Avoiding the yield traps key for income investors

The end of government support in September is one of the key obstacles for loacl equities to navigate this year. Picture: Jeremy Piper

Record-low interest rates and heightened economic uncertainty will make dividend payments and outlook statements from corporate Australia more important than ever this August.

With the dividend yield of the Australian sharemarket near record lows, but still well above cash, and global economic fuelling uncertainty about dividends, avoiding “yield traps” — companies at risk of cutting their dividend — will be critical for successful income investing, Macquarie Equities says.

The investment bank’s Australian equities strategist, Matthew Brooks, identified higher-yielding stocks with a lower probability of a dividend cut, and as well as those with a high chance of cuts.

In his first group are a couple of old favourites — Spark Infrastructure and Aurizon Holdings — and one that’s only more recently been classed as a dividend stock, Fortescue Metals. Those with a high chance of cuts include Bendigo Bank, Nine Entertainment and Origin Energy.

Indeed, the traditional sources of yield are shifting, with more representation from the materials and industrials sectors and less from financials and consumer discretionary stocks.

“In this environment stocks with dependable dividends are more likely to see outperformance into their ex-date than those with less dependable dividends,” Mr Brooks said.

His dividend cut prediction model aims to determine which dividends are more dependable, by forecasting the probability of a company cutting its dividend in the near term.

Companies cutting their dividends are likely to have poor price momentum, low growth in dividends per share, low-quality metrics such as return on assets or return on equity, high volatility measured by the standard deviation of returns, and higher measured dividend yields.

Mr Brooks noted that the forecast dividend yield for the S&P/ASX 200, now just under 3.4 per cent (before franking), is close to its lowest point since 1994, yet the same is true, however, for global and Australian bond yields.

“Again, while equities may appear unattractive at an absolute level, the relative return to cash is still significant,” Mr Brooks said.

“Many investors, be it retail or institutional, still need to generate return to meet cashflow needs or total return targets and equities can provide some of this income.”

But he conceded that the earnings outlook was set to “remain cloudy” after earnings season, with only half the normal number of companies expected to provide guidance in August.

Interestingly, though, stocks that have given guidance have tended to outperform, even if they cut their guidance, suggesting the market was putting a value on certainty of earnings.

On the flip side, the worst-performing stocks since the high have been those that withdrew guidance, followed by those that did not issue guidance.

“In both cases, investors are faced with higher earnings uncertainty, which may lead to a discounted valuation,” Mr Brooks said. “Stocks with sustainable dividends should also be supported by the TINA (there is no alternative) trade.”

Some 80 per cent of the top 100 companies among those that provided forward looking comments before COVID-19. At the peak of the pandemic, 38 per cent withdrew their guidance, while another 18 per cent reduced guidance.

“Given uncertainty over the duration of fiscal stimulus and the lingering impact of COVID-19, we expect half the normal number of stocks to give guidance in August,” Mr Brooks said.

“We also expect more companies to provide guidance on specific variables or segments, rather than a group bottom-line forecast.”

Macquarie’s top picks into results include Fortescue, Amcor, Goodman, Charter Hall and Coles.

Meanwhile, UBS Australia quantitative analyst Pieter Stoltz tells clients to “stay overweight cyclical equities for now, but watch sign posts for defensive rotation”.

He noted that the economy was performing better than feared, and earnings forecasts were rising along with economic forecasts, thanks to record fiscal stimulus.

While his forecasts assume more stimulus, Mr Stoltz thinks it will be insufficient to stop a “fiscal cliff” caused by the removal of $100bn of stimulus in September.

He estimates fiscal stimulus has contributed about 30 per cent of the 32 per cent rise in the S&P/ASX 200 from its March trough, and about half of the sharemarket will be “impacted” by a lessening of stimulus and 37 per cent will be “highly impacted”.

“We think if consumers save more in the September quarter and further stimulus does not meet market expectations, equities may fall,” Mr Stoltz said.

But it depends how many of the 3.5 million people on JobKeeper find another job by September, as well as consumers’ willingness to spend without stimulus, versus the government’s willingness to stimulate if spending disappoints.

“Equities are likely to be supported by further positive data releases in the third quarter,” Mr Stoltz said. “We expect cyclicals to outperform until September on the back of a rebound in the consumer, which could see strong retail sales for July and August.”

But he sees “large volatility” in the economic data after the potential fiscal cliff in September.

“Cyclicals, particularly discretionary retail, are likely to come under pressure without JobKeeper supporting consumption.”