Dividend v earnings growth: are you a Buffett or a Rockefeller?

If you want to ignite a discussion on investments, it’s easy: simply express a strong view on dividends.

Australian shareholders are more Rockefeller than Buffett.

If you want to ignite a discussion on investments, it’s easy: simply express a strong view on dividends.

Legendary investors have taken opposite positions on whether dividends are the shareholder’s friend or enemy.

John D Rockefeller, in his day the world’s richest investor, set out his preference this way: “Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.”

At the opposite extreme is Warren Buffett of Berkshire Hathaway. Buffett accepts that “above all, dividend policy should always be clear, consistent and rational”. But he commits “(to) relish the dividends we receive from most of the stocks that Berkshire owns, but pay out nothing ourselves”.

In my view:

●Dividends will remain a large part of total returns to Australian investors.

●Our high dividend payouts will crimp the ability of companies to grow their earnings — but the concern is less valid than is usually claimed.

●When interest rates are extremely low dividends are more highly valued.

●Dividend yields can help investors identify when it’s a good time to invest in shares, and also assist their selection of which individual shares to hold.

●Investors should be alert to “dividend traps”.

Payouts and returns

Australian shareholders are more Rockefeller than Buffett. Recently, our businesses have been paying out 80 per cent of earnings as dividends. That reflects our (commendable) system of dividend imputation but also our relatively heavy taxation on capital gains. Here, the dividend payout rate is more than twice that of the US, where the double taxation of dividends and the lighter tax on capital gains encourages share buybacks over dividends. Over the next couple of decades, dividends (plus franking credits) will contribute well over half of the average returns from Australian shares.

Market indicator

Currently, the trailing dividend yield (dividends paid in the preceding 12 months as a per cent of current share prices) of Australian shares is 4.5 per cent, a little above its long-term trend.

The “real” (or after-inflation) dividend yield of Australian shares is 3.2 per cent. That’s well above its “normal” level and, as the chart shows, a high real dividend yield is a usually a positive influence for the share market outlook.

From my experience, the real dividend yield is one of the half-dozen or so key influences on shares that investors should consider in assessing whether it’s a good time to invest.

How much is too much?

Because of highly accommodative monetary policies and the near-disappearance of inflation, interest rates are extremely low in just about every country.

As a result, investors around the world are on the hunt for yield — with a keen appetite for shares paying stable or rising dividends.

We often hear claims Australian companies pay “too much” in dividends. It’s seen as a sign that companies can’t find scope to expand, and it’s said to stifle their growth.

Prior to the big changes in tax announced in 1985 — dividend imputation and the taxation of longer-term capital gains — Australian companies paid out as dividends only a third of after-tax profits; the rest was kept to finance growth. Some companies used their retained earnings wisely, but far too many didn’t.

In general, there’s a case for profitable companies to pay good dividends — and to raise additional equity capital when good projects come along.

In any event, many listed companies in Australia are relatively mature and do not need to resort to retained earnings to finance future growth. The problems Australia faces from a high payout ratio are too often overstated.

‘Dividend traps’

The sustainability of dividends is crucial to investment decisions.

Dividends “paid” from asset revaluations and funded by capital market raisings are definitely a total no-no.

As well, a “high” dividend yield on a share might simply reflect the drop in its share price as the market factors in an imminent cut in dividend.

Another thing: Average dividends usually fall cyclically in recessions; the decline in average dividends per share is milder than the drop in average earnings per share; nonetheless, it usually catches investors unaware.

Don Stammer is an adviser to Altius Asset Management, Stanford Brown Financial Advisers and the Third Link Growth Fund. The views expressed are his alone. [e-mail]