Chasing sustainable income without blowing up capital

As Mayfair 101 investors can attest, there is no point chasing higher rates of income if it is not sustainable or results in capital destruction.  

Here are 4 key qualities that investors can look for when researching a company, infrastructure or property trust in order to assess the sustainability of income.

Dividend Payout Ratio

Hugh Dive (Portfolio Manager Atlas Funds Management) says that generally anything above 80% suggests that the current level of the dividend may not survive the inevitable variabilities in profits from the economic cycle.  Though this can be industry-specific, a regulated electricity utility such as Spark Infrastructure can handle a higher payout ratio due to greater certainty of earnings than a mining company such as Alumina.  Spark Infrastructure offers investors an income yield of around 6.3% based on the current share price.

Financial Health of the company

If a company is highly geared, there is a greater risk that the dividend may be reduced or cut to placate its bankers when economic conditions worsen.

Franked income = tax payments

While companies can make a range of aggressive accounting choices that can boost their earnings per share (and dividend per share), a company is unlikely to maximise the tax they pay to the government. Firms that pay franked dividends have significantly more persistent earnings than firms that pay unfranked dividends. It indicates that a company is building up tax credits by generating taxable earnings in Australia. This measure is not useful for companies such as CSL and Amcor who generate large proportions of their profits outside Australia and therefore cannot pay fully franked earnings.

Growing income

Roger Montgomery (CEO Montgomery Investment Management), sums it up by saying that the key is not the search for a high yield, but for a growing income.  There’s a very strong correlation between rising levels of income and share prices so investors who can put together a portfolio of businesses whose earnings march upwards over the years will find the market value will do likewise and they win twice.

SCA Property, a listed property trust with exposure to non-discretionary retail by owning 91 suburban shopping centres anchored by long leases to major supermarkets with low gearing, is an excellent example of an investment displaying these characteristics according to Dive.  Dive also points to packaging giant, Amcor as a sustainable dividend payer given it pays out 65% of profits as dividends and the nature of packaging earnings is stable. 

Montgomery highlights National Storage REIT, Waypoint REIT and Ingenia Communities as sustainable income plays.  He also suggests that Transurban and Sydney Airport will again provide high levels of sustainable income once the vaccine rollout becomes more advanced and economies reopen.

Listed investment companies (LIC), managed by high quality management teams with good performance track records should also be on the radar for yield hungry investors.  Many listed investment companies allocate profits from good years into a profit reserve account so that in poorer times, the dividend may be maintained.  The level of profit reserve account is freely available to investors in the financial accounts of the LIC published half yearly.  

Platinum Asia LIC and Perpetual Equity Investment Company LIC have rewarded investors with a 5% fully franked dividend in the last 12 months.  Both of these LIC’s have material profit reserve accounts established.

Care should be taken not to pay a premium for LIC’s which is relatively straight forward as most LIC’s publish their asset backing regularly.

Dive believes the biggest potential trap for investors is looking at a company's historical yield and making an investment decision based on this single measure. 

Telstra for many years paid close to 100% of its earnings as dividends and some years borrowed to pay its dividend.  This continued until the NBN blew a hole in earnings and Telstra cut their dividend from 31 cents per share in 2016, over time to 16 cents per share in 2019.  Those who invested in Telstra when it was around $6 in 2016 based on historical dividends have seen their capital dwindle in their blinkered search for income.

Better than cash yields are on offer in today’s market, but care needs to be taken to avoid the ‘dividend traps’.

 

Every month, Mark Draper (GEM Capital) writes for the Australian Financial Review.  This article appeared in the paper edition of the Australian Financial Review on Wednesday 24th February 2021