Hugh Dive, Head of Listed Securities

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Tales from the Trenches - Searching for Yield to Pay Bills Part 2

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In last week's piece we looked at how falling cash rates are fuelling the search for yield, as at current rates even wealthy retirees who have amassed $1 million in a superannuation face a very meagre retirement if they are looking to live off their income rather than eat into their capital. Whilst the 2.6% rate on term deposits in Australia looks grim, spare a thought for retirees in the US who are currently being offered 0.2% for the same term from Citibank, or German investors also receiving 0.2% from Deutsche Bank! In this week's piece we are going to look at why dividends are important, and the dividend sustainability and growth factors that we look for in a security.

Why dividends matter

Dividends are the stream of income that an investor receives from entrusting their capital with a company's management team. In mature companies such as Woolworths this income is paid today with a percentage of earnings retained to maintain the quality the company's asset base and invest in new projects. In emerging companies such as the 66 companies in the biotechnology sector (outside CSL and Sirtex), an investment is made based on the promise of high dividends at some stage in the future.

Unlike earnings, dividends that have been paid are real and cannot be restated by management at some stage in the future. Despite moves to improve the quality of earnings, a company's profit and loss accounts are susceptible to a range of financial shenanigans that are often employed in desperate times to boost the earnings reported to shareholders. Paid dividends are not impacted by revenue tricks, expense traps or liability shifting scams. Former tech giant Nortel (peak market cap US$250 billion) restated their earnings three times in three years after hiding US$952 million liabilities to engineer illusory profits and allow management to collect bonuses. Closer to home in 2012 global building services company Hastie restated their reported earnings for the first half from $58 million to zero due to accounting irregularities.


Finally, as a part owner in a company you should like dividend-paying companies, albeit for reasons outside of the joy of receiving that semi-annual dividend cheque. Paying dividends to shareholders enforces a degree of discipline on a company's management team, as it does not allow large amounts of retained earnings to build up the balance sheet that often burn a hole in management's pockets. When a management is forced to come cap in hand to investors asking for funds to make an acquisition, investors can scrutinise the business case and then decide whether to commit additional capital. Several years ago a large company owned by the fund I was managing approached me with their plans to make a significant acquisition in New Zealand. This company was a regular dividend payer with insufficient retained capital to fund the acquisition, and as such the acquisition was planned to be funded by a mix of debt and a rights issue to existing shareholders. As we saw that the company was planning on paying a very full price buying an asset in an unfamiliar market from a seller with a reputation as a shrewd seller of assets, investors were able to convince the company to abandon the acquisition as major shareholders were not going to support it.

Key factors for a stable and growing dividend

When we look at dividend-paying stocks we are not overly concerned with the trailing or next period dividend payment, but rather in understanding whether a company can maintain their dividend over the longer term and grow it ahead of inflation. Indeed picking a basket of stocks solely based on their dividend yield has been a path to underperformance, see Tales from the Trenches - High dividends... low returns?

When looking through the list of the highest yielding stocks in the ASX200, a common factor is usually a high payout ratio. This can be attributed to these companies either being mature low-growth companies with few internal investment opportunities to grow their business, or management looking to maintain the dividend in an environment where the company's earnings are deteriorating. In some situations these companies are

even borrowing to pay their dividend and may be retaining insufficient cash to maintain their assets. As we saw with Rio Tinto’s result last week a low payout ratio allows a company the opportunity to maintain dividend payments to shareholders in the face of adverse market conditions.

In evaluating the quality of a company’s dividend a factor that we look at closely is the direction of change in that company’s dividend. Historically changes in the absolute dividend provides a signal from company insiders (board and management) as to the sustainability of a company’s free cash flow. Whilst Metcash may be currently yielding a very attractive 8.4%, over the last three years the company has been progressively reducing their dividend. This indicates to me that the company insiders are concerned about the future of IGA in the Australian grocery market.

The quality of a company’s financial statements assists in assessing a company’s ability to pay a stable and growing dividend. Piotroski[1]’s work on financial statements analysis seeks to score a company based on a range of measures such as profitability, liquidity, leverage, equity and margins. Here the analyst is not looking at absolute measures such as gross margin or long term debt, but rather the change in these items.  This model has proven to be a good forecasting tool for dividend growth. Currently steel company Arrium has a 10.6% yield, however when scoring the company’s financial statements it is clear that the quality is deteriorating, which would lead one to question the stability of this dividend. Looking into the company’s statements Arrium’s cash flow from operations was below reported profits, and margins across their business units (ex mining) were declining.

Another factor that to look at that may indicate that a company is likely to pay a stable and growing dividend is whether that dividend is franked. Franked dividends have a tax credit attached to them which represents the amount of tax the company has already paid on the distribution to their shareholders. Firms that pay franked dividends have significantly more persistent earnings than firms that pay unfranked dividends as it indicates that a company is building up tax credits by generating taxable earnings in Australia. Obviously companies such as CSL and Incitec Pivot who generate large proportions of their profits outside Australia are unable to pay fully franked earnings. Continuing on with the example above, Arrium’s unfranked dividends in 2013 and 2014 could be viewed as an indicator that the quality and sustainability of the company’s dividends was not high.

In seeking to build a portfolio delivering above the meagre returns being offered by term deposits,  it is not enough simply to pick high yielding stocks; a detailed assessment must be made of the ability of a company to continue paying and actually grow distributions ahead of inflation.

[1] Piotroski, Joseph D., Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers, Journal

of Accounting Research 38, 1-41



This article has been prepared by Philo Capital Advisers Pty Ltd ABN 70 119 185 974 AFSL 301808 (Philo) and contains general investment advice only. The information in this article does not take account of your objectives, financial situation or needs or those of your client. Before acting on this information readers should consider whether it is appropriate to their situation. We recommend obtaining financial, legal and taxation advice before making any financial investment decision. To the extent permitted by law, neither Philo nor any of its related entities accepts any responsibility for errors or misstatements of any nature, irrespective of how these may arise, nor will it be liable for any loss or damage suffered as a result of any reliance on the information included in this article. The information in this article is based on information obtained from sources believed to be reliable and accurate at the time of publication but we do not make any representation or warranty that it is accurate, complete or up to date. We accept no obligation to correct or update the information or opinions in it. Opinions expressed are subject to change without notice. Past performance is not a reliable indicator of future performance. Any forecasts included in this article are predictive in character and may be affected by incorrect assumptions or by known or unknown risks and uncertainties. Nothing in this article shall be construed as a solicitation to make a financial investment

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Hugh Dive, Head of Listed Securities

Prior to joining Philo, Hugh was Head of Basic Materials Group Investment Research; covering the chemicals, building materials and steel sectors. In the 2011 Reuters StarMine Equity Analyst Awards, he was rated 5th overall in Australia for stock picking and first in the Diversified Industrials and Chemicals sectors. Hugh has extensive portfolio management experience gained at Investors Mutual, with a successful track record managing both small and large cap value funds. In 2009, one of the funds he helped manage, the IML Future Leaders Fund, won the AFR Smart Investor Award for the best Australian small cap fund.

Hugh started in funds management with CC&L Investment Management in Vancouver; Canada’s largest independent fund manager with C$37B under management. At CC&L he focused on asset allocation and then Canadian equity analysis. Hugh holds bachelor’s degrees in both Economics and Law from Sydney University and the University of British Columbia, Canadian Securities Course (Honours) and is a CFA charter holder.


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