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This article appeared in the July 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Investors must look at sustainable yields, not just share prices.

Photo of Rudi Filapek-Vandyck By Rudi Filapek-Vandyck, FNArena

It has been written and declared by market commentators and investment specialists alike: the 'buy and hold' strategy no longer works and is, indeed, dead.

What these experts fail to acknowledge is that investing in the sharemarket is not only about movement in share prices. Investment strategies that have focused on corporate dividends have generated positive returns and if current indications are correct, dividends will only become more important in the years ahead.

Watch Rudi's video on "Stocks that Consistently Beat the Market".

Earnings growth since 2008 has proved rather lacklustre outside energy and mining companies in Australia. But dividends have grown strongly as companies have repaired their balance sheets, reduced debt and restored payout ratios to shareholders. This process is continuing, so it is more than just a fair assumption that growth in dividends in the year ahead will exceed growth in profits.

By how much profits and dividends will grow next year remains the subject of debate. Analysts' forecasts have been in a downtrend since May last year and just about everyone is convinced that present forecasts will have to be downgraded further in the months ahead. Even then, the differences between individual companies will remain large.

Note, for example, that solid dividend payers such as Australian Real Estate Investment Trusts (A-REITs) and infrastructure trusts have outperformed the broader market in recent months. Not only had many of these securities arguably been neglected for too long (since the GFC), which created a valuation gap, but sector analysts are also of the view that overall risks to forecasts are lower compared to most other sectors.

A-REITS and infrastructure trusts

(Editor's note: Do not read the ideas below as recommendations. Do further research of your own or talk to your financial adviser before acting on themes in this story).

With many of these trusts promising payout yields well in excess of the market average of 4-4.5 per cent, the attraction has been obvious. A-REITs such as ING Office Fund, Bunnings Warehouse Properties, and Dexus, as well as infrastructure trusts such as Australian Pipeline Trust and Spark Infrastructure, still offer dividend returns above market average. A-REITs and infrastructure trusts offer lower risks and higher dividend returns, but most do not have a strong growth profile. Analysts expect dividends for infrastructure funds to increase an average 4-6 per cent this year and next.

Potentially larger returns can be achieved from owning dividend-paying financial and industrial shares, as many of these have been sold off and de-rated over the past few years. Today they offer higher dividend yields and the potential for share price appreciation in case of an economic and market recovery, but only if present analyst forecasts prove accurate in light of continuing downward pressures on earnings.

Macquarie analysts' conclusions

Macquarie analysts recently conducted a study into prospective dividend yields and the risks attached. The conclusion was that a number of high-yielding shares carried relatively low risk, which means the analysts have some conviction that forecasts do not need to be cut.

Companies selected by Macquarie included major banks ANZ and Westpac; retailers David Jones, Metcash and Woolworths; toll roads operator Transurban; property developer GPT; property trust CFS Retail Trust; building materials provider Adelaide Brighton; oil refiner Caltex; media conglomerate Consolidated Media Holdings; mining services provider Monadelphous; and internet portal

Macquarie strategists believe that equities are repeating the experience of 1964-1981, when shorter, sharper economic and market cycles kept financial markets volatile and earnings uncertainty unusually high. Despite many ups and downs during the period, equity markets ended at the same level in the early 1980s as they were in 1964.
Macquarie argued that during such periods, dividend yield is an increasingly important component of returns. The analysts point out that capital returns over the past five years have been close to zero, meaning dividend yield has contributed nearly 100 per cent of total investment returns. Clearly, argues Macquarie, in such an environment shares with relatively high and sustainable yields will outperform.

Promises need substance

Not everyone necessarily agrees with Macquarie, but research conducted by economists and market strategists at UBS and Citi points in the same direction: dividend yields will form an increasingly important part of investment returns from now on. UBS is of the view that the new macro environment since the GFC is likely to reduce average annual returns in the sharemarket to about 8 per cent, from 9.8 per cent before 2007.

On my own analysis, 'buy and hold' returns from healthy dividend-paying shares such as David Jones beat those from fast-growing, low-dividend payers such as Rio Tinto fair and square over the past eight years, even with a commodities super cycle taking place and a de-rating of retailers.

For investors who want to do their own research, the trick is not to be misled by promises that are simply too good to be true and are not backed up by growth in profits. Telstra shares through the years have promised yields of up to 13 per cent, but shareholders still have a sour taste today due to the telco's lower share price. In the absence of sustainable profit growth, the share price kept weakening over time, keeping total returns in the negative. In such an example, investing in dividends proved no different from investing in a share not paying dividends. Growth is essential.

Ideally, an investment today would at least earn the market average yield of 4.5 per cent and grow in years to come. Good dividend investing is all about growing returns. Note that as investors hold on to their shares and dividends grow in line with profits, yields grow ever higher on the original investment made. This is a factor too often underestimated. For example, the yield on Monadelphous shares bought in 2005 has risen to 18 per cent this year. David Jones shares purchased in 2003, today yields 30 per cent.

The PE factor

To assess the risks that come with apparent dividend yields on offer, I suggest that paying attention to prospective dividend yield and forward-looking price-earnings ratios (PEs) can provide an indication about how much risk is in play. Investors should always remember that the market does not offer great bargains for no good reason. If an offer appears to be a good one, it is probably because risks are elevated.

The ideal risk/yield reward, I believe, is usually to be found among shares trading on PEs of 11 to 13 while offering yields above market average. Companies that have these characteristics include Fleetwood, Ardent Leisure, JB Hi-Fi, Metcash, GWA Holdings, GUD Holdings and David Jones.

The final category of shares comprises those for which the payout ratio is expected to jump. That means today's yield may not look overly attractive, but if everything goes according to plan this will change over the next 18-24 months or so.

I believe the balance between PE and yield is the code Mr Market uses to communicate 'risk' to investors. The sooner investors learn to read this code, the better their returns will become.

Note that resource companies are by nature highly volatile, both in share prices and earnings, and thus not suitable for longer-term, dividend-oriented investment strategies.

The upside in banks

Australian banks deserve a special mention. Over the past few years, major banks in Australia have been sold short, derated, reregulated and reappointed as the Uber-Villains by politicians in Canberra and some media. Today share prices for the Big Four have not progressed much, on a net basis, from August 2009.

But those who owned banking shares over the period have received dividends equal to around 12.5 per cent of their investment. These dividends are fully franked, which means owning banking shares has beaten cash deposits, which earned less than 12%, before deducting tax on the accrued interest.

Shareholders could potentially have added extra benefits by participating in the banks' dividend reinvestment plans and they retain exposure to future upside potential. And they can continue looking forward to additional and higher dividends.

The example of the banks highlights two important observations: market indices do not tell the full story, and investors ignore dividends at their peril.

About the author

Rudi FilapekVandyck is editor of FN Arena, a financial news website.

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