Michael Price is Portfolio Manager of the Ausbil Active Dividend Fund at Ausbil Investment Management.
Regular equity income can help beat longevity risk and inflation, but finding quality income in equities is not as simple as it seems. Ausbil’s Michael Price talks us through successful active dividend investing.
Investors in the later stages of their accumulation phase, approaching retirement, and in retirement can benefit from the use of equities as part of their overall income plan. With a rolling 10 year dividend yield of 4.18%, equities can provide a vastly more attractive income than alternatives. Investors face two major risks that impact how much they have to fund retirement, and how long this will last: longevity risk, and the risk of inflation/rising costs over time. In simple terms, longevity risk is the risk of outliving your money. Inflation risk is the risk that rising costs (such as healthcare) reduces the purchasing power of your money each year. An equities approach to income can help outpace those rising costs, and provide long-term capital appreciation to help replenish funds.
Why does active dividend income investing work?
An active dividend investment approach can add value to a portfolio, and generate outperformance, through focusing on quality companies with strong dividends and dividend growth, companies with sustainable earnings growth, maximising the benefits available through the tax and imputation system, and tactical allocation to capture a greater share of dividend income.
Markets are efficient, but not perfect. The first and most fundamental reason that an active approach to income investing works is the fact that the market is relatively inefficient, particularly in the short term. However, some inefficiencies can be traps.
The risk of chasing yield for yield’s sake
The assumption that many income investors make regarding dividend yields is that the relationship of current dividend yield to future earnings growth is linear, that is, the higher the dividend yield, the higher the future earnings growth from which dividends are paid. This assumption does not actually hold in the market.
On average, the top dividend yield companies actually see low, or even negative, earnings growth going forward compared to companies in the 4th to 7th decile of companies, as illustrated in Figure 1. This has been true for the last 20 years. An active approach does more than simply chase the highest yield, as would a passive approach to yield. An active dividend income strategy can increase income from companies whose dividends are healthy, but maybe not the highest, because they are also investing earnings into a growing business, hence into better earnings growth in the year ahead. Another quirk of dividend investing is that the highest yielding stocks are more volatile, as illustrated in Figure 2.
Top decile dividend yielding companies tend to show higher volatility in returns, on average. An active approach to dividend income investing can seek to reduce portfolio return volatility by not chasing yield for yield’s sake, but investing judiciously on the fundamental value of future sustainable earnings growth. Finally, top dividend paying securities may not be good value-for-risk, as illustrated in Figure 3.
Chasing the highest dividend yield companies can provide poor value for risk taken when compared to the market. Lower decile stocks by dividend yield demonstrate a better performance for risk than for the top decile of dividend yield companies. High dividend payout ratios may also be indicative of a lack of equity reinvestment opportunities for a company, back into growing their own business. A company with a sustainable dividend profile usually seeks to reinvest some earnings into their business, into positive return projects that can generate earnings growth in the future. A classic example of a high dividend paying company compared to a company which has reinvested some earnings into productive opportunities for reinvestment is the difference between Telstra and CSL.
Purely to illustrate two different journeys, take a look at the following example. Telstra was long considered a key dividend paying stock, but the burden of being the largest telco, legacy systems and infrastructure cost, rapid change and limits to growth have seen Telstra lose its status as a key dividend stock. By contrast, CSL has steadily transformed itself from also being government owned, as the Commonwealth Serum Laboratories, into a global leader in biotechnology, largely by balancing the payment of dividends with significant reinvestment into areas that can generate future growth in earnings, as illustrated in figure 4. Of course, these relationships may change over time, but it can take a long time for a company to change its course.
Astute active dividend income approaches can seek dividend yield while avoiding companies with no opportunity to reinvest to improve earnings and returns. With active dividend income approaches, investors like SMSFs, retirees, and investors approaching retirement can diversify away from traditional sources of income, like fixed income and term deposits, for a longer-term approach, diversified across high-quality Australian companies. They can do this in equities without sacrificing the potential for long-term growth.
 Source: S&P Dow Jones, S&P ASX 200 rolling 10-year dividend yield
About Ausbil Investment Management Ausbil is a leading Australian based investment manager. Established in April 1997, Ausbil’s core business is the management of Australian equities for major superannuation funds, institutional investors, master trust and retail clients. Ausbil is owned by its employees and New York Life Investment Management a wholly-owned subsidiary of New York Life Insurance Company. As at 31 July 2019, Ausbil manage over $12.2 billion in funds under management.
Unless otherwise specified, any information contained in this publication is current as at the date of this report and is prepared by Ausbil Investment Management Limited (ABN 26 076 316 473 AFSL 229722) (Ausbil). Ausbil is the issuer of the Ausbil Active Dividend Income Fund (ARSN 621 670 120) (Fund). This report contains general information only and the information provided is factual only and does not constitute financial product advice. It does not take account of your individual objectives, financial situation or needs. Before acting on it, you should seek independent financial and tax advice about its appropriateness to your objectives, financial situation and needs. Securities and sectors mentioned in this monthly report are presented to illustrate companies and sectors in which the Fund has invested and should not be considered a recommendation to purchase, sell or hold any particular security. Holdings are subject to change daily. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested. Past performance is not a reliable indicator of future performance. Unless otherwise stated, performance figures are calculated net of fees and assume distributions are reinvested. Due to rounding the figures in the holdings, breakdowns may not add up to 100%. No guarantee or warranty is made as to the accuracy, adequacy or reliability of any statements, estimates, opinions or other information contained herein (any of which may change without notice) and should not be relied upon as a representation express or implied as to any future or current matter. You should consider the Product Disclosure Statement which is available at http://www.ausbil.com.au before acquiring or investing in the fund.