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Three rules to find yield

This article appeared in the February 2013 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.

Good dividends are available, provided you know how to avoid the yield traps.

Photo of John Abernethy By John Abernethy, Clime

More soft data on the local economy and the lack of strong news on the global front means the Reserve Bank is going to continue its easing cycle into this year and cut interest rates further. What that means for investors, especially retail investors, is a further erosion of high bank term deposit rates.

Bond market returns are also coming down. Worldwide, the 10-year bond market is sitting at around 2 per cent. That's down from the 4 per cent it was three or four years ago but, alarmingly, it has remained at these low levels for the four years since the GFC. It is in this environment that investors are rolling over their term deposits and coming back to the sharemarket as they look for better-yielding assets.

That is not necessarily a bad thing, but what is of concern is an unsophisticated chase for yield. Remember the old adage, if something looks too good to be true, it probably is. So if a company is yielding more than 10 per cent you need to understand you are taking on a sizeable risk for that result.

Although there has also been a raft of hybrid instruments (a type of ASX-listed interest rate security) flooding onto the market, I would caution retail investors against jumping into any products they don't understand. If an investor is looking for long-term growth, and all good investors should be, they will need to be diligent when it comes to screening for the best-yielding companies.

As an example of what can go wrong, if an investor were to buy a portfolio of stocks that was purely a search for the highest yield, without adjusting for risk, they could end up with shares like Seven West, Adcorp and PMP. These are not bad companies, but I do not have them in my income portfolio.

How much should you pay for yield?

What investors should be looking for is a yield of between 3 to 4.5 per cent and a growing stream of fully franked dividends. You need to be examining companies to make sure the yield a company is delivering is sustainable and the possibility for growth is there as well.

It is not difficult to find company accounts online from which to do your own due diligence. If a company's website is not easy to navigate, track the information down at ASX.

(Editor's note: The ASX dividend tool is an easy way to search for dividends).

Franked versus unfranked

Simply put, a franked dividend means a company has already paid the tax on the income. So if a dividend is not franked (and it is not an international company) you might want to query why.

A review by Treasury released late last year tightened up the regulations surrounding companies' abilities to frank dividends, so it is not always the case that a company might be avoiding tax. Laws have changed and they now allow an expanding range of companies to pay dividends; they can pay them on assets other than profits as long as it does not send the company insolvent.

This means companies with debt on their balance sheet and not technically profitable, are allowed to pay dividends, but these are still not allowed to be franked. Companies know that investors prefer franked dividends and would much prefer to issue them franked in most instances.

Sectors to examine for yields

Banks were some of the best-yielding stocks last year and are still worth a look. I have Commonwealth Bank and Westpac Banking Corporation in my income portfolio, and they are both yielding grossed-up dividends (accounting for franking credits) of over 8 per cent.

Telstra was a good yielder last year and I expect that to continue this year.

But if you are not confident making your own dividend plays, consider Listed Investment Companies (LICs).

Investing in a portfolio of 10 LICs that hold high dividend-yielding stocks hands over the responsibility of picking shares to a fund manager. It can also give you a tidy stream of returns in the process as well as a bargain if you buy the LICs at a discount to their net tangible asset (NTA).

Clime Capital Limited (CAM) is a LIC that has performed well in the past year, generating a shareholder return of more than 29 per cent in the past 12 months from share price gains and dividends.

The past seven years might have been difficult but it has provided an environment that has really tested businesses. Companies have been through a bull market, the GFC, a mild recovery, a sustained higher Australian dollar, and mixed fortunes in China. Any company that has been able to weather all this and still grow dividends is definitely worth examining further.

Sectors to avoid for yield

Listed property trusts or retail investment trusts (REITs) were once the darlings of the yield-seeking investor. But after the GFC revealed the high debt levels of those vehicles they quickly came unstuck. Gearing levels have come down since then and some are sitting on reasonable balance sheets, but the growth outlook is not good.

Retail investors need to be very aware of what they are paying for and many of these REITs have assets such as offices and warehouses that do not necessarily behave like the rest of the property market and are often difficult for the untrained investor to understand. I would say parts of the REITs sector are expensive now: the top-end property trusts are priced for absolute perfection, in my view.

How to invest for high yield

There are three questions investors need to ask themselves if they are looking for sustainable yield over the long term.

Question 1: Will the company be around in five to 10 years?

If you are buying a large listed company you know you are going to have an asset in four or five years' time. Woolworths is a classic example of a company I'm willing to bet will be around in a decade's time.

Small-cap stocks may have been delivering stellar market returns but offer much more volatility and you need to be seeking a greater risk-adjusted yield for that uncertainty. You should be allocating more of your portfolio to the top end of the market than the bottom; two-thirds versus one third is a good rule of thumb.

Question 2: Does the company have a high return on equity (ROE)?

And has it delivered that high ROE for at least the past five years and possibly the past 10 years? A high return on equity is a sign of sustained profitability.

Question 3: Does the company have low debt-to-equity ratios?

Low debt levels are important. A company that is funding its dividend payments from borrowings is rarely a good idea. Banks, which need the debt on their balance sheets, are an obvious exception to this rule.

A model portfolio

Clime Investment Management screens an investment world of more than 600 stocks using its proprietary MyClime research methodology. We assign a required return for a company that we need to see before we are prepared to invest in it. That return is higher for smaller caps and lower for companies that have a strong brand and which we expect to be around for years to come.

Our Clime Quality Rating is a view on a company's financial health. Screening for high-yielding dividend companies on a five-year view with strong fundamentals reveals a universe of the following companies, which would not be a bad start for the income-seeking investor. Here are 10 such stocks worthy of further investigation:

  1. David Jones
  2. Duet
  3. GUD Holdings
  4. Ardent Leisure Group
  5. Fleetwood Corporation
  6. NAB
  7. NIB Holdings
  8. Tatts Group
  9. SMS Management and Technology
  10. Telstra

About the author

John Abernethy is the Chief Investment Officer of Clime Asset Management. The Clime Australian Value Fund is one of the best-performing Australian equity funds over 1, 3 and 5-year periods.

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The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.

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