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Secure Your Future With 3 Rock – Solid Dividend Stocks

Face it, you want it all. You want to have your cake and eat it too.

You want the reliable income and stability that dividend-paying stocks provide, but you also want capital gains too.

Sound like a pipe dream? It’s not.

According to Ned Davis Research, between 1972 and 2010, dividend-paying US stocks returned 8.6% versus just 1.4% for companies that didn’t pay a dividend. That’s an astonishing outperformance that means the difference between turning a $100,000 portfolio into $2.4 million versus just $174,000.

And for those worried about the storm clouds that are seemingly never far away, Ned Davis also showed that during periods of market decline between 1970 and 2000, dividend payers outperformed their stingy counterparts by 1.5% per month.

Ned Davis isn’t on its own. Investment manager Tweedy Browne looked at a range of studies — both from researchers and actual investors — that examined the returns of high yields across various eras. The upshot? According to Tweedy:

  • “There is substantial empirical evidence to support a direct correlation between high dividend yields and attractive total returns.”
  • “At least one study demonstrated that the returns associated with market-beating high dividend yield stocks were also less volatile in terms of the standard deviation of returns.”
  • “At least one study found that high dividend yield stocks outperformed other value strategies as well as the overall stock market return in declining markets.”

Here’s why they trounce the market so impressively

For one, since dividends are paid in cash, when you invest in a dividend-paying stock you can be more confident that the company you’re investing in actually makes cold, hard cash. That may sound simplistic, but some companies report accounting profits without actually banking any of the folding stuff.

In addition, the beauty of many dividend stocks is the long-term dependability of the companies backing them. This allows investors to take advantage of compounding returns over long periods of time. Long-time dividend investors are surely on board with Albert Einstein, who supposedly called compound interest “the most powerful force in the universe.”

Don’t forget the tax benefits

Australia is one of only a few countries in the world that avoids the ‘double taxation’ of dividends. For every $100 of pre-tax company profit, the tax man takes $30, leaving only $70 for dividends. Before we introduced the concept  of dividend imputation – ‘franking’ to you and me – that $70 paid in dividends was then subject to further taxation at up to the top marginal rate of 45%, meaning the $100 in earnings dwindled to only $38.50 by the time company and personal tax had been paid.

(If you’re wondering about the calculation, the company tax is 30% of $100 or $30 and the personal tax is 45% of the remaining $70, or $31.50. $100 – $30 – $31.50 = $38.50.)

Fortunately for us, previous governments recognised the folly of this ‘double taxation’ and provided investors with a credit for the tax already paid by the company.

What that means is that a 6% term deposit provides a significantly inferior after-tax cashflow to a 6% dividend yield. You pay full tax on the interest earned from savings, but only the ‘extra’ tax payable over the company rate on dividends. Of course, cash in the bank is safer when backed by a government guarantee, but your principal can’t grow the way shares can.

Want growth with that?

Australian companies, partly because of those tax benefits, tend to provide higher dividend yields than their global peers. In the US, a dividend yield (the annual dividend divided by the share price) of 2.5% to 3% is considered quite good. In Australia, sustainable yields of 5, 6 and 7% are quite common.

For Australian investors, that means dividends are arguably even more important than they are for our international counterparts.

Cash alone is sensational – it’s wonderful. We love it. But we’re ambitious Fools – we want more. With 5 to 6% interest available in term deposits at the moment – they’re a tempting alternative. Sure, they don’t carry the franking credits, but they do have a government guarantee. That’s almost enough to call it a wash.

Well-chosen shares can deliver something that a bank account can never offer – growth. Not only do we want good dividends yield, we also want growth in those dividends.

$1,000 invested in a 10-year term deposit at 5% will earn you $50 per year, for a total return of $500 at the end of the decade. If you could find a company paying a 5% dividend yield, and that company’s profits and dividends grew sustainably at, say, 8%, you’d earn $50 in the first year, $54 in the second year and $58.30 in year three. In year 10, your dividend would be $99.95 and your total cash received over that 10 years would be $724 – a full 45% more than the cash in the bank.

Want some icing on that cake? I thought you’d never ask! Not only have we not included the benefits of franking credits in that example, but it’s very likely that a well-bought company with that sort of dividend growth would also have seen a (roughly) corresponding increase in share price.

(Of course, the examples above are necessarily simplified, but you get our point – dividends really can be an investor’s best friend).

Without further ado, then, here are three businesses we think can meet our need for solid dividends with hopefully a cherry of growth on top.

Telstra (ASX: TLS)

Go on, admit it – you knew this one was coming.

But you probably also remember the bad old days. The tech boom, the first tranche of the privatisation, then the second and third. The first tranche, known as T1, seemed like a steal at $3.30 when T2 hit the market at $7.40… which in turn really hurt when T3 was back down to $3.60.

On share price alone, all three tranches were underwater in late March 2012, with Telstra shares trading at around $3.25.

Of course, even if you’ve managed to erase that traumatic experience from your mind, you’d remember former CEO Sol Trujillo taking the fight to the government – always a dangerous assignment, and so it turned out for Sol.

Ah, anchoring – my investing nemesis. When a price goes down we feel the loss keenly. When a price goes up, we want to avoid paying more today that we did (or could have) yesterday. If you own Telstra, you’re probably sitting on a paper loss; especially given the shares have traded as high as $9.20. If you once owned it, it’s equally likely you suffered capital loss. And if you’ve never owned it, you’re still probably scarred by association.

I want you to purge all of that history though – and look at Telstra through new eyes. That’s a good strategy regardless of the company in question and your experience with it – and particularly necessary with Telstra.

Instead let me tell you about a nationally dominant telecommunications carrier with almost universal brand recognition. A business that has been revitalised through new management, that has been refocussed on the customer, and one that will receive $11 billion (in net present value terms) from the government for giving up some of its infrastructure.

The growth in data consumption – both fixed-line and mobile is strong and likely to continue, and this company has the largest mobile network and is leading the charge into the newest mobile data technologies.

And on a personal note, the company’s customer service has taken a brand new direction. I’m sure there are still kinks in the process – the sheer size of its workforce and complexity of its systems almost guarantee it – but my recent experiences with Telstra customer service have been revolutionary.

I’ve just described the good bits, but there are drawbacks. Fixed line calls – the most profitable part of Telstra’s business – are in long-term decline, and the growing areas of the telecommunications market are much more competitive and have lower margins. The blue sky does have the occasional cloud.

Overall, though, Telstra is doing the right things to shed (or have taken from it) the low-growth and perishing legacy businesses. The directories (phone book) business can’t be long for this world, and the Trading Post is now purely digital. The NBN will assume Telstra’s fixed broadband business.

A freed up and focussed Telstra is readying itself for a bright (and increasingly mobile) future.

I hope I’ve given you a good sense of why I believe Telstra can be successful well into the future. But this isn’t a tech report, or even a growth report. ‘Show me the money’, right?

Telstra’s dividend is almost the stuff of legend these days. The holy grail that is the 28 cent per year payment has almost become seen as a divine right – and would only be lowered by management as an absolute last resort, such is the expectation of its retail shareholder base.

To be honest, I’d actually like to see Telstra keep some of that cash to pay down debt more quickly and shore up its balance sheet. The NBN payment will help in that regard, but will come with lower earnings from the infrastructure that the company will have to cede in the trade.

That 28 cent dividend translates to a dividend yield of around 6.6% based on recent prices – and that’s before franking. It certainly makes a 4.5% term deposit look stingy. That 6.6% becomes fully 9.4% when it’s grossed up to include those franking credits.

You probably won’t get astronomical growth (or capital gains), but when you consider the market’s average yearly return is around 10 to 11% historically, Telstra’s grossed-up dividend almost gets you there itself. A capital gain would be icing on the cake.

Platinum Asset Management (ASX: PTM)

The Motley Fool is often critical of the asset management industry – and with good reason. Managed funds often charge large fees that are percentages of their fund-holders’ investment (known as assets under management), regardless of the return on those funds (but then charge an extra fee if they beat the nominated benchmark).

But we’re not ideologues. We’re more than happy (as investors) to pay for performance, when the fee is reasonable and in proportion to the extent to which a manager exceeds the market return.

Platinum Asset Management has traditionally been one such business – but rather than suggesting you place your funds in their hands, we’re suggesting you get a piece of Platinum’s action by owning some shares in the fund manager itself.

Funds management can be a difficult business. You need to deliver market-beating performance, to convince investors to place their funds with you. Then you need to make sure you can find a way to promote your success so that investors know who you are and how then can invest.

Platinum, which invests exclusively outside Australia, has done the former with a long track record of success. The copybook has been blotted somewhat in the last year or so, but everyone is entitled to the occasional lull in performance and Platinum CEO Kerr Neilson has – more than most – earned a little bit of latitude.

The latter – attracting investments in its funds – has been a slightly tougher road, but one of the company’s own making and for all of the right reasons.

Many managed funds really work their distribution networks hard, obtaining listings on ‘preferred funds’ lists of financial planning networks, but Platinum has taken a direct approach, simply asking financial planners to consider its funds because it was best for the client. It’s a principled approach that has almost certainly meant the fund is smaller than it otherwise might be – but it lets Neilson and co sleep at night. Unsurprisingly, it’s an approach we applaud.

Platinum also has a third hill to climb – the irrationality of the investors in its funds. When stocks are expensive, the herd mentality often leads people to commit more and more funds to Platinum’s care – at exactly the time good investment ideas are thin on the ground. When markets fall and fund managers are salivating at the value on offer, investors are usually heading for the hills.

So at the time of most value, Platinum (and other fund managers) are hunting for new funds to take advantage of them (and being forced to sell at low prices to provide funds for investors who are withdrawing their cash.

When Platinum was initially listed on the ASX in 2007 just before the financial crisis hit, shares quickly ran to $8. In the space of 14 months – and sailing into the teeth of the GFC – Platinum shares fell to around $2.60 as share prices fell and investors withdrew their money from Platinum’s funds. The Australian dollar also rose, completing an unwelcome trifecta for the company.

An investment in Platinum can be something of a counter-cyclical play – when share prices fall and assets under management are low, Platinum’s profit (and hence share price) will suffer. Of course, if (when) the market recovers, share prices will rise and cash inflows will become a torrent. If you get in front of that wave, you could be carried a fair way higher from here.

Make no mistake – this is a very attractive business, run by successful stock pickers, but subject to the vagaries of the market. On the upside, that means there should be good opportunities to buy shares while the herd underestimates the potential of the company.

With a share price of around $3.72, Platinum looks slightly expensive on historical metrics, trading at over 16 times earnings. As with other cyclical companies though, that level of earnings is unlikely to prove at the lower end of the cycle, so looking at only one year can be misleading.

However, even at this depressed level of earnings, Platinum is still offering a fully-franked 5.6% dividend yield (8% grossed-up), and should report significantly higher earnings (and possibly higher dividends) as the economic (and sharemarket) cycles improve.

Supermarket Smackdown!

We promised you 3 Rock Solid Dividend Stocks, but we like to under-promise and over-deliver!

You see, when we were trying to split two grocery giants we struggled – both had different things going for them. Rather than make an arbitrary choice, we decided to share both ideas with you, and let you make you decision based on your individual needs.

Metcash (ASX: MTS)

When Australians finish bashing banks and debating the impact of China on our major resources business, the next cab off the rank is often the duopoly of our major supermarkets – Woolworths (ASX: WOW) and the Wesfarmers (ASX:WES) – owned Coles.

The usual concern is the degree to which these two retailing behemoths – usually calculated to have a market share of upwards of 80% of grocery sales between them – control the market. They are blamed for putting greengrocers, bakeries and butchers out of business, as they soak up more and more of each consumer dollar.

Of course, suppliers aren’t fans of these two businesses either. Many apparently won’t go on the record for fear of retaliation, but if the news reports are to be believed, the differential in market power between the supermarket behemoths and their suppliers is such that the latter group simply have to toe whatever line they are provided.

Less obvious, and much less commented on, is the self-proclaimed ‘third force’ in Australian retail – wholesaler and retail franchisor Metcash (ASX: MTS).

Those of you with long memories may recall the failing Davids Holdings – the forerunner of today’s Metcash. Davids was a once-prominent Australian grocery wholesaler that had fallen on tough times. The South African wholesaler/retailer Metro Cash and Carry bought a large chunk of Davids – since renamed Metcash – which marked the beginning of that company’s recovery.

Metcash undertook an aggressive consolidation of the independent retail sector. Among the changes, Metcash used the IGA brand to consolidate over 20 different retail brands (including names such as Wise Owl, 4 Square, Rainbow and Clancys) and it bought the Western Australian wholesaler Foodland Associated Limited (FAL) to complete its mainland footprint.

With a newly consolidated wholesale and retail footprint (Metcash uses variations of the IGA brand to denote the size and range of its different customers), Metcash has managed to grow sales and profit from its grocery division.

Of course, while Metcash has the bulk of its business in grocery wholesaling, the company has expanded to provide logistics and retailing services to other sectors. Its Australian Liquor Marketers business provides wholesale liquor distribution (predominantly wine and spirits) to bottle shops around the country, and the C-Store distribution business delivers to petrol stations and convenience stores.

Metcash also operates the Campbell’s Cash and Carry self-service wholesaler, and has bought the Mitre 10 hardware business, largely in response to Wesfarmers’ ownership of Bunnings and Woolworths’ purchase of hardware wholesaler Danks and development of its Masters home improvement chain. Metcash has also taken a 75% stake in Automotive Brands Group – owner of the Autobarn franchise and Autopro dealership groups.

Metcash recently had a victory over the Australian Competition and Consumer Commission (ACCC) which had vetoed Metcash’s planned purchase of independent grocery chain Franklins. The ACCC argued that the deal would lessen competition in the independent grocery wholesaling market (Franklins was wholesaling products to a small number of franchisees of its brand), but the Federal Court determined that the ACCCs definition of the market was too narrow, and that the more relevant market definition should include all grocery retailing.

The federal court recognised that the elephant in the room for the independent retail sector wasn’t its wholesaling options, but the competition from the big supermarkets.

In that sense, the investment case for Metcash becomes a little clearer – at least in defining its market and the risks and opportunities that are present for the business. Metcash is effectively the only large wholesale option for its customers, meaning less pricing pressure form a competing wholesaler. However, Metcash’s rise or fall will largely be governed by the extent to which the independent grocery sector can compete with Woolworths and Coles.

Andrew Reitzer, the outgoing Metcash CEO, and his team have done an excellent job of taking a disparate group of retailers, serviced by a loose coalition of wholesaling warehouses and turning them into a single branded offering for consumers and an efficient wholesale supply chain.

Sometimes – such as the airline market – more than two players can really wreck the economics of a market. However, in this case, it’s likely that Woolworths, Coles and Metcash can successfully coexist.

The IGA supermarkets for the most part provide a very different value proposition to consumers, compared to the two large chains. Whereas the latter group are all about lowest prices and largest ranges, IGA has been able to secure a place for itself as competitive on price, but a local, friendly and convenient option, often for small ‘top up’ shopping visits.

The success of the group in recent years has shown that this segment of the market can be prosperous. While recent retail price wars have taken a toll on all supermarkets, Metcash doesn’t share the pain of lower retail prices to the same extent as its franchised stores – its model is much more contingent on the volume of products it moves through its distribution centres.

At its current share price of around $3.56, Metcash is trading at an undemanding forecast price/earnings multiple of around 10.7 times, and is offering a fully-franked dividend yield of 7.7% (which becomes 11% ‘grossed-up’).

While growth is a little hard to come by in the face of aggressive chain store discounting, these pressures should lighten once the economic environment improves – giving that dividend a good chance of improving over time.

Woolworths (ASX: WOW)

There’s not much that can be said about this supermarket superstar that hasn’t already been said.

After a lacklustre few years in the 1980s, Woolworths was taken private by IEL. In 1993, the company returned to the ASX, in what was then the largest IPO in Australian history. The share price is now around 10 times the level of 19 years ago – and that’s without including the many dollars of dividends paid during that period.

From its humble origins as a department store retailer in the 1920s, 87 year old Woolworths is now a diversified retail company with close to 2,500 stores. Many of its products are non-discretionary, meaning even in tough times people still need to shop from one of Woolworths’ brands. In tough times spending also tends to increase on gambling and alcohol products; two markets in which Woolworths has strong brands.

It would be hard to travel five kilometres in any major city without passing at least one of Woolworths’ owned stores.

Ten years ago, Woolworths was comprised mainly of supermarkets, liquor stores, Big W and Dick Smith Electronics. Today, Woolworths retains all of those businesses (although it has offloaded Dick Smith) and has expanded into licenced hotels, New Zealand supermarkets and more recently into the $24 billion home improvement sector through a joint venture with Lowe’s, the world’s second largest home improvement retailer.

Woolworths-operated petrol stations have grown from 166 in 2001 to over 600 canopies, and increasing by around 20 new stations a year.

The company operates more than 325 hotels Australia wide and owns and operates more than 160 Dan Murphy’s liquor stores and 437 BWS bottle shops.

In 2006, Woolworths moved into New Zealand through the acquisition of Foodland Supermarkets and now operates 207 supermarkets in that country.

The home improvement joint-venture’s takeover of Danks gave Woolworths immediate access to 3 thriving retail brands; Home Timber & Hardware, Thrifty-Link and Plants Plus Garden Centres and a retail distribution network.

The first Masters branded store was opened in Victoria in September, with another 4 opened in October and first NSW store opened in December last year. 22 stores are currently open and the company is targeting 150 stores within five years.

Woolworths has continued to grow its store footprint, steadily increasing the number of stores for each division. Over the last 5 years, Woolworths has added on average 17 new supermarkets, 18 new petrol stations, 7 Big W stores, 6 Hotels and 2 NZ supermarkets each year. Woolworths has plans to expand all its retail offerings in the years ahead, which should include 15-20 Masters stores per year.

A good measure of retailer efficiency is the Cost of Doing Business (CODB) ratio. The Cost of Doing Business is the total of all expenses other than the cost of buying the products it re-sells, and the CODB ratio is that total divided by revenue. Woolworths has maintained a CODB ratio of less than 20% for the last four years. By Comparison JB Hi-Fi (ASX: JBH) has a CODB ratio slightly over 15%. Wesfarmers has acknowledged that its Coles Division’s CODB is higher than Woolworths, and has been working on reducing it to similar levels.

Woolworths has been a consistent performer over the last fourteen years. Revenues have grown by an average of 9.4% per year since 1998 from $17 billion in 1998 to over $55 billion in 2011. EPS growth has averaged 17% per year since 1998.

Woolworths is currently trading on a price/earnings ratio of 14.5 compared to its historical average of around 20, and is currently paying a dividend yield of 4.7%, which becomes 6.7% when grossed up with franking credits.

While earnings (and therefore dividend) growth is likely to be lower in future than in the past decade, the company has a very solid business selling products that consumers need and want. Even when times are tight, people still need to eat, and as we spend less time in restaurants, we’re likely to eat more at home – and that food will come from Woolworths and its counterparts.

Splitting the Grocery Giants

When we were trying to decide which of these two grocery businesses we should include in this report, we ended up with a conundrum.

Firstly, we didn’t see a significant difference between the two in terms of likely future growth.

Next, Metcash’s dividend is significantly higher than Woolworths, with a grossed up yield of 11% for the former, compared to Woolies at 6.7%.

And lastly, we think the Woolworths business is significantly stronger – and less susceptible to external shocks – that Metcash.

It’s close to a tie – but each with different advantages. We could have made an arbitrary decision, but decided to provide you with both options. We think Woolworths dividend is much safer than Metcash’s – its size and its geographic and business diversity put it ahead there. Metcash’s dividend is one half more than Woolworths’.

There’s a trade-off there – if absolute dividend security is your aim, Woolworths is the one for you. If you’re prepared to risk the chance that Metcash’s dividend is less assured, you might be happy to take the higher dividend (and the accompanying chance it may be reduced at some point).

There you have it – four of our best ideas for investors looking for solid dividends with the opportunity for growth on top.

Last updated: 30th November 2012

This report has been written by Scott Phillips and updated Mike King. Employees and contractors of The Motley Fool, including Scott Phillips, Mike King and Bruce Jackson, may have an interest in any shares mentioned in this free report. These interests can change at any time. The Motley Fool has a clear and concise disclosure policy.

 

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