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Why I love dividends and you should too

Posted On:Aug 13th, 2014     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

Up until the 1950s most share investors were long term investors who bought stocks for their dividend income. This changed in the 1960s as bond yields rose on the back of inflation and investors started to shift focus to capital growth. However, thanks to the volatility seen over the last decade or so, and an increased focus on investment income

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Up until the 1950s most share investors were long term investors who bought stocks for their dividend income. This changed in the 1960s as bond yields rose on the back of inflation and investors started to shift focus to capital growth. However, thanks to the volatility seen over the last decade or so, and an increased focus on investment income as baby boomers retire, interest in dividends has been on the rise. Investor demand for dividends is clearly evident in Australia with even the big resource stocks starting to heed the call. This is a good thing because dividends are good for investors in more ways than just the income they provide.

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It’s well-known Australian companies pay out a high proportion of earnings as dividends. This is currently 75%, and it’s averaged around this since the late 1980s. Banks, telcos, consumer stocks and utilities are the big dividend payers. By contrast in the major global markets dividend payout ratios range from 31% in Japan to 49% in the UK.

However, some argue that dividends are irrelevant and simply don’t matter – as investors should be indifferent as to whether an investment pays a dividend, or whether the company retains earnings that are reinvested to drive earnings growth. Or worse still, some argue that high dividend pay outs are a sign of poor long term growth prospects or that they are not sustainable. And of course, some just see dividends as boring relative to the excitement that can come from speculating on moves in share values. My assessment is far more favourable.

Dividends are cool

There are lots of reasons to love dividends and here they are. First, dividends do matter in terms of returns from shares. For the US share market it has been found that higher dividend pay outs lead to higher (not lower) earnings growth.¹ This is illustrated in the next chart which shows that for the period since 1946 whenever US companies have paid out a high proportion of earnings as dividends (the horizontal axis) this has tended to be associated with higher growth in corporate profits (after inflation) over the subsequent 10 years (vertical axis).

Source: Global Financial Data, Thomson Reuters, AMP Capital

And of course higher growth in company profits contributes to higher returns from shares over the long term. This all suggests dividends do matter & the higher the better (within reason). There are several reasons why this is the case:

  • when companies retain a high proportion of earnings there is a tendency for poor investments which subsequently leads to poor earnings growth;

  • high dividend pay outs are indicative of corporate confidence about future earnings (otherwise companies would not feel comfortable in paying them);

  • high dividend pay outs are a positive sign as they indicate earnings are real, ie backed by cash flow.

The bottom line is that strong dividend pay outs are more likely to be consistent with strong, not weak, earnings growth. The higher dividend yield and pay out ratios for Australian companies, compared to mainstream global share markets, is a positive sign for relative returns from the Australian share market on a medium term basis – particularly at a time when the boost to national income from the terms of trade is going in reverse.

Secondly, concerns about the sustainability of dividends fly in the face of all the evidence that companies like to manage dividend expectations smoothly. They rarely raise the level of dividends if they think it will be unsustainable. As can be seen below, dividends move roughly in line with earnings but are a bit smoother. For an investor this means the flow of dividend income is relatively smooth.

 

Source: Thomson Reuters, AMP Capital

Thirdly, decent dividend yields provide security during uncertain times. As can be seen in the next chart dividends provide a stable contribution to the total return from shares over time, compared to the year-to-year volatility in capital gains. Of the 11.8% pa total return from Australian shares since 1900, just over half has been from dividends.

Source: Global Financial Data, AMP Capital Investors

Fourthly, investor demand for stocks paying decent dividends will be supported over the years ahead as more baby boomers retire and focus on income generation.

Fifthly, with the scope for capital growth from shares diminished thanks to relatively high price to earnings ratios compared to 30 years ago, dividends will comprise a much higher proportion of total equity returns than was the case in the 1980s and 1990s globally and in Australian shares up until 2007. Around half of the total return from Australian shares over the next 5 to 10 years is likely to come from dividends, once allowance is made for franking credits.

Finally, and for some most importantly, dividends provide good income. Grossed up for franking credits the annual income flow from dividends on Australian shares is currently around 5.7%. That’s $5700 a year on a $100,000 investment in shares compared to $3500 a year on the same investment in term deposits (assuming a term deposit rate of 3.5%).

Another angle on dividend income

The next chart illustrates just how powerful investing for dividend income (without even really trying) can be relative to investing for income from bank term deposits. It compares initial $100,000 investments in Australian shares and one year term deposits in December 1979. The term deposit would still be worth $100,000 (red line) and last year would have paid $4,150 in interest (red bars). By contrast the $100,000 invested in shares would have grown to $1,054,000 (blue line) and would have paid $45,000 in dividends before franking credits (blue bars). This would translate to around $59,650 if franking credits are allowed for. The reason for the difference is over time an investment in shares tends to rise in value, whereas an investment in term deposits is fixed.


 

Source: RBA, Bloomberg, AMP Capital

New highs

Finally, while we all bemoan the fact that Australian shares are still trading around 20% below their 2007 all-time high, once reinvested dividends are allowed for (ie looking at the ASX 200 accumulation index) the Australian share market is now above its all-time high. In other words an investor who (god forbid) put all their money into the market at the peak in 2007 would now be in the black if they had reinvested dividends along the way.

 

Source: Bloomberg, AMP Capital

Why dividend imputation is important

Which brings us to the topic of dividend imputation. This arrangement was introduced in the 1980s and allows Australians to claim a credit for tax already paid on their dividends in the hands of companies as corporate earnings and effectively boosts the average dividend yield on Australian shares by around 1.5 percentage points. However, in recent times it has been subject to some questioning with the interim report of the Financial System Inquiry questioning whether dividend imputation was creating a bias to invest in domestic equities and adversely affecting the development of the corporate bond market. Meanwhile, some such as Treasury argue that it along with other tax concessions (like negative gearing) primarily benefit the rich.

The trouble is that dividend imputation actually corrects a bias by removing the double taxation of earnings – once in the hands of companies and again in the hands of investors. It also encourages corporates to give decent dividends to shareholders as opposed to irrationally hoarding earnings. Interest on corporate debt never suffered from double taxation as it is paid out of pre-tax corporate earnings. And all such concessions encourage savings in the face of Australia’s relatively high marginal tax rates. The removal of dividend imputation would not only reintroduce a bias against equities but substantially cut into the retirement savings and income of Australian investors, discourage savings and lead to lower returns from Australian shares. So hopefully common sense will prevail and dividend imputation will not be tampered with.

Concluding comments

Dividends are often overlooked. But they provide a great contribution to returns, a degree of protection during bear markets and a great income flow. Investors should always allow for them in their investment decisions.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

¹ See R.D.Arnott and C.S.Asness, “Surprise! Higher Dividends = Higher Earnings Growth”, Financial Analysts Journal, Jan/Feb 2003. Of course it’s become a bit complicated for US shares in recent times as the tax system effectively encourages companies to return capital to investors as buy backs as opposed to dividends, which might be argued to be the same thing.

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

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The medium term return potential for major assets – still constrained

Posted On:Aug 07th, 2014     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

Most investment analysis and commentary is focused on the here and now and the implications for investment markets just a little bit ahead. But getting a handle on the return potential for major asset classes over the medium term, ie the next five years or so, is of value from several perspectives. First, such return projections are a critical driver

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Most investment analysis and commentary is focused on the here and now and the implications for investment markets just a little bit ahead. But getting a handle on the return potential for major asset classes over the medium term, ie the next five years or so, is of value from several perspectives. First, such return projections are a critical driver of the strategic asset allocation (SAA) to each asset class (shares, bonds, property, etc) within traditional diversified investment funds.

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Second, and more fundamentally, it gives a great guide to return potential between asset classes, which helps inform asset allocation generally. For example we use medium term return projections as part of our Dynamic Asset Allocation process.

Finally, it can help provide a guide to what sort of returns investors can expect beyond the short term. After a couple of years of double digit returns from shares and balanced growth superannuation funds there may be a temptation to assume we have now returned to a world of ongoing double digit returns. But this could be mistaken if it’s not sustainable.

This note takes a look at the medium term return potential for major asset classes and what that means for investors.

Getting a handle on return potential

The first thing to note is that simply taking a long term average of historical returns for each asset class and using that as a guide may be use, but often offers little guide to their medium term outlook given the significant impact of starting point valuations (eg, if current yields are significantly lower than normal then this will constrain returns relative to any long term norm) and the broad economic environment. Another approach may be to come up with a bunch of themes and start from there. But without a framework in which to place them this can simply lead to a muddle.

So our approach is to go back to basics, recognising firstly that the components of the return flowing from an asset are the yield (or income flow) it provides and capital growth and secondly that the starting point yield is key, ie, the higher the better. Then apply themes around this where relevant. We also prefer to avoid a reliance on forecasting and to keep the analysis as simple as possible. Complicated adjustments can lead to compounding forecasting errors without any value in terms of the broad message.

  • For equities, a simple model of current dividend yields plus trend nominal GDP growth (as a proxy for earnings and capital growth) does a good job of predicting medium term returns. This approach allows for current valuations (which are picked up via the yield) but avoids getting too complicated1. The next chart shows this approach applied to US equities, where it can be seen to broadly track big secular swings in returns.


Source: Thomson Reuters, Global Financial Data, AMP Capital

  • For property, we use current rental yields and likely trend inflation as a proxy for rental and capital growth.

  • For unlisted infrastructure, we use current average yields and capital growth just ahead of inflation.

  • For bonds, the best predictor of future medium term returns is the current five year bond yield. In other words capital growth is zero because if a five year bond is held to maturity its initial yield will be its return.

Medium term return projections

This framework results in the return projections shown in the next table. The second column shows each asset’s current income yield, the third their five year growth potential and the final column their total return potential. Note that:

  • We assume central banks meet their inflation targets over time, eg, 2.5% in Australia and 2% in the US.

  • We allow for forward points in the return projections for global assets based around current market pricing – which adds 1.8% to the return from world equities (Australian interest rates above that in other advanced countries) but detracts 1.9% from emerging equities.

  • The Australian cash rate is assumed to average 3.5% over the next five years. This is one asset where the current yield is of no value in assessing the asset’s medium term return potential because the maturity is so short. So we assume a medium term average. Normally, for cash this would be around a country’s medium term nominal growth rate, but we have made an allowance to adjust for higher than normal bank lending rate margins over the cash rate and higher debt to income ratios which have increased the interest sensitivity of households, and in turn pulled down the neutral cash rate.

  • The Australian equity return adjusted for franking credits (that adds about 1.4% pa) is shown in brackets.


# Current dividend yield for shares, distribution/net rental yields for property and 5 year bond yield for bonds. ^ Includes forward points. * With franking credits added in. Source: AMP Capital

Thematics

Several themes have been reflected in these projections:

  • Low inflation – while inflation worries abound reflecting the quantitative easing programs of the last few years, this is likely to be offset by continued global excess savings and spare capacity along with central banks being mandated to meet inflation targets.

  • Aging populations – resulting in slower labour force growth than seen over the last twenty or so years and a demand for yield bearing assets with less focus on capital growth.

  • Slower household debt accumulation – the surge in household debt growth seen in the decades prior to the GFC looks to have run its course with tougher bank lending standards and more cautious consumer attitudes.

  • The commodity super cycle has turned down – on the back of slower growth in China and increased commodity supply. This will act as a constraint on growth for some emerging markets (eg South America) but benefits commodity user regions (such as Asia, Europe and Japan). It also means the terms of trade has gone from a tailwind for Australian growth and profits to a headwind. To allow for this we have reduced nominal capital growth potential by 0.5% pa for Australian shares.

  • Technological innovation – with its intensified focus on labour saving (eg robotics, 3D printing) it is likely good for productivity and corporate margins but ambiguous for consumer spending.

  • Reinvigorated advanced countries versus emerging markets – while the emerging world still has a higher growth potential (reflecting its lower starting point) it’s likely to be slower over the decade ahead than last decade reflecting a slowdown in economic reforms but at the same time the US, Europe and Japan appear to be reinvigorating themselves after a tough decade (or two in the case of Japan).

  • A multi-polar world – the end of the cold war and the stabilising influence of the US as the dominant power helped drive globalisation and the peace dividend post 1990. Now China’s rise and Russia’s retreat are arguably resulting in a more difficult environment geo-politically.

  • Backtracking on free markets in parts of the world – a greater scepticism of unfettered markets and increased focus on regulation post the GFC.

Most of these will likely have the effect of constraining returns. But not universally so. Technological innovation remains positive for profits and the renaissance in the US, Europe and Japan is very positive.

Observations

Several observations flow from these projections.

  • While advanced countries may have exited a secular bear market, return potential is still constrained. The starting point for returns today is less favourable than when long term bull markets started in bonds and equities in 1982 (with much lower investment yields today) & the thematic backdrop is less favourable. Our medium term return projections imply a 7.7% pa return from a diversified mix of assets. This is well below the 11.9% pa return Australian super funds saw over the 1982-2007 period which was underpinned by the combination of high starting point investment yields and very favourable investment thematics with the shift from high to low inflation, deregulation, easy credit, globalisation, the peace dividend, the IT revolution, favourable demographics and finally for Australia a surge in commodity prices.

  • Sovereign bonds offer low return potential – after a thirty year secular decline in bond yields the combination of very low yields and the risk they will rise resulting in capital loss implies low medium term return potential.

  • Unlisted commercial property & infrastructure continue to come out well reflecting their relatively high yields – but don’t forget their illiquidity.

  • Australian shares stack up well on the basis of yield, but it is hard to beat Asian ex-Japan shares for growth potential and traditional global shares offer improved prospects.

Implications for investors

There are several implications for investors:

  • First, have reasonable return expectations. The world is in far better shape today than at any time since the GFC but don’t expect year after year of double digit returns.

  • Second, asset allocation remains critical reflecting: the relatively constrained medium term return potential; a likely wide range in returns between major asset classes; continued bouts of volatility (eg as extreme monetary policy conditions in the US and elsewhere are eventually unwound); and as the correlation between bonds and equities remains low (in the absence of a common driver like falling inflation provided in the 1980s and 1990s).

  • Third, there is still a case for a bias towards Australian shares, particularly for yield focused investors, but with traditional global shares looking a bit healthier after a long tough patch have a bit more offshore. Asian ex-Japan shares are preferred relative to emerging market shares generally.

  • Fourth, focus on assets providing decent sustainable income as it provides confidence regarding returns. Commercial property, infrastructure, quality yield shares and investment grade credit stack up well here.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

 

1For example, adjustments can be made for: dividend payout ratios (but history shows that retained earnings often don’t lead to higher returns at the country level so the dividend yield is the best guide); the potential for PEs to move to some equilibrium level over time (but this relies on forecasting the equilibrium PE correctly which can be hard and in any case extreme dividend yields send a strong enough valuation signal anyway); and adjusting the earnings/capital growth assumption for some assessment regarding profit margins (but again this has been shown to be very hard to get right at the country level, eg US profit margins have been strengthening for decades and it’s hard to see what will turn this around). So we prefer to keep any reliance on forecasts to a minimum and to keep it simple.

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

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Market Watch – August

Posted On:Aug 05th, 2014     Posted In:Rss-feed-market    Posted By:Provision Wealth

Download Market Watch – August edition and read the full report.

In this month's issue:Australian dollar: where to next?

5 things investors need to know about hybrid securities

Infrastructure boom: Opportunities for industrial property

Natural gas extraction: What’s the ‘fracking’ problem

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Download Market Watch – August edition and read the full report.

  • In this month's issue:Australian dollar: where to next?

  • 5 things investors need to know about hybrid securities

  • Infrastructure boom: Opportunities for industrial property

  • Natural gas extraction: What’s the ‘fracking’ problem

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Investment outlook after another solid financial year

Posted On:Jul 24th, 2014     Posted In:Rss-feed-video    Posted By:Provision Wealth

Key points with Shane Oliver, Head of Investment Strategy and Chief Economist:

The past financial year saw solid to strong returns from most asset classes drive good returns from balanced and growth oriented investment strategies, including from super funds.

Investors should expect returns to slow over the year ahead, but they are likely to remain solid as share valuations are

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Key points with Shane Oliver, Head of Investment Strategy and Chief Economist:

  • The past financial year saw solid to strong returns from most asset classes drive good returns from balanced and growth oriented investment strategies, including from super funds.

  • Investors should expect returns to slow over the year ahead, but they are likely to remain solid as share valuations are still reasonable, the global economy continues to grow, the Australian growth outlook improves and monetary conditions remain easy.

Chapters in this video:

  • What's been happening in markets? (00:00)

  • What's the outlook for the economy? (00:52)

  • Final thoughts (01:52)

This video must be taken in its entirely and any given chapter viewed in isolation does not represent the entire message.
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Investment outlook after another solid financial year

Posted On:Jul 24th, 2014     Posted In:Rss-feed-video    Posted By:Provision Wealth

Key points with Shane Oliver, Head of Investment Strategy and Chief Economist:

The past financial year saw solid to strong returns from most asset classes drive good returns from balanced and growth oriented investment strategies, including from super funds.

Investors should expect returns to slow over the year ahead, but they are likely to remain solid as share valuations are

Read More

Key points with Shane Oliver, Head of Investment Strategy and Chief Economist:

  • The past financial year saw solid to strong returns from most asset classes drive good returns from balanced and growth oriented investment strategies, including from super funds.

  • Investors should expect returns to slow over the year ahead, but they are likely to remain solid as share valuations are still reasonable, the global economy continues to grow, the Australian growth outlook improves and monetary conditions remain easy.

Chapters in this video:

  • What's been happening in markets? (00:00)

  • What's the outlook for the economy? (00:52)

  • Final thoughts (01:52)

This video must be taken in its entirely and any given chapter viewed in isolation does not represent the entire message.
Read Less

European Central Bank provides more monetary stimulus

Posted On:Jul 24th, 2014     Posted In:Rss-feed-video    Posted By:Provision Wealth

Dr. Shane Oliver, Head of Investment Strategy and Chief Economist discusses the European monetary stimulus.

Chapters in this video

Snapshot of the European economy (00:00)

Why is monetary policy easing in Europe? (00:56)

What does it mean for investors? (01:38)

This video must be taken in its entirely and any given chapter viewed in isolation does not represent the entire message. Read More

Dr. Shane Oliver, Head of Investment Strategy and Chief Economist discusses the European monetary stimulus.

Chapters in this video

  • Snapshot of the European economy (00:00)

  • Why is monetary policy easing in Europe? (00:56)

  • What does it mean for investors? (01:38)

This video must be taken in its entirely and any given chapter viewed in isolation does not represent the entire message.
Read Less
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