Dividends have been a significant source of returns for ASX investors over time.
The Focus Portfolio is not an income strategy. In fact, the portfolio has a lower dividend yield than the market, albeit with a stronger earnings growth profile and a superior ROE compared to the index.
However, we recognise that equity income investing, with a focus on companies with high dividend yields, has a number of inherent appeals for some investor groups, including:
- Dividends help to ‘smooth’ total returns during periods of market weakness.
- The income from dividend payments can help support investors’ immediate cash needs, which is particularly relevant for retirees or individuals seeking passive income.
- Thanks to franking credits, the income from dividends paid by Australian companies is typically tax-advantaged compared to the income from fixed income investments.
While dividends have been a significant component of the ASX 200’s total returns over time, we note that high dividend yield stocks (as measured by the S&P/ASX Dividend Opportunities Index) have on average underperformed the broader market over the long-term.
This suggests that simplistically pursuing equity income investing solely on the basis of dividend yields (i.e. by simply buying high yield stocks) has been a futile strategy over time. However, we note there are a range of well managed equity income strategies that have meaningfully outperformed the market by following more sophisticated approaches to income investing.
Recognising the key appeals of equity income investing for some investors, in this report we discuss our approach to equity income investing (albeit the Focus Portfolio is not an income strategy). Our approach looks beyond companies’ dividend yields, to uncover opportunities that will deliver the strongest and most sustainable income over time.
When investing in stocks for income, there are three key considerations we believe investors should make:
- Growth Potential –
income investors should consider near-term dividend yields, alongside a consideration of the company’s medium and long-term earnings growth potential. - Balance Sheet Strength –
a company’s financial position should be a key consideration, given this underscores its ability to continue paying out capital to investors in the form of dividends. - Earnings Quality –
companies with defensive earnings streams are less prone to dividend cuts.
1. Growth Potential
Dividend yields, in isolation, are not a good indicator of a company’s long-term income potential.
While stocks with high dividend yields will deliver the greatest income in the near-term, the companies that can compound their earnings (and therefore dividends) strongly over time will typically deliver the greatest income (and capital returns) in the long-run – even if they have low starting dividend yields.
Consequently, it can be short-sighted to screen out stocks with relatively low dividend yields if they have attractive growth prospects. At the same time, it is worth remembering that companies with high dividend yields are often businesses with limited growth potential or are cyclical businesses that are at 'peak earnings', thus high yields often precipitate a period of stagnant or negative earnings (and dividend) growth.
Therefore, the optimal approach to income investing is to consider dividend yields, alongside an assessment of the company’s long-term earnings (and dividend) growth potential. Naturally, investors need to strike a balance between near-term income requirements and longer-term earnings growth.
Case Study – TechnologyOne vs NAB
A comparison of TechnologyOne (TNE) and NAB (NAB) illustrates the importance of considering growth – and not just dividend yields – as an income investor. As one of the ‘Big 4’ banks, NAB has long been favored by yield-hungry investors looking for ‘reliable income’.
In 2009, NAB and TNE both offered dividend yields of ~5%. Therefore, if assessing dividend yields in isolation, both companies would have been equally as attractive as income stocks.
However, with the benefit of hindsight, TNE has delivered significantly more income on a dollar basis – alongside more attractive capital gains. If you had invested $100k in both companies in 2014, TNE would have paid you >$25k in dividends this year, compared to just ~$6k for NAB.
This is because TNE has consistently grown its earnings and dividends over this time frame, while NAB’s earnings have been stagnant. The comparison illustrates the importance of looking beyond yields and considering the trajectory of a company’s earnings over a longer time frame, to maximise income over the long-term.
2. Balance Sheet Strength
Dividends are discretionary payments that are decided by a company’s Board of Directors.
As such, the strength of a company’s balance sheet – which underscores its ability to pay out capital to investors in the form of dividends– should be a key consideration for income investors.
If a company's gearing becomes excessive, it can be prudent for them to cut or cancel their dividends until their financial position improves. For example, Mineral Resources cancelled its final dividend of FY24 – as its gearing became stretched well above peers, following a period of significant capital investment and at a time of softening lithium and iron ore prices.
On the other hand, when balance sheets are in a formidable position, companies have the flexibility to return surplus capital to shareholders through special dividends (and buybacks). For example, in May this year, Westpac announced a $500m special dividend which was underpinned by its exceptionally strong balance sheet position.
Therefore, when constructing an equity income portfolio, balance sheet strength is an important indicator of the sustainability and strength of future dividend payments. To measure this, we use leverage ratios like net debt/EBITDA, interest coverage (interest expense/ EBIT), and gearing (debt/total assets) (specifically for REITs).
3. Earnings Quality
The reliability of a company’s dividends is also determined by the quality of its earnings.
While there is a place in an equity income portfolio for cyclicals (resources stocks have historically been significant dividend payers during supportive commodity cycles), our bias is towards high quality businesses with defensive earnings streams that are relatively agnostic to changes in the macro environment.
Low beta businesses with contracted or regulated earnings streams (e.g. utilities, toll roads, ports, real estate) or defensive underlying demand profiles (e.g. consumer staples, telcos) generally have a high degree of earnings predictability. This makes them less prone to dividend cuts compared to highly cyclical businesses.
Dividend quality is also an important consideration. The companies that offer greatest level of certainty around their future dividend streams are those that fund their dividends from their operating cash flows (rather than debt), have sustainable payout ratios, and have a consistent track-record of dividend payouts.
Screening the ASX for Income
As we have explored, when analysing income stocks, it is important to look beyond dividend yields to also consider a company’s long-term earnings growth prospects, balance sheet strength, and earnings quality.
Figure 6 shows a screen we have conducted of the ASX 300 in line with these principles, with the aim of striking a balance between the near-term desire for attractive yields and sustained earnings/dividend growth over the longer term.
We have screened the market for stocks that fulfil the following characteristics:
- Grossed up dividend yield of >3% in FY27e (accounting for franking credits). By looking out to FY27, we are taking into account the income investors are likely to earn over the medium-term (rather than just in the next twelve months).
- Dividend per share (DPS) growth between FY24a and FY27e – must be positive, which recognises that dividend growth will be the key driver of a stock's income over the long-term. It is prudent to avoid companies with negative earnings momentum which creates the risk of dividend cuts.
- A balance between growth and yield. i.e. a high yield stock can have lower growth but a low yield stock (2-3%) needs significant medium and long-term growth (>10% DPS CAGR).
- Balance sheet strength – using various leverage/ gearing ratios, several companies (e.g. APA) have been excluded due to balance sheet pressures which may weigh on their future dividends.
- Earnings quality – a qualitative assessment of each company’s competitive position and industry backdrop, alongside a consideration of its degree of earnings cyclicality. Our preference is towards high quality businesses with relatively predictable earnings profiles, although there is scope to selectively invest in cyclicals like resources and banks for fully franked income.
- In resources, we have screened out the iron ore majors due to our expectation of weaker iron ore prices over the medium-term, which will likely weigh on their dividends. Our preference is towards resource companies exposed to commodities with positive supply/demand dynamics and supportive bottom-up drivers that underpins free cash flow and dividend growth over the medium-term.
| Company Name | Ticker | 3yr DPS CAGR (FY24-27) | FY25 | FY27 | Franking | Focus Portfolio holding | ||
| Net dividend yield | Gross yield | Net dividend yield | Gross yield | |||||
| Santos | STO | 14% | 4.6% | 6.1% | 7.9% | 10.5% | 77% | x |
| HealthCo REIT | HCW | 4% | 7.8% | 7.8% | 8.4% | 8.4% | 0% | x |
| Super Retail | SUL | 1% | 5.8% | 8.3% | 5.6% | 8.1% | 100% | |
| Telstra | TLS | 5% | 4.7% | 6.7% | 5.2% | 7.4% | 100% | |
| ANZ | ANZ | 1% | 5.6% | 7.3% | 5.6% | 7.3% | 70% | x |
| Rural Funds Group | RFF | 3% | 6.6% | 6.6% | 7.2% | 7.2% | 0% | |
| Collins Foods | CKF | 9% | 2.9% | 4.1% | 4.7% | 6.7% | 100% | x |
| South32 | S32 | 50% | 3.0% | 4.3% | 4.4% | 6.3% | 100% | x |
| Coles | COL | 8% | 3.6% | 5.2% | 4.4% | 6.3% | 100% | |
| Ridley | RIC | 21% | 3.7% | 5.2% | 4.4% | 6.2% | 100% | |
| Worley | WOR | 9% | 3.9% | 4.8% | 5.0% | 6.1% | 50% | x |
| Transurban | TCL | 5% | 5.0% | 5.0% | 5.6% | 5.6% | 0% | |
| Steadfast | SDF | 10% | 3.3% | 4.7% | 3.9% | 5.5% | 100% | x |
| Lottery Corp | TLC | 5% | 3.2% | 4.6% | 3.8% | 5.5% | 100% | x |
| Scentre Group | SCG | 4% | 4.8% | 4.8% | 5.2% | 5.2% | 0% | |
| Sandfire Resources | SFR | >100% | 0.1% | 0.2% | 3.4% | 4.9% | 100% | x |
| Macquarie Group | MQG | 9% | 2.9% | 3.4% | 3.5% | 4.1% | 40% | x |
| CAR Group | CAR | 14% | 2.0% | 2.6% | 2.6% | 3.3% | 64% | x |
Source: Refinitiv, Visible Alpha, Wilsons Advisory.
Written by
Greg Burke, Equity Strategist
Greg is an Equity Strategist in the Investment Strategy team at Wilsons Advisory. He is the lead portfolio manager of the Wilsons Advisory Australian Equity Focus Portfolio and is responsible for the ongoing management of the Global Equity Opportunities List.
About Wilsons Advisory: Wilsons Advisory is a financial advisory firm focused on delivering strategic and investment advice for people with ambition – whether they be a private investor, corporate, fund manager or global institution. Its client-first, whole of firm approach allows Wilsons Advisory to partner with clients for the long-term and provide the wide range of financial and advisory services they may require throughout their financial future. Wilsons Advisory is staff-owned and has offices across Australia.
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