STEADY AS SHE GROWS 16th January 2002

Peter Freeman - Bulletin

STEADY AS SHE GROWS



Sharemarket uncertainty means investors are better off sticking with solid industrials paying good dividends rather than betting on growth stocks, writes Peter Freeman.


The uncertainty that has dominated Australian and overseas sharemarkets for more than 18 months, resulting in large performance fluctuations, has added significant weight to the view that investors are better served by targeting quality, income-generating shares rather than chasing mainly growth stocks.

For while the sharemarket boom of the late 1990s, especially in the US, delivered big gains for investors, the subsequent correction provided a sharp reminder that paper profits can evaporate quickly. In contrast, shares that pay good dividends, although not immune from a market downturn, at least provide an ongoing return that is real, not just a hope for the future.

Making this point in The Bulletin early last year, Peter Thornhill of Motivated Money cited the slump in technology stocks as a dramatic vindication of this approach. In his view, nothing has happened since then to change his assessment. On the contrary, he says, the fluctuating fortunes of Wall Street in the past six months or so provide further evidence that the average investor who bets on getting a return by picking growth stocks rather than "boring industrials" paying good dividends is making a mistake.

"A high share price can disappear as fast as it appears, often even faster," he says. "This is even true of major companies. Just look at News Corporation, whose price fluctuations are truly amazing."

Thornhill's original comments were made in the context of continuing claims that Australia's new capital gains tax system, which taxes only half of any gain provided the asset has been held for a year, would see companies and their shareholders shift away from a concern with chasing dividends.

Instead, the argument ran, many more companies would retain the bulk of their earnings to fund growth, with the result that their payout ratios would fall and dividends would stagnate. After all, with gains treated so favourably from a tax perspective, a shift in corporate strategy to emulate the US pattern, where about 70% of corporate profits are retained to fund expansion, seemed like a logical development.

However the reality hasn't borne out this prediction, with most established industrial companies in Australia continuing to maintain their payout ratios, in the process lifting their dividends. One reason has no doubt been the more sober outlook for growth as the US economy first slowed then slipped into recession. Another, more enduring factor, has been the operation of Australia's dividend imputation system, a point stressed by Anton Tagliafero, head of investments at boutique fund manager Investors Mutual.

"Imputation is a very powerful reason for local companies to continue to pay good dividends, and for investors to target them," he says. "These are usually the companies that have good, soundly based businesses and that have a proven track record of being able to increase their dividends steadily."

Tagliafero rejects the claim that capital gains tax concessions will eventually result in companies and investors putting less emphasis on dividends. He points out that not only are dividends highly tax-effective but that companies generating good dividends that are sustainable are often also the ones that produce the best total return once both dividends and share price growth are combined.

He says the uncertain investment environment means targeting these types of stocks makes even more sense than usual. In his view, the risks associated with growth stocks in the coming year are quite a bit higher than buying industrial companies generating solids dividends that carry good imputation benefits.

Just how significant the imputation system is should be apparent to anyone interested in investing rather than merely speculating. Established in 1987, the system gives investors a credit for the corporate tax already paid by the company distributing the dividend.

Although reductions in the company tax rate mean this credit has been cut from 47¢ in the dollar to 30¢, even at this level it is an extremely valuable benefit. This is particularly true now that any unused franking credits can be converted into a tax rebate. Before this change, which took effect on July 1, 2000, investors on low tax rates, including allocated pension funds that pay no tax, often wasted imputation benefits since they had insufficient taxable income to make full use of the franking credits they received.

Thornhill stresses, however, that focusing mainly on companies with a solid track record of paying dividends makes good investment sense even without the imputation system. "These are usually the companies that only retain earnings when they have fully assessed an expansion opportunity, unlike some that chase growth for growth's sake," he says.

In his view, it is all a question of getting the right balance between reinvesting profits and paying dividends. It is certainly not a case of favouring companies that pay high dividends if they also have a very high payout ratio. Investors should also remember that while listed property trusts trade on high yields – usually at least 6.5% to 7% for the major trusts – they generally deliver only very limited capital growth, mainly due to the way they distribute virtually all of their net income to investors.

In Australia, it is generally accepted that an industrial company's payout ratio – that is, the ratio of its earnings to dividends, calculated by dividing its dividend per share by earnings per share – should not exceed about 70%, with the average ratio being about 50% to 60%. In the US, the average is about 30%. While Thornhill questions the wisdom of the US approach, he is more critical of companies that have unrealistically high payout ratios. A recent example was PMP, which at one time was paying out almost 100% of earnings in a bid to avoid cutting its dividend.

Besides this issue, there are probably three other key factors to examine when deciding which dividend-paying companies to target. The most important is whether a company has a reasonable chance of at least maintaining its earnings, and so its dividend level, in coming years. Another is whether the company has its gearing under control, while the third brings us back to imputation and whether it is paying fully or partly franked dividends.

The main group of stocks that generally satisfy all criteria are the banks, although their recent share price increases mean that most are trading on yields of just over 4%, rather than the 6% or so that has often applied. Companies that are delivering yields of about 5%-6% and are generating fully franked dividends with good prospects of at least maintaining dividend levels include Abigroup, Burswood, Hills Industries, Qantas, Sims Metal and Tabcorp. Two other good prospects, Sydney Aquarium and Ten Network, have even higher yields, both at about 7.5%. While AGL, Boral, Coates Hire and Goodman Fielder have not been paying fully franked dividends, they are also worth considering.

Tagliafero says the issue of whether a company will be able to sustain earnings and so maintain its dividend involves some crystal-ball gazing and is subject to all the uncertainty that surrounds any prediction. Once account is taken of this, it is clear that some of the stockbroking reports that circulate among investors include forecasts for earnings and dividends that have an unjustified air of precision.

All an investor can do is assess whether there are any unusual factors that boosted last year's dividend and whether the company faces any major difficulties in the next few years.

If the companies pass these tests, it is reasonable to assume it has a decent chance of at least maintaining earnings and dividends.


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