Ask a Fund Manager
The Motley Fool chats with fund managers so that you can get an insight into how the professionals think. In part two of this edition, Senior Portfolio Manager & Co-Founder of Plato Investment Management Peter Gardner tells us how to avoid dividend traps and shares his top 2 ASX dividend shares to buy today.
Motley Fool: Investors can get pulled in by ASX dividend shares with high trailing yields that may not be repeated. What’s your experience here?
Peter Gardner: We often talk about avoiding dividend traps because we think this is a critically important factor in generating strong income to help our clients make ends meet.
Dividends traps occur when you look at company data and see a large dividend yield. The problem is this yield figure is based on historical dividends and can be taken against a falling share price. When it comes to dividend traps, that super-high historical yield figure may never come to fruition because the company’s earnings may be likely to fall, causing it to reduce or completely cut its dividends.
MF: So how do you target tomorrow’s high yielding ASX dividend shares?
PG: You first have to eliminate the dividend traps. At Plato, we’ve developed statistical models over many years to help forecast the likelihood of dividend cuts and avoid dividend traps.
When identifying where dividends are poised for growth, investors should remember that the ability of a company to pay and grow its dividends is linked to earnings and cash flow growth. So, a strong underlying business model is very important.
MF: What else do you look for to avoid dividend traps?
PG: Some other factors that can impact a company’s future profitability, and their ability to pay dividends, include macro factors like prevailing tax policy or the overall state of the economy.
Industry-specific factors can also create issues for a subsector of the market. For example, the impact of the price of oil on airline shares.
MF: What are the 2 best ASX dividend shares to buy right now?
PG: Macquarie Group Ltd (ASX: MQG). That’s because Macquarie has continued to deliver consistent earnings growth and consistent dividends in recent years despite the challenges that have faced the financial services sector. Most recently it achieved a record profit for the December 2021 quarter.
The Group is very diversified, and we are particularly buoyed by the strong performance of its markets facing business, strong AUM [assets under management] growth, and investment in renewables.
Importantly, it has a lot of cash on its balance sheet which indicates it can sustainably grow dividends in the foreseeable future.
MF: And your second top ASX dividend share?
PG: Then there’s BHP Group Ltd (ASX: BHP).
The big Australian is in a really good position to continue delivering big dividends for its Australian shareholders.
During the recent reporting season, BHP announced a record first-half dividend of $1.50 per share, fully franked. This equates to a gross dividend yield of 6.2% for this dividend alone. While it was 49% larger than last year’s interim dividend, the payout ratio is still a healthy 78%.
This dividend was announced along with increasing revenues, increasing [earnings before income, taxes, depreciation and amortisation] EBITDA, and increasing profit.
There’s also the BHP and Woodside merger deal on the horizon which we believe will be a tax-effective income opportunity for BHP shareholders. The deal will likely see BHP’s petroleum assets spun off in the form of a special dividend with franking credits attached, in order to merge with Woodside. Franking credits are one of the most tax-effective forms of income for low-tax investors.
We also see BHP’s recent delisting from the London Stock Exchange as a positive for Australian shareholders. This enables more of those franking credits to ultimately be distributed to shareholders.
MF: What investment move do you most regret?
PG: We’ve been on the right side of some of the more recent trends in the markets as bond yields rose, capturing the outperformance of commodities and missing the underperformance of expensive tech.
But our biggest recent regret – there are always plenty of regrets in funds management – is not having a larger exposure to commodities and a lower exposure to stocks impacted by rises in bond yields.
For example, we have holdings in James Hardie Industries PLC (ASX: JHX) and Aristocrat Leisure Ltd (ASX: ALL) whose underlying businesses have been performing well, but who have also been hit as bond yields rose.
MF: Has Russia’s invasion of Ukraine changed your investment approach?
PG: You can’t ignore this sort of event and we must consider how it could impact company dividends now and into the future.
However, our investment approach has not changed, as this horrific event has just exacerbated some pre-existing trends that we were exposed to such as continued increases in commodity prices and concerns about inflation.
We’re one of the most active, nimble income funds that I know of, and we rotate our portfolio in order to capture the strongest dividends in the market. We also continue to generate additional income through tax-effective portfolio management, something unencumbered by the sad developments in Ukraine.
(If you missed part one of our interview with Peter Gardner, you can find that here.)