With the RBA recently reducing the cash rate to 1%, people have to have over $10m in the bank just to have a shot at maintaining an average standard of living off bank interest. In this new paradigm of low-interest rates, it is clear why more and more investors are looking at dividend stocks for income. Typical dividend stocks like banks often pay a dividend of around 6%, which does not allow all investors to attain the lifestyle they aspire to. This is why we identified three stocks in the ASX 200 paying a dividend of 9%. Two of these names pay a dividend yield of over 10% and are the highest two yielding stocks in the index. For investors who want to maximise the income from their portfolio, it makes sense to look at companies who pay out the most in dividends.
The companies operate across three sectors: energy, mining and real estate. Real estate investment trusts pay out high dividend yields because tenants pay most outgoings and the trust hardly needs to reinvest any of the money it makes. Energy and mining stocks often pay out high dividends because they are cyclical, and investors don’t always know if the dividend will continue. A high dividend in and of itself is not enough to warrant making an investment decision and ensuring that the yield you get is quality yield is important.
The search for quality yield is about finding a stock that is unlikely to cut its dividend and can slowly increase its dividend yield over time through steady earnings growth. The payout ratio is a good proxy for a dividend cut; if a business is paying out more than 80% of profits, like Westpac (ASX: WBC) and CommBank (ASX: CBA), it often has a higher than average chance of needing to cut its dividend to get some cash to reinvest. Cyclical sectors such as banking and mining are also susceptible since their earnings can swing more than normal in a downturn.
For our analysis, we use a forward dividend yield, which is based on the projected dividend yield the company will pay out after you buy the shares. The dividend you receive is much more important to you than what the previous owner of the shares received, which is why we focus on this measure. The three stocks in this report are projected to continue yielding 9% or more after you buy the shares, another reason to consider these stocks.
High yielding stocks tend to perform better than the market in recessions and downturns because investors look for stable income opportunities. Not all dividend stock, however, will outperform, and some will badly underperform if they are in cyclical industries. US banks, for instance, lost an average of well over 80% of their value in the GFC, and many have either gone completely bust (Lehman being a case in point) or never recovered. This is why it’s not good enough to just search for yield, you need quality yield.
Unibail-Rodamco-Westfield (ASX: URW)
URW is a real estate investment trust that was formed after Unibail merged with Westfield. The REIT trades on the ASX and, unlike other real estate investment trusts, has heavy exposure to offshore real estate. Their offshore exposure is to properties in Europe and the United States, so the countries do not have a particularly high level of risk. The advantage of investing offshore is that you can get much higher yields on real estate assets, and they are in safe developed countries with good regulatory environments.
One problem that affected Australian REITs in the GFC was very high levels of debt, which magnified asset value declines. While URW’s 79.7% debt to equity ratio is high, it is similar to taking out a 40% home loan on your property since there is more equity than debt.
The company is projected to actually increase its dividend yield over the next two years, despite it already being the third-highest on the ASX 200. This is because commercial real estate tenants have long leases, and agree to pay higher rents every year, in line with inflation.
While Unibail-Rodamco-Westfield has a high yield, there are a couple of stocks on the ASX 200 which pay a dividend yield over 10%. One of these is 25%, so if you are even more ambitious with dividend income, the next two stocks are likely to be of interest.
Fortescue Metals Group (ASX: FMG)
Fortescue Metals (ASX: FMG) pays out a 12.3% dividend yield and is one of the largest companies in the iron ore market. The company is forecast to increase its earnings this year and has a low payout ratio of 59%. This means that the company has the capacity to take a hit to its profits without compromising its ability to deliver high dividend payouts. While nothing stops the company cutting their dividend voluntarily, at least there is a cushion for profits to fall before they are forced to cut their dividend payout.
The main factor holding investors back from Fortescue Metals is that they produce a lower quality iron ore, known as 58% grade iron ore, as compared to the 62% grade produced by BHP and Rio Tinto. This leaves the company more exposed to corrections in the iron ore market since more consumers will choose the better grade of iron ore when it is cheap. This means that the price of Fortescue’s grade of iron ore will fall the most in a bear market for the commodity, which increases share price volatility.
Despite this weakness, Fortescue has improved the sustainability of its business model by aggressively pursuing cost reduction. This strategy ended up making Fortescue the lowest cost producer in the industry, meaning that it would not make any sense for the iron ore price to go below their cost of production since all producers will be making a loss. While many analysts are bearish on the commodity, Fortescue’s CEO recently said that she continues to see strong demand levels in China, despite the trade war creating growing concerns in financial markets.
Coronado Global Resources (ASX: CRN)
Coronado Global Resources is a listed coal producer, which paid out a phenomenal 25.2% dividend yield at the end of last year. The company produces met coal, which is a necessary ingredient in steel production. This is because of the heat generation capacity of met coal. Thermal coal, which is used for electric power stations could see falling demand if the switch to renewables accelerates but met coal does not have a substitute in the steel production process. This means that if you do invest, you are buying into a relatively high-quality coal producer.
There are considerations other than the dividend yield however, one of which being the sustainability of their income. Analysts are projecting a bearish picture for coal prices, with futures pointing to coal price declines. Nevertheless, even if these bearish forecasts do pan out, the company will still yield around 10%. While that alone is not enough to make an investment decision, it isn’t often that a company still yields 10% if pessimistic forecasts eventuate.
Is There any Magic Formula for Quality Yield?
On HALO, our portfolio management and analytics tool, we have a monitor designed to identify companies with a quality yield. This helps identify companies which will not only provide you with a stable income stream but also one that grows over time.
Given that the average Australian house cost well under a thousand pounds a century ago, it is imperative to make sure your income keeps up with inflation. Many dividend investors, however, think that it is fine for a company to now grow its dividends at all, and some even unquestioningly live with declines in dividend income that go on for years. We don’t, which is why our quality yield monitor will only return companies that have growing dividends.
It is also important however that if you are investing for yield, the company you are investing in has dividends which are better than average. While we do recommend keeping an open eye to global opportunities, the Australian market does have higher average dividends than most other global exchanges, primarily due to the tax advantages of paying out profits in the form of dividends. We ensure that all the dividend stocks we recommend have a yield of over 5%, which is 25% above the average for the index. While Australia is a dividend investor’s paradise, you still want to be doing better than average in terms of the income you will get today.
Since the monitor is designed by a top-performing fund manager who has seen a few financial crises, it excludes any companies with a debt to equity ratio above 30%. This automatically rules out the big banks and has been included because companies with high levels of debt often go bust in recessions, leading to permanent loss of capital. Anyone who has been in the markets a while can tell you that permanent loss of capital is a much bigger problem than price risk or even dividend cuts because the entire investment is lost forever. This is why we make sure that we focus on low debt companies; when well-managed, these businesses are unlikely to go bankrupt and are more likely to be able to maintain dividend payouts.
Figure 1: Dividend cuts often come at the worst times (Source: Standard and Poor)
Another factor we consider is the return of equity of the business. Many investors turn a blind eye to this metric, losing large sums of hard-earned money in the process. Return on equity is the profit of the company divided by the amount of money the business investment to get those returns. This is often very different from the market capitalisation of the business and represents the efficiency by which management gets returns on the cash invested.
This is important because it is too low, management is most likely not efficient at making money, or the business operates in a low-quality industry. Both these factors make dividends more unstable and increase the chance of a dividend cut. The problem with dividend cuts is that you often take a capital loss by moving the money elsewhere, which is why we make sure that all companies we invest in have a return of equity that is over 10%. This is a good indicator that the business is of a reasonable overall quality.
The last part of our monitor screens out businesses with a market capitalisation of less than a billion dollars. While not essential, it gives us businesses that investors are more likely to be aware of, as well as ones that are more liquid.
Is this all I need to do?
Before investing in a company, it is always a good idea to understand the business model. If you’re an existing subscriber, you have the option of contacting one of our advisors, reading our reports or seeing what the large investment banks and brokers think will happen to the dividend over the next three years through HALO. If you don’t use our service however, you still have access to company presentations and annual reports by searching the company’s stock ticker on the ASX website. While this won’t be as comprehensive a research process, it will certainly be better than doing nothing.
By understanding the business and speaking to an advisor, you will be able to pick up issues which might not come up, at first sight, using the HALO monitor. One such example is a company making great returns on equity with low debt and high dividends, that have grown year on year because the industry is in a cyclical upswing. If the cycle changes, a company like this may still see a dividend cut, similar to BHP in 2016. This is why we would recommend at least reading a few company presentations to better understand the business and industry in which it operates before making a trade.
Is There a More Set and Forget Way to Invest in Dividend Stocks?
Our international high dividend Vue, a selected list of international stocks with attracts no management or performance fees, pays an 8-9% dividend yield. For investors who also want to not tie all their assets to the health of the Aussie economy, an 8-9% dividend yield beats 1% in local banks. This is one of the many options that investors have if they want to boost their income and get out of the trap of declining interest rates that has defined term deposits over the past few years.
One of the securities we hold in the Vue is Gaming and Leisure Properties Inc. This is a Real Estate Investment Trust (REIT) covering high-quality properties in the United States. While gaming is a cyclical business, the beauty of the REIT is that it only controls the underlying real estate, not gaming businesses like casinos. Their properties are leased to experienced operators in triple net lease arrangements, which means that they will get a steady income stream for years. Their clients are large, safe and experienced gaming operators, which are very unlikely to go bankrupt. The attractive 7.11% yield significantly outpaces Aussie REITS, which typically yield 3-5% for properties of similar quality.
We also hold a top 3 Global private equity firm, which manages over US$220 billion in AUM. PE firms run investment funds that buy out entire businesses, improve efficiency and profitability as they transform the operations of those companies, sell them at a profit. After this, the PE firm will close its fund and receive a large component of its performance fees.
This creates a volatile earnings stream, given the company is paid for their performance after a few years. For this reason, private equity as an industry tends to be poorly understood by investors. In a market obsessed with quarterly earnings, the great 20%p.a. long-term growth rate of a brilliant business with sustainable competitive advantages is completely ignored by the market. This creates a great opportunity for us to use our long-term investment mindset to our advantage, and lock in a 7.81% yield at 7.6x earnings.
The importance of quality yield explains why we still recommend stocks paying a 4-5% dividend locally, despite being able to easily find stocks paying much more. We would rather a 4-5% dividend that could sustainably grow to over 10% of the initial investment over a few years, than a 10% dividend for a company in terminal decline.
This article has been prepared by the Australian Stock Report Pty Ltd (AFSL: 301 682. ABN: 94 106 863 978)
(“ASR”). ASR is part of Amalgamated Australian Investment Group Limited (AAIG) (ABN: 81 140 208 288 Level 13, 130 Pitt Street, Sydney NSW 2000).
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ASR has no position in any of the stocks mentioned.