Dividends, especially of the fully-franked variety, are all the rage for Australian investors — and with some good reason.
Dividends are tax-advantaged in a way that doesn't apply to bank interest or property rental thanks to our dividend imputation (or 'franking') system.
Dividends are a concrete way to make money in investing that don't require you to try to sell at the 'right' time, or worry about capital gains tax. And research has shown that companies that pay dividends tend, on average, to be more successful.
Lastly, dividends make up the majority of long-term investment returns.
That's a pretty full list of advantages. But here's one disadvantage that might make you think twice:
Your dividend is not guaranteed.
Where did my money go?
Now, that much is obvious to anyone who's been investing for any length of time. We've seen lots of companies cut their dividends over time, some never to be reinstated, while others took a while to come back.
Take, for example, undies-to-towels business Pacific Brands — the name behind Bonds and Sheridan, among others. The company paid 15 cents per share in dividends in the 2005 and 2006 financial years, and 17 cents per share in 2007 and 2008.
It finished 2008 with a $1.63 share price. That's a very nice 10.5% dividend yield.
In 2009, the dividend was cut to… well… zero. Nothing, nada. Not a red cent. And it stayed that way for 2009 and 2010. The share price closed 2010 at $0.89.
2011 heralded a return to dividends, with 6 cents being paid. That was cut to 5 cents in 2012 and 2013 and then 2 cents in 2014. In 2015 it was cut to zero… again.
Shares finished 2015 selling for $0.47 each.
So, those investors who bought at $1.63 in 2008 saw a 75% loss in their capital, and the dividend per share fall from 17 cents per share to nothing.
If you'd planned to reinvest those dividends — or, worse, use them to pay the bills — you've been left sorely wanting. And you had that 75% share price fall to add insult to injury. So much for a great income stock.
"Ah, but that's just Pacific Brands," you say, with not just a little bit of hindsight bias. "I'd never have bought that." That may well be so, but it's worth checking out today's dividend darlings.
Beware the so-called 'blue chips'
You'll have to try very hard to find an Australian share portfolio that doesn't have a large smattering of banks. The very companies that have — for more than two decades — made many Australians a good deal richer.
The run has been so long and so strong, that we've developed a tin ear for potential risk.
The banks have been writing down bad debts. That will reverse. House price growth (on which bank lending skyrocketed) is slowing. And cash profit growth is already slowing. Some analysts are already predicting a cut to bank dividends.
And then there's BHP. The miner has, amazingly, committed to a 'progressive' dividend policy — that is, higher dividends each year. But it's already planning to borrow to fund the dividend.
That's the equivalent of using your furniture for firewood. Maybe the vagaries of commodity prices will be kind to BHP and it'll escape unscathed. If not, promising a progressive dividend policy will, sooner or later, be shown up as folly.
So how do you avoid these sorts of problems? Here's a quick three-point checklist:
- Focus on the future earnings growth of the business — that's where the dividends will come from
- Don't rely on a dividend that's higher than a company's earnings or cashflow; and
- Don't invest — for dividends or capital growth — using the rear vision mirror
And a fourth for free. No-one holds a gun to your head and makes you buy any company's shares. If you're not sure, simply move on to the next idea.
Look at the bigger picture
Dividends are wonderful. Fully-franked dividends are even better. But neither matters if the company can't continue to pay them well into the future. Starting with yield is alluring, but it can be a trap for young players.
Start with great companies and work your way to the dividend from there.
