If you're an Australian investor and you're breathing, there's a very good chance you love your dividends. Australians — thanks largely to our relatively rare dividend-imputation system — love dividends like almost no-one else on earth.
And with good reason — the corporate culture among our listed companies and the limited growth options for many businesses means that an unusually large proportion of profits are returned to shareholders every six months.
The flow of cash really is a sight to behold — but it's not all beer and skittles. A company that returns cash to shareholders is implicitly or explicitly saying "Here, take this. We can't use it to grow profits.".
And here's the rub: It's those reinvested funds that will pay for future profit growth. In many cases it's the equivalent of skimping on servicing your car — if you don't maintain it properly, you can't expect it to perform the way you want. Some companies that are paying out lots of cash today are robbing tomorrow — or at the very least admitting there's nothing useful for them to reinvest in.
Where's the growth coming from?
Whether they're running down the corporate car or just honestly admitting there's not much growth in store, that's telling you a lot. If you're extrapolating the past high levels of growth, stop. If you're expecting high growth, stop. And — most importantly — if you're expecting that dividend to grow meaningfully in the future, stop. (Of course there is the rare exception — the company that requires little or no reinvestment to keep the growth engine racing. You just need to be careful.)
It's very easy to be seduced by today's yield. 4.5% is great. 5% is wonderful. 6% leaves many investors giddy. But if that dividend of $6 from every $100 in shares you own seems impressive now, that's only half of the story.
The danger lurking in the shadows is something many investors ignore: inflation. Consider Telstra (ASX:TLS) investors who took advantage of the company's 28-cent dividend in 2005 — around a 5.5% yield, depending on when the shares were purchased — had to wait nine years for an increase. And while the dividend held steady, inflation took just over 1 in every 5 dollars over that period. The impressive starting yield is looking just a little sicker.
If you're investing, you should be aiming to beat inflation by a reasonable margin — not get taken backwards.
The beauty of 'good' dividends
That's not to say investing for dividends is bad — far from it. Dividends are often responsible for between 40% and 60% of the total returns from shares.
Lest you think I'm talking out of both sides of my mouth, there's a happy medium. Dividends are wonderful — but only when the company can continue to grow. Woolworths (ASX:WOW) paid a very nice little dividend as its share price went from $3 to $30 and beyond.
Banks have been wonderful investments over the past few decades — profit growth has come from the increase in credit (mortgages credit cards and personal loans), consolidation (buying up the small players) and the GFC, which froze credit for non-bank lenders and forced them out of the market.
The banks' payout ratios have been steadily climbing just as the current and future prospects for growth are arguably bleaker than they've been in many years. Woolies and Wesfarmers are great businesses, but hardly have the growth potential of years' past. That doesn't make them necessarily bad investments — I own some Woolies myself (bought at lower prices).
