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This article appeared in the July 2012 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.

Know how to avoid companies that promise fat dividends, but fail to deliver.

Photo of Christine St. Anne By Christine St. Anne, Morningstar

In a period of extreme volatility, the chase for income has only intensified, with high-dividend stocks having emerged as the chief focus for many investors.

However, investors need to consider a number of pitfalls if they are to avoid the yield trap and achieve a total investment return.

1. High-yield stocks do not always mean safer companies

Higher-yielding stocks are often associated with more established companies, which make these stocks seem safe.

According to Colonial First State (CFS) senior portfolio manager Rudi Minbatiwala, research over the past 10 years has shown the volatility behind high and low-yield stocks has been largely the same.

Sectors like financials, telecommunications, property trusts and utilities were exposed to heightened volatility during the global financial crisis.

Russell Investments senior portfolio manager Scott Bennett says investors must be careful not to fall into a "yield trap", meaning they should be aware of companies that promise high dividends but don't have the cash flow to support the payments.

"Some of the more sustainable and better quality companies are paying consistent and attractive yields," Bennett says.

He believes a grossed-up yield of between 6 and 9 per cent is sustainable and that companies paying anything higher would be "very risky".

2. Be wary of chasing franking credits

Minbatiwala says retirees believe that due to their zero tax status, franking credits are simply a source of cash back from the tax office, so pursuing them makes sense.

Many investors, however, target these franking credits in the belief that the value is not being fully reflected in the market prices.

"However, recent trends suggest this idea may now be out of date. Simply chasing stocks with high franking credits results in a reduced focus on after-tax total returns," Minbatiwala says.

"Consequently, by chasing franking credits, investors are effectively leaving themselves at risk of a lower after-tax return.

"Just trying to lower investors' tax bills does not always improve their after-tax returns."

Russell's Bennett says while there is evidence that franking credits may not always be reflected in the price, they still provide benefits to a portfolio on an after-tax return basis.

(Editor's note: to learn more about franking credits, read Michael Kemp's article in the Yield Basics section in this issue).

3. Ignoring total return - the curious case of BHP and Telstra

The Russell High-Dividend Australian Shares ETF (RDV) has BHP Billiton (BHP) among its top 10 holdings. A resource company like BHP is not known for paying the juicy dividends associated with a company like Telstra (TLS).

Analysis by Bennett, however, revealed that in contrast to Telstra, BHP has consistently increased its dividend payments to shareholders.

In 2002, BHP's dividend was 19 cents. Today, it is $1.10. Telstra's dividend in 2002 was 22 cents. Today, it is 28 cents - not much of an increase compared with BHP's dividend growth.

Minbatiwala says investing in BHP from a total-return perspective would also net investors substantial benefits.

According to his analysis, if an investor bought $10,000 worth of Telstra shares in 2001, the total value today would be $10,953. If the same $10,000 had been invested in BHP, the value today would be $50,440.

"The primary reason for this result is total overall return, because each year's capital return provides the base from which next year's income return is generated," Minbatiwala says.

4. Focusing on yield, not growth

Understandably, income generation is the primary focus for many retirees seeking a stable income to fund their lifestyle over their retirement.

Today, people have at least another 30 years of retirement living (due to longer life expectancies). Therefore, capital growth should also remain a priority.

To effectively manage income and longevity, investors need to focus on wealth, not just income, which means the total return of their investment needs to be considered.

"To achieve this outcome, stock selection is absolutely critical, because a stock that pays a regular dividend (and therefore an income) may not provide the capital growth required to ensure your money lasts," Minbatiwala says.

Bennett says the over-emphasis on yield investing also applies to term deposits, with many retirees still heavily invested in these assets.

"Term deposits may be offering some attractive returns at the moment, but they won't give you the capital growth needed to last your retirement," he says.

"You need to have capital growth so that you won't always have to eat into your investments."

5. Focusing on the yield and ignoring volatility

Bennett acknowledges that dividends tend to remain consistent during periods of volatility.

An analysis of the sources of return of the Russell's RDV ETF has shown dividends provide a consistently positive return with a much lower volatility compared with price returns.

Bennett says it is important investors understand that dividend yield alone is not a good indicator of future income.

While the RDV does focus on yield, it also looks at other factors, including earnings variability, to determine the financial health of a company and its ability to sustain its dividends.

Minbatiwala says investors also need to look at the share price, as share investors cannot obtain dividend income without maintaining exposure to the share price.

"Income is only one component of the total return. During periods of uncertainty and sharemarket volatility, a focus on managing your overall wealth is essential," he says.

About the author

Christine St. Anne is the online editor of Morningstar. She is also the author of, A Super History, which explores the beginnings of Australia's compulsory superannuation industry.

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