Australian investors who rely on income from dividends could soon find themselves struggling, but there are still options available for individuals willing to expand their portfolio horizons.
Citi SMSF technical specialist Leonie Di Lorenzo said SMSFs especially will be “particularly hard” hit by variations in company profits and expectations due to the reliance of dividend payments to fund pension payments to members.
“It is well known that SMSFs hold a large proportion of their assets in Australian equities and cash, which includes term deposits,” she flagged.
Last year, Australia’s big four banks ranked in the top six listed shares as held by SMSFs, but with the Australian Prudential Regulation Authority’s (APRA) early April advice to the banks to reduce their dividends, Ms Di Lorenzo said it will have a negative impact on SMSFs that are reliant on dividends for income.
“The resulting reduction in dividends is a burden investors are going to have to carry.”
This is especially so when falling interest rates were already in sharp focus, with Ms Di Lorenzo conceding “many were already feeling the pinch to their cash flows”.
And with record-low interest rates set to continue and a new set of challenges resulting from COVID-19, the pain for SMSFs is far from abating.
The technical specialist said SMSFs in retirement phase who are on a zero tax rate “will lose the most, given the benefits of franking credits”.
In addition, those who are required to withdraw to meet annual pension payments may now need to sell bank shares at a low price to ensure they have enough cash to meet requirements.
As a result of the uncertainty, Ms Di Lorenzo said Citi had seen “an increase in SMSFs wanting to lock in returns and reduce risk”.
The specialist said volatility is driving “a renewed focus on income options like corporate bonds and tailored investments that can give investors access to equities in a structure that can reduce risk, and which provides an agreed rate of income upfront”.
According to her, fixed-income options offer up two main benefits to investors: They tend to be more resilient and reduce the volatility of portfolio returns without “overly” hindering performance, and they maintain a reliable source of income for the investor, provided the business does not default.
The death of dividends
Corporate bonds and equities aren’t the only option to be offered up to investors wary of the current investment climate.
GSFM CEO Damien McIntyre has also weighed in on the dividend dilemma, but believes the numerous predictions around the “death” of dividends to be “greatly exaggerated”.
Observing how Australian investors “are already well versed in receiving dividends for income”, he stated that there is generally a reliance on overweight domestic equities – with individuals too focused on the benefits of franked dividends.
As a result, they are unaware “of the diversification benefit and potential of comparable dividend income gained by investing globally”.
“But in uncertain times such as these, the diversification benefit of global equities becomes much clearer,” he outlined, when bond yields alone “are not up for the job”.
“In this new investing environment, investors would do well to focus some of their attention on companies outside of Australia, those with global brands operating across multiple geographies.”
The CEO has advised investors that they should look to companies with solid balance sheets and resilient earnings and cash flows – such as tech, healthcare and utilities, where “a greater universe of companies fitting this profile is found outside of Australia”.
He said that the two sectors typically hit hard during recessions are financials – as we have already seen in Australia and consumer discretionary stocks.
“Conversely, two sectors that have typically held up well in recessions are tech and healthcare,” he continued.
“Dividends are much more stable in the tech sector. And healthcare tends to be virtually recession-proof, with very modest declines in earnings per share and dividends per share.”
In saying this, investors should be wary when interpreting high-level commentary around the negative impact of COVID-19 on dividends, as it can vary greatly depending on geography and sector.
Mr McIntyre added that while an investor is obviously looking for companies with attractive yields, it is important to not simply buy stocks with the highest dividend yields.
This is because not all yields are created equal.
“A high yield could be the product of a one-time windfall or a collapsing stock price, which may not be sustainable,” the CEO said.
But “to identify dividend streams that are sustainable and growing, it is important to understand what drives free cash flow at individual companies, and then look for companies that can grow their operating cash flow by at least 3 per cent annually.”
It’s equally important to determine whether the company has a capital allocation policy that is disciplined, transparent and shareholder friendly, Mr McIntyre continued.
This is because not all businesses will face the same degree of stress from the government restrictions on social interaction, and some will continue to generate material cash flows.
“Others entered this period with ample liquidity to withstand a temporary demand hit.”
The case for sound capital allocation
Mr McIntyre also revealed another factor worthy of consideration by Australian investors.
He said that despite the deterioration of the short-term market environment, the ability of many companies to pay dividends has actually improved over recent years.
“Most firms are pursuing ‘capital light’ business models: Substituting technology for both labour and physical assets at a pace never seen before.”
He explained that through the deployment of technology, less labour and less investment in physical assets is required to generate the same level of revenues.
“Since the universe of profitable opportunities in which to invest that capital is not likely to expand at a rate greater than the savings generated from the effects of technology substitutes, companies with thoughtful capital allocation policies will return more capital to their shareholders.”
And even in light of the current pandemic, he does not expect such “sound capital allocation policies to disappear”.
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