Declining interest rates and bond yields, coupled with investors’ thirst for income, means strategies around equity income are here to stay, according to Warwick Cumming.
Income investing has been a major theme for some time now.
In my view, it is more than just a trend; it will be an enduring theme for years to come as investors whose retirement savings have been hit by the global financial crisis seek ways to rebuild their retirement income.
While the more traditional income strategies, such as bonds, continue to have an important role to play in portfolio construction, income from equities should not be overlooked.
With one of the highest yielding equity markets in the world, as well as favourable tax treatment of dividends, Australian equities are an attractive option for those seeking yield.
Historically, the Australian equity market has been one of the highest dividend yielding markets in the world, and this situation is likely to continue due to limited scope for further investment growth, strong cash flows, healthy balance sheets and the potential for companies to further increase their dividend payout ratios.
Also supporting the attractiveness of income from equity markets are issues such as declining yields in bond markets.
Bond market yields
In June this year, Dutch government bonds yields touched their lowest yield in 500 years (1.53 per cent). Similar records have been set over the last 12 months in the US (220-year low), Germany (200-year low) and France (260-year low).
This trend has been driven primarily by the flight to the perceived safety of bonds, which has skewed global asset flows to unsustainable ‘bubble-like’ levels.
According to Bank of America Merrill Lynch, 63 per cent of global flows have gone into investment grade and high yield bond funds during 2012 alone.
In Australia, this undervaluation of equities compared to bonds is at the lowest since at least 1988, as shown Chart 1.
In my view, this sets the scene for a move back into equity markets as portfolios are rebalanced.
Demographic changes
As the population ages, there will be increasing demand for income-generating assets that also offer the potential for capital growth.
There has been a great deal of discussion in most developed countries for many years now about the challenges of an ageing population. In addition, medical advances mean people are also living longer.
The two regions that have the most advanced ageing of their populations are Japan and Europe. As Chart 2 shows, 23 per cent of Japan’s population is aged over 65; in Europe, it is 17 per cent; and Australia and the US are 14 per cent and 13 per cent respectively.
However, both the US and Australia have population growth which will help to slow their rate of growth of the ageing population relative to Japan and Europe. (See Chart 2.)
This will underpin the demand for yield for many decades to come, as governments in developed countries find it increasingly difficult to finance the growing cost of ageing populations, requiring individuals to fund their own retirements.
Australian dividend yields
Australian dividend yields are high by global standards, as highlighted in Chart 3. Australian companies are encouraged to pay dividends due to the favourable tax treatment of dividends for Australian residents.
Chart 3 also shows that the current level of Australian dividends is higher than the five-year average of 4.5 per cent. This reflects both the de-rating of the market over time and the increase in payout ratios.
Investing in the Australian market therefore provides the potential dual benefits of participating in a re-rating of the market as well as continued dividend growth.
In my view, we are likely to continue to see dividend growth. While there is earnings growth, significant re-investment opportunities outside the resources sector are limited due to the weak global environment.
However, cash flows are strong and balance sheets are healthy, with gearing levels approaching a 30-year low, thus making it attractive for companies to continue paying dividends.
Furthermore, payout ratios for Australian companies are increasing as companies respond to calls for increased dividends and other forms of capital management.
Over the last decade, the payout ratio for the S&P/ASX 200 Index (excluding resources) has risen from 60 per cent to 70 per cent.
Overall, income strategies have performed very well compared to other global market indices, despite the uncertainty and volatility in equity markets in recent years.
As an example, the MSCI AC Asia Pacific High Dividend Yield Index has outperformed the MSCI AC Asia Pacific Standard Index over the last eight years, with the gap widening in more recent years, as shown in Chart 4.
High yield strategies
Over the last decade or so, there has been a progressive de-rating of the Australian equity market.
The 12-month forward price to earnings ratio (P/E) has fallen from a high of around 19 times in 1999 (and 16 times in September 2009) to current levels of around 13 times.
At the same time there has been a fall in earnings per share (EPS). The combination of lower pricing and lower EPS has contributed to the underperformance of the Australian equity market relative to Australian bonds.
Despite this, dividends have provided a stable return of around 5 per cent per annum to shareholders.
This is one of the few occasions over the last 50 years that an earnings decline and an earnings de-rating have occurred simultaneously.
Investors are therefore in a position to benefit from a repricing of the market and a recovery in EPS growth, while being paid to wait for this to occur through a high dividend yield.
However, investors should keep in mind that not all high-yield strategies are alike.
Simply buying the highest-yielding stocks has not been as successful a strategy as buying stocks with more sustainable yield characteristics, which can provide greater growth in dividends over time.
Research by Goldman Sachs shows that over the last 15 years the total average return from the top 10 dividend paying stocks was approximately 6 per cent per annum, compared to 9 per cent per annum for the S&P/ASX 100, despite the superior yield of the former.
This reflects the fact that stocks that are ex-growth (ie, have reached or passed their highest growth rates) may pay out a much higher percentage of dividends.
An even bleaker scenario is that companies that are in earnings decline attempt to protect their share price with high payout ratios.
Selecting stocks that provide more sustainable dividend growth on the back of earnings growth and lower payout ratios is likely to provide investors with a more attractive combination of capital and income growth.
For Australian investors, as interest rates fall and the rates on term deposits continue to decline, the ‘flight to safety’ approach of investing in cash will inevitably need to be adjusted.
While fixed income and bond funds will continue to play an important role in providing income as well as defensive characteristics in a portfolio, high-yielding Australian equities should also remain an attractive source of income, as well as providing investors with an opportunity to benefit from the repricing of the Australian equity market.
Warwick Cumming is deputy head of Australian equities at Tyndall AM.
