Investing for future yield

Market insights

Tuesday 07 June 2016

Are Australian equities a sustainable source of income?

Currently the ASX200 has a forecast 4.6% dividend yield over the next year, significantly higher than the government bond yield of 2.6%. The divergence between the two is typically seen as a good proxy for the attractiveness of equities for income – with a dividend yield above the government bond yield seen as a positive indicator.

Australian Equity Dividend Yield versus Bond Yield

Source: Macquarie

What are the problems with “current yield” investing?

The companies which offer the highest current dividends fit into three categories, each with their own drawbacks;

  1. mature companies, by definition have lower growth;
  2. distressed companies, have a high degree of forecasting risk; and
  3. end of lifecycle companies, a short timeframe.
Typically Australian yield investors focus on mature companies that make up a large portion of the ASX200 index. As an example, three of the four major banks have significantly increased their dividend payout ratios over the past 5 years. Going forward, we expect banks dividend growth to be limited to earnings growth, which is currently forecast to be an average of 2.9% over the next 3 years, based on consensus estimates.

Bank Payout Ratios

Source: Macquarie Investment Management

How to find future yielders?

From our perspective, finding a future yield stock is not as simple as running a quantitative screen. Fundamental research must be undertaken in order to satisfy certain criteria that need to be met in order for a company to be a “future yielder”. This analysis includes;

  1. Quality / Earnings Certainty: Earnings and thus dividends can be hard to predict for some companies. This is especially true of commodity exposed companies – they can be highly cyclical between earnings and losses! It’s best to steer clear of these companies.
  2. Consistent growth: Earnings and dividends need to be growing at a steady rate. Lumpy and unpredictable payouts are of little use to investors searching for an income stream.
  3. Indication of future capital return: Growth companies in particular, often reinvest the majority of their free cash flow generation back into their own businesses. However, for a future yielder we need to have a commitment from management that returns to shareholders are a priority.

Example of future yield

Chorus is a New Zealand based telco company (dual listed in Australia and NZ) that is responsible for the build and operation of the majority of New Zealand’s new Broadband network. Between now and 2020 Chorus is expected to build a fibre network that will enable connections to over 850,000 premises. This clearly has a high degree of capital intensity – but they are currently at the peak rate of spend. Over the next four years free cash flow available for dividends is expected to increase as the build completes. The high degree of visibility of both revenue, expense and capex has enabled Chorus to start paying dividends – placing it on a 5% current dividend yield with consistent growth expected.

Chorus Free Cash Flow Yield

Source: Chorus

Future Yield – the opportunity is still there!

There is and will continue to be an ongoing need for income for a broad range of investors. The Macquarie High Conviction investment team continues to search for, and find stocks that fit into our future yield framework. For most investors, this combination of both growing capital and income is likely to prove attractive.

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