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Top shares for income and growth

Photo of Dr Don Hamson, Plato Investment Management By Dr Don Hamson, Plato Investment Management

min read

Building a reliable dividend portfolio is a key to long-term wealth creation.

Although cash and fixed-income investments are traditionally considered income investments, there is a strong case for investing in equities, particularly Australian stocks, for generating income as well as capital growth.

The Australian S&P/ASX 200 generated 4.5 per cent per annum cash dividend income over the 10 years to 31 March 2017. Over the same period, the official overnight cash rate averaged 3.8 per cent and the one-year term deposit interest rate also averaged 4.5 per cent. However, the term deposit income did not, of course, include franking credits, which the dividend income stream did.

For Australian resident investors, franking credits represent a credit or refund of company tax paid on Australian company profits. Australian pension-phase superannuation investors currently receive a full refund of franking credits, so franking credits represent extra income.

Using the S&P/ASX 200 Franking Credit Adjusted Annual Total Return Index (Tax-Exempt), franking credits were worth approximately 1.5 per cent per annum over 10 years to 31 March 2017.

Chart 1 below highlights the importance of both dividends and franking credits for Australian tax-exempt investors such as charities and pension-phase superannuation.

Although the broad sharemarket has predominantly tracked sideways over the 10 years to March 2017 in capital terms, cash dividends have contributed almost $6,000 on a $10,000 initial investment on an accumulated basis (that is those dividends being reinvested).

With reinvesting the value of franking credits to a tax-exempt investor, gross dividends including these have contributed approximately $8,000 to that initial investment on an accumulated basis.

Chart 1: Australian S&P/ASX200 cumulative returns with and without dividends and franking credits – 10 years to 31 March 2017, based on investment of AUD$10,000.

Source: S&P

Dividend income and franking credits have been an important part of the total return for share investments. For the 10 years to 31 March 2017, income has represented all the return from Australian S&P/ASX 200 Index, with franking credits contributing approximately a quarter of the income for a tax-exempt investor.

How to build a reliable income portfolio – diversify

Diversification is a fundamental investment concept. Spreading investments around rather than putting all your eggs in the one basket reduces investment risk.

The yield on the Australian S&P/ASX 200 Index has been remarkably stable for the past five years, averaging around 6 per cent per annum on a gross-of-franking basis.

However, this is the yield on a diversified portfolio of 200 stocks. Single stock dividends can be far more volatile. For example, BHP Billiton, once the bellwether Australian stock, cut its dividend by 80 per cent in the 2015-16 financial year.

It has increased interim dividend 144 per cent this year, but the large cut last year highlights the risk of relying on a single stock for dividends. If an investor only had BHP in their portfolio, their income would have fallen by 80 per cent in a single year.

The big four banks (ANZ, CBA, NAB and Westpac) represent a large portion of the index and have been great yield investments over the past 20 years, but all four banks cut their dividends during the GFC.

It is important to have a good spread of stocks providing income rather than relying on a few individual names, and it is important to ensure good diversification across different industries and sectors. For example, in our opinion holding shares in just four big banks and Telstra is not a well-diversified portfolio, although it may be a very high-yielding one.

We do like the big four banks for the strong dividends, but prefer to build a well-diversified portfolio that is not overweight in banks relative to indices such as the S&P/ASX 200, to ensure there is not too much focus on a single industry.

It’s not all about income

Although investors might be focused on income, they should also be very focused on the total return outcome – the combined return from dividend income and capital return.

The capital return even on a diversified portfolio of equities can be quite volatile. Accordingly, if you are investing in shares to provide income, you need to take a long-term perspective, arguably a full market cycle of say five to seven years or more.

We would certainly not recommend investors use equities as a short-term income investment, because share values can easily fall 5 to 10 per cent in a short time.

Over the 10 years to March 2017 the Australian market fell more than 5 per cent in 13 individual months, which means there was just under a one in 10 chance of the market falling by more than 5 per cent in any given month. In two of those months the market fell by more than 10 per cent.

Beware the dividend traps

One important final word of warning about investing in equities for income relates to dividend traps. Dividends should not be taken for granted; the 80 per cent cut in BHP’s dividend highlights the risk.

It can be worse. Some companies cut their dividends completely, such as Metcash in June 2015 and it has not paid a dividend since.

We believe one of the worst ways to pick income stocks is to choose stocks with the highest historic dividend yields. Just before Metcash announced it would not be paying a dividend in 2015 it was trading on a very high historic dividend yield of approximately 12 per cent on a cash basis and over 15 per cent on a gross-of-franking basis. But this high yield provides a warning signal.

Historic dividend yields represent the last 12 months of dividends divided by the most recent share price. The reason Metcash was trading on a high historic yield was because its share price had fallen significantly over the previous year.

When building an income portfolio, investors need to look ahead at future dividend prospects rather that invest by looking in the rear-view mirror at dividends paid last year.

Looking forward, we still expect the Australian equity market to provide around 6 per cent income grossed-up for franking in the coming year, which is still an attractive level of income compared to current cash and fixed-income investments.

About the author

Dr Don Hamson is Managing Director at Plato Investment Management Limited. This article is for general information and does not take account of personal objectives, financial situation or needs. In early May, Plato was due to list LIC PL8, an actively managed, diversified portfolio of Australian shares with an income focus, paying monthly dividends.

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