AMP Capital Equity Income Co-Portfolio Manager Dermot Ryan discusses the attributes of a sustainable dividend.

There are possibly few questions as important for retirees looking for an income stream than the question around whether a company can maintain and grow its dividend over time.

Finding companies able to pay out high dividends is one thing – we have means to do this quite easily in a quantitative way, meaning we can rank the share market according to which companies paid the highest dividend in the previous year or over the past few years.

But those who have tried investing in companies with the highest dividends historically may have already learned that past dividend payments aren’t a reliable indicator of future income streams.  

On average, companies in the top 10 per cent of expected dividend yield deliver negative earnings growth, negative dividend growth and underperform the market over time, our analysis suggests. 

To find the companies with genuinely sustainable dividends, you need to dig much deeper than these simple historical measures. 

A high pay-out ratio is often an early sign a company is stretching itself to deliver regular income.

Low returns, volatile earnings, poor momentum, high payout ratios and the use of borrowing to finance dividends – these are all tell-tail signs a company’s dividends are unsustainable, but some of these factors aren’t immediately apparent until you scratch the surface.  

Listed company executives know there’s high demand for income, given the number of retirees investing in the share market at the moment looking to generate income. Historically low interest rates mean returns from cash holdings aren’t enough to ensure savers are keeping ahead of inflation. Some companies will give investors what they want because it attracts investors, stimulating demand for their shares. But without sufficient earnings to support high dividend payments this approach looks more like a short-term ploy as opposed to a long-term strategy.  

Stretching the yield

A high pay-out ratio is often an early sign a company is stretching itself to deliver regular income to investors – this is a measure of the proportion of earnings that gets paid out.

Borrowing to finance dividends is another sign management is trying to make its shares more attractive to income-hungry investors in a way that may not ultimately be sustainable.

Tracking companies closely and understanding their respective stories relating to the way they allocate capital to grow versus returning capital to shareholders is an important part of determining whether they have a narrative that supports a sustainable dividend. 

Following the first earnings season for 2018, now is a good time to separate companies with sustainable dividends from those we believe might struggle to maintain their dividends going forward.

One area we are seeing dividend pressure at the moment is in the media sector where there continues to be pressure on the business models – content delivery is changing and broadcasting is different than in the old days because they’ve lost their oligopoly on eyeballs with people turning to social media for their entertainment and they’re avoiding advertisers. 

As a result, many of these companies have dropping earnings with legacy cost structures and high payout ratios. Investors in these types of companies should be careful not to fall into what we call a ‘yield trap’. 

Beyond sustainable dividends

Finding companies with sustainable dividends is one thing, but it’s also important to avoid concentration risks and other risks that might come with thinking solely about dividends at the expense of thinking about anything else.

For one thing, high demand for income in the share market has led multiple expansion where a company share prices stretch well beyond where earnings might justify, making these companies risky and potentially more volatile for investors.

Beyond considering valuations, franking credits are extremely valuable to retirees, so we are always on the lookout for companies with the potential to conduct off-market buy-backs in the near future. 

We are currently seeing some of the bulk miners in a position where they have strong earnings again and, because they’ve cut costs in the past couple of years, they’re now able to shift to profitable value. Add to this the fact they have been paying tax locally and banking franking credits along the way. 

Investing for income alone can often lead to poorly diversified portfolios and sometimes investing with this lens on can lead to a concentration in certain traditional sectors such as financial services. Indeed, banks have been consistent dividend payers over the years, the question is whether they can continue to sustain their dividends in the face of regulatory pressures and a slowing domestic property market.

When it comes to diversifying an income portfolio, one thing I’d say is not to rule out areas of the share markets where dividends might be low but where free cash flow and earnings are generated and business conditions are picking up. Currently we’re looking closely at energy companies where dividends have been cut in the past but where fortunes are looking like they’re starting to turn around.