.
THREE COMPONENTS OF EQUITY RETURNS
Owning shares in a listed company entitles an investor to exactly that: part ownership of the assets and earnings of a company - a ‘share’ of the business. Australian equity investors receive three sources of return, which together produce the total return of the investment.
The share price return is the first, and it is the change in the price at which the shares you own are traded on the stock exchange. While share price movements can be volatile, the average share price returns (over the past 40 years from the S&P/ASX All Ordinaries / ASX 200 index or “Benchmark”) has been an average rise of 4% a year.
Secondly, share investors also receive a share of the profits earned by companies, paid as dividends. Over the long term, the annual dividend yield on the benchmark has averaged 4.3% a year. It’s a dividend yield which is certainly attractive in the current environment, and when compared to traditional retirement income investments such as term deposits which offer close to zero return.
Thirdly, for Australian-based companies which pay tax in Australia, the dividend payments will often include an attached imputation credit. This imputation credit reflects the tax that the company has already paid on its profits. Since its introduction in 1987, the average level of imputation credits has been 1.3% a year.
The fact that the Australian equity market is one of the highest dividend-paying markets in the world is in part thanks to the impact of imputation credits. The imputation credit system passes through the tax paid by companies as credits to investors when they receive their dividends.
It was introduced to avoid the double taxation of profits (when earned by the company and again when investors pay their own income tax). It prompts companies to pay ‘franked’ dividends to investors, rather than undertake other forms of capital management such as buying back their own shares on market, which would see tax credits accumulate needlessly inside the company.
In total, it means Australian investors can expect the benchmark will return them a gross dividend yield of 5.6% a year (the 4.3% average dividend yield plus the 1.3% imputation credit).
And given that the underlying value of the shares is also growing at an average of 4%, it means that annual income has more than kept up with inflation and maintained its purchasing power.
So far, so good.
SEEKING AN INCOME AND GROWTH SPLIT
However, based on an investor’s initial investment (or super balance), a 5.6% gross yield on average may not be high enough to provide the income level that they require or wish to have.
Some investors may choose to sell some of their capital base to fund the difference: but, as we will explain, this is a bad idea. Others may seek to invest in those companies which pay higher dividends: but again this is a bad idea.
The good news is that there is a way in which investors can earn a higher yield of their equity investments.
As Chart 1 shows, ideally investors would be in a better position if they received the total return of the ASX 200 in slightly different proportions:
This approach is especially attractive for Australian investors who can reclaim imputation credits on dividends earned.
A higher dividend component = a higher level of imputation credits. This is an additional bonus as our analysis also shows that the value of imputation credits is not fully recognised in share price movements when companies declare and go ‘ex-dividend’. This occurs due to the fact that offshore investors may not be able to claim these imputation credits and some taxable investors may wish to avoid earning dividends to reduce their taxable income.
Being able to earn additional imputation credits is why focusing on maximising your dividend income will always be a better option in the long term, versus selling assets to make up for a lower dividend yield (assuming your total return is at least the same as the benchmark before tax credits).
RULE #1: LOOK BEYOND EXISTING HIGH YIELDS
When investors look to maximise income capture from Australian equities it is easy for them to think that they can just buy those stocks currently paying the highest dividend relative to their price (the high yielders). But this approach is often a recipe for disaster. This group will include companies whose share prices are currently depressed and under stress.
This could in fact be a precursor to needing to cut their dividend payments. A high yield may also indicate a lack of growth opportunities: thus management is returning profits to shareholders rather than reinvesting in new opportunities.
Focusing on a high past dividend and low current price can deliver a decent dividend harvest for investors, but this approach runs the risk of your invested capital falling by more than just the impact of a high dividend payment.
Our advice to income seeking investors is to look beyond high yielding stocks and embrace all dividend opportunities including off-market share buybacks. History shows that there are over 300 individual dividend payment events on more than 100 distinct trading days each and every year across the ASX 200 universe.
Not every company pays their dividends on the same day, some pay two dividends each year (interim and final), some four while some even pay special dividends from time to time.
Trading into and out of companies based on expected dividend payments through the year can achieve good results. It pays to consider expert estimates of dividend payments to assist in trading across different companies and sectors over the course of the year.
Investors also need to be on the lookout for off-market buybacks. This is when companies seek to return excess capital to investors in the form of a large fully-franked dividend and a small capital component. Such events can be beneficial to retirees and low tax rate payers.
RULE #2: ALIGN STOCK SELECTION WITH YOUR OBJECTIVE
Looking beyond just the highest yielding companies to a broader set of dividend payers requires a degree of turnover to position the portfolio to capture the excess income that investors desire. This is where stock selection can assist: it is important to invest in those companies which are attractive because they pay a dividend and because they are attractive as investments in the here and now.
Our view at Redpoint is that the most relevant stock selection views must be weighted towards shorter horizon views: sentiment based disciplines which focus on near term events related to change in analyst earnings estimates and the re-rating of share prices driven by investor preferences, news and corporate announcements are what we focus on.
At the same time, we also incorporate longer horizon views on company quality, growth and ESG sustainability as conviction elements in our overall stock selection.
Earning a higher income from equities necessitates that overall portfolio growth (price return) is lower by a similar amount. We believe that additional insights from stock selection which operate within the same frequency as the turnover required to capture additional income is best placed to provide an additional uplift to overall portfolio performance in the long term.
RULE #3: BEING RISK AWARE MAKES FOR A BETTER LONG TERM TRADE-OFF
Lastly, it also makes sense to consider the risk of your overall portfolio relative to a standard index (such as the S&P/ASX 200 or 300). Stepping too far away from benchmark in a search for excess income can lead to being overly invested in a few industries while having no exposure to others. Noting that different companies within the same industry pay dividends at different times of the year can open up opportunities to trade across multiple companies to earn excess income. Using stock selection insights to inform this decision can also be of benefit.
But it is a trade-off…. and a complicated one at that. We all want the cake and to be able to eat it: higher income, commensurate growth, risk awareness, stock selection, sustainability, low cost trading.
When it comes to maximising the income from your equity portfolio you cannot review your portfolio only a few times each year. Those in retirement will know how hard they have worked to save for a comfortable retirement – and it is important to ensure your client’s investment portfolios continue to work hard for them in retirement.
Max Cappetta is chief executive and lead portfolio manager at Redpoint Investment Management.
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