Call us on 1300 794 893

The Experts

Don't fall into the dividend trap

Bookmark and Share

By Michael McCarthy

Share dividends and estimated dividend yields have a firm grip on the investing public’s imagination. The company reporting season just passed saw some of the sharpest share price sell-downs directed at businesses that cut their dividends. Yet dividend yields are estimates subject to change, and are often a poor predictor of overall returns.

Sustainability is a primary consideration in estimating dividend yields. A bank with higher levels of capital, a lower pay-out ratio and no sign of bad or doubtful debts is not under pressure to cut dividends. A telco with a looming growth challenge currently paying out 100% of profit as dividends is ripe for a dividend cut. There are sustainable dividend yields and there are dividend traps.

This requires re-iteration as this very important difference has largely slipped from the investing consciousness.

Any dispassionate examination of the contributors to share market returns shows that the impact of share price change is orders of magnitude more powerful than estimated dividend yields. Yet some investors are using dividend yields as their primary (and in some cases only) measure to determine a share’s attractiveness. This method will likely end in tears.

That so many investors are doing this at this point speaks to the power of experiential learning in investment. Put simply, a good investment experience biases investors towards that style of investment. This neatly explains the rise of the dividend yield as an investment selection tool. Think back to late 2011. After a rally off the 2009 lows, the Australia ASX/S&P 200 index again slid into the last half of the year. The outlook for shares was clouded at best.

The problem for investors was that interest rates were low and looked like going lower. Staying in cash preserved capital but gave minimal returns. As fears eased investors sought ways to put their money to work. And they were most underweight shares.

What shares do you buy when you believe the worst is over but the short-term outlook is worrying? A share that you can afford to hold through any market wobbles. A share that pays better dividends, meaning investors can receive income while waiting for any share price recovery. Investors who bought bank shares at this time enjoyed large gains as more investors joined the theme. This not only increased the popularity of dividend yields but saw the search spread to other sectors.

Australia’s tax imputation system only enhances the bias. The tax credits shareholders receive reflects the fact that tax is already paid on the dividends by the company. The combination of a generally higher dividend yield for the Australia ASX/S&P 200 index and attached franking credits supported the dividend yield strategy.

Dividend yields are expressed as an interest rate. However, the capital position associated with dividend yields is vastly different to most interest rate products. The capital risk of shares is relatively enormous and can dwarf the holding yield. This risk can be positive or negative – share prices can go up as well as down.

When shares are nearer lows than highs, and look attractive on valuation, selections based on sustainable dividend yields make sense because capital risks are lower. But when markets and valuations are stretched the capital risks make dividend yields a minor factor. The potential for a company to cut its dividends adds to the risk.

This is just one of the investment lessons from Telstra’s recent share price troubles. The decline from a highpoint above $6.50 just two years ago illustrates a number of important market guides.

First, when “market darlings” turn, the damage can be substantial. Telstra is now back at five-year lows. Without a growth plan beyond the NBN it’s hard to imagine the share price improving anytime soon.

Secondly, using dividend yields as a primary stock selector is appropriate only at particular points of the market cycle ie market lows. Employing this methodology at higher points in the market cycle can be dangerous.

Thirdly, even where it is appropriate to apply dividend yields as a selection criterion the dividends must be sustainable. Companies facing significant capital expenditure, increasing bad debts, paying out 100% of earnings or facing an earnings downturn are unlikely to increase or even maintain dividend levels.

Lastly, investment circles are as subject to fashion as any other field of human endeavour. Once an investment approach or style approaches mania it is increasingly unstable and dangerous. Those basing stock selection on dividend yields alone may wish to examine their exposures.

Published: Tuesday, September 05, 2017


New on Switzer

blog comments powered by Disqus

Index             Current Change %    
Market Summary Quotes

ASX indexes live. Other indicies accurate at end of their market.

Pixel_admin_thumb_300x300