Australians have a love affair with dividends. And it isn’t surprising. Our local indexes have dividend yields that far surpass what is available in other markets. Then there are franking credits which provide another boost for Australian investors who own Australian shares.

Despite this preference for dividends and the willingness of companies to indulge this preference there is one thing missing from the local landscape. There are no ASX listed shares that are dividend aristocrats.

A dividend aristocrat is a US coined term that denotes a company that has raised dividends for the last 25 years. Not content with dabbling among the aristocrats? Perhaps the dividend kings are more your speed. Those are companies that have raised dividends for the last 50 years.

The number of companies that quality for these lists is not inconsequential. There are 67 dividend aristocrats in the US. 54 of those aristocrats qualify as dividend kings. The fact that there are no ASX listed companies that qualify as a dividend aristocrat is interesting. But it also has implications for Australian investors.

This week's episode discusses those implications and whether it is important for Aussie income investors to look outside of our market.

You can also read the full article here.

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You can find the transcript for the episode below:

Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It doesn't take into consideration your personal situations, circumstances or needs.

Mark Lamonica: Alright so, we're going to talk about your book, Shani.

Jayamanne: Well, we're going to share two embarrassing stories from our childhood.

Lamonica: I'm not embarrassed about my story.

Jayamanne: Okay. I'm embarrassed about mine.

Lamonica: I'm embarrassed about most of the rest of my childhood. So, Shani had a couple drinks before she went on leave and mentioned that she wrote a book, which is generous because it was 29 pages.

Jayamanne: Yes.

Lamonica: And this was some sort of school assignment.

Jayamanne: Well, in Year 12 in Australia, you have a number of units that you need to complete to complete the school year. And so, you can have anywhere between 10 to 13 units to qualify to finish Year 12. And one of them, I took as much English courses as I could. So, it's 4 units of English.

Lamonica: Because it's your second language.

Jayamanne: Yes.

Lamonica: You really wanted to master it.

Jayamanne: And so, I took four units of English. And the last unit of English requires you to do a project. And the project is a book. And so, I wrote a book. And I have not read that book again after Year 12 because it's extremely embarrassing. It's the same as -- if you ever do anything when you are younger and you just cringe when you look at it. So...

Lamonica: Well, I've read it multiple times, since you sent it, because I got Shani to send it to me.

Jayamanne: I don't know how you convinced me to do that, to be honest. You're the only one outside of the HSC markers that have read it.

Lamonica: I think it was the drinks that I mentioned. So, anyway, yeah, I've read your book. So, the summary of your book is clearly...

Jayamanne: Well, it's an allegory, I remember.

Lamonica: Yes. So, it is about a totalitarian government that is posing all of these restrictions on people. And one of the restrictions is, and there's this group of people called the Dissonance. And they are trying to overthrow this government from the inside. And so, the main character, his parents, were killed by the government when they raided -- like opera house where there was an orchestra performing because the government didn't want people making music. Now, my favorite part about the book is there's the main character. And then I think you wrote yourself into the book as the love interest who ultimately is killed by the government forces because the main character is just this white dude. The other character is a Sri Lankan woman. And so, you went after this mythical totalitarian government.

Jayamanne: Are you making comments about my taste in men? Is that the conclusion you're drawing?

Lamonica: You told me this wasn't you. If anyone emails me, I'll send it to you.

Jayamanne: Anyway, now, I'm going to share your embarrassing story from your childhood, which is Mark, you played a musical instrument.

Lamonica: I played the trumpet.

Jayamanne: Okay.

Lamonica: Most kids are forced to play a musical instrument.

Jayamanne: Well, that's not the embarrassing part. So, Mark was part of a little child orchestra.

Lamonica: It was a school orchestra. It's a little child orchestra.

Jayamanne: Anyway. So you had a concert and you were so bad at playing the trumpet that they hired a professional trumpet player to sit behind the stage and play and ask you to pretend to play the trumpet.

Lamonica: Yeah, to press the little things down on the trumpet. Yeah.

Jayamanne: But you weren't allowed to blow in it.

Lamonica: No, because I was really bad.

Jayamanne: Okay. Anyway, that was a very, very long introduction, so those are two embarrassing stories from our childhood. Anyway.

Lamonica: More embarrassing, I think for you, but anyway. All right. I have a question for you now that's related to this podcast topic.

Jayamanne: Okay.

Lamonica: How many dividend aristocrats are there in Australia?

Jayamanne: Well, Mark, I was away for a month in Europe.

Lamonica: Probably writing your second novel, the follow-up.

Jayamanne: And I was reading the articles that you wrote, so I know the answer to your question. There are no dividend aristocrats in Australia.

Lamonica: That is correct, Shani, zero. And since you were carefully reading my articles on your trip, you can probably answer my next question as well. What is a dividend aristocrat?

Jayamanne: Well, Mark, a dividend aristocrat is a company that has managed to raise their dividend for 25 consecutive years.

Lamonica: That is also right, Shani, gold star. So dividend aristocrats should not be confused with dividend kings, Shani. So those are companies that have raised their dividend for 50 straight years. And there are 67 dividend aristocrats in the U.S., and 54 of them have been crowned as dividend kings.

Jayamanne: Okay. This is a lot of talk about aristocrats and kings. They couldn't come up with other names?

Lamonica: Apparently not. Are you ready to storm the barricades?

Jayamanne: Always, Mark, ready to take my mask off and join the revolution.

Lamonica: Yeah, exactly. As we learned in Year 12. All right. So you don't have to worry about finding those aristocrats and kings in Australia, which isn't great news for Australian investors. So today, I thought we would talk about some reasons for that, the implications for investors, and offer seven opportunities for investors interested in dividend growth.

Jayamanne: It's an action-packed episode.

Lamonica: Exactly. And I will also make fun of your book during the rest of this episode. But yes, I've been working over the last month.

Jayamanne: You are just about to go on leave, Mark.

Lamonica: For one week.

Jayamanne: Yeah. Well, you're passing the baton on to me.

Lamonica: For one week. But okay, let's start with the reasons for the lack of dividend aristocrats in Australia. Reason number one is that the dominant sectors in Australia are cyclical. So dividends, of course, are paid from earnings to grow dividends consistently means consistently growing earnings. Consistent earnings growth is not just a function of how well a company is run. It's also based on the type of business environment the company operates within. Cyclical companies operate in sectors where results follow the business cycle. Certain parts of the business cycle earnings tend to increase, and other parts of the cycle earnings struggle. So cyclical sectors include financials, basic materials, consumer cyclical, and real estate.

Jayamanne: All right. On to reason number two. Dividend payout rates are higher in Australia. To consistently grow dividends does not mean a company must grow earnings every year. Every company goes through a rough patch. The ability to raise a dividend consistently is also related to the amount of earnings that are paid out in dividends. The higher the dividend payout rate, the less flexibility for a company to grow the dividend if earnings fall over the short term. The ASX 200 has traditionally paid out approximately 65% of earnings in dividends. The S&P 500 pays out approximately 32% of earnings as dividends. A lower payout rate provides American companies more wiggle room to keep growing dividends even if earnings fail to grow over the short term.

Lamonica: The next reason is the fact that the dominant sectors in Australia are capital-intensive. Basic materials is the second largest sector in the ASX 200, and companies within the sector require huge outlays of capital to maintain or expand production. The spending is typically cyclical and adds to the cyclicality of the sector. A mine and the associated infrastructure is expensive to establish, so during periods of expansion there may be a lack of funds for dividends. Once the mine is operating, the profits pour in and dividends increase.

Jayamanne: And the other dominant sector in Australia is made of the banks. Banking has become more capital-intensive as regulations enacted since the GFC have required banks to hold more capital to reduce risk. The capital held on the balance sheet is cash that can't go towards raising dividends. This takes a cut of loan growth as a larger loan book means more capital must be held.

Lamonica: Meanwhile, the U.S. market consists of more technology or technology-enabled companies. Unlike mining, these companies tend to naturally scale. As revenue grows, earnings grow more, which is great for maintaining and raising a dividend.

Jayamanne: The last reason is all about expectations.

Lamonica: And it has been said, Shani, you know that happiness is expectations minus results.

Jayamanne: And in this case, we're talking about differences between expectations of investors in the U.S. and Australia.

Lamonica: So maybe for the rest of this episode, we could call Australia the dividend aristocrat desert and the U.S. the land of plentiful aristocrat.

Jayamanne: Okay, we won't be doing that. But since you are American, why don't you talk about what U.S. investors expect out of dividend payers?

Lamonica: Okay, so in the U.S. the expectations are that dividends are not cut. Speculation about a dividend cut impacts share prices and if the cut is actually announced, shares typically dive. And that is different from Australian investor expectations. Would you like me to answer this one since I am also Australian, Shani?

Jayamanne: I think I can handle it. In Australia, there is a more understanding that dividends will fluctuate and in both the U.S. and Australia over the long term, investors want dividends but the expectations about those pathways influence what companies do.

Lamonica: That's right, and all of this is related to some of the previous things we've discussed. Higher payout rates in Australia mean that if earnings fall, the dividend generally follows that path. And the cyclicality of the major Australian companies means we see more fluctuation.

Jayamanne: Well, we've gone through the reasons that there are no dividend aristocrats in Australia. The question, as always, is, does this matter? Are there implications for Australian investors?

 

Lamonica: Well, we spend a lot of time as investors focused on individual investments, which share, ETF or fund to buy. What we are really trying to do as investors is to create a mix of investments in a portfolio that is designed to meet our goals. And today, we're talking about dividends. So we're looking at putting together a portfolio to generate income.

Jayamanne: Your favorite subject?

Lamonica: One of the many subjects that I'm interested in, Shani. But in this case, we're talking about a portfolio. As I said, designed to generate income. I've long argued that income investors need to balance income growth and current yield in a portfolio. It is understandable that income investors gravitate towards the highest yielding shares, but this approach can be short-sighted. Many non-retired income investors would benefit from a focus on the future income streams that can be generated. Growing income faster than inflation is a pathway to financial independence as purchasing power increases over time. Retirees also need to focus on growth. Retirement may last decades and growth is needed to sustain and ideally increase your standard of living.

Jayamanne: And this, of course, is the challenge with the Australian market. While yields are high, there are less opportunities to find dividend growth among the largest high yielding shares in the ASX that are popular with dividend investors.

Lamonica: Okay, we're going to go through an example. So, of course, the big four banks are very popular with income investors. Since 2008, the compounded annual growth rate of their dividends are as follows. ANZ 1.66%, Westpac 0.34%, NAB is actually negative, a negative 0.89%. And CBA is 3.04% none of that's very impressive.

Jayamanne: And to understand the implications for investors, it's important to note that since 2008, inflation has averaged 2.7%. Certainly, CBA managed to barely exceed inflation. And this means that if an investor is interested in generating a growing stream of income, or in this case, just to match inflation and maintain purchasing power, the banks have failed investors.

Lamonica: Now, obviously, this is the past, but I can't say I'm too optimistic about the future. The banking sector in Australia has coalesced into an operating environment where four banks control 75% of the market share. It's hard to imagine a scenario where this collective market share would increase. And even if this was possible, it's unlikely that regulatory authorities would allow it. Each of the big four has structural competitive advantages that prevent smaller banks from meaningfully increasing market share. But these same competitive advantages limit relative market share gains for CBA, Westpac, ANZ, and NAB. None of them have been adept at global expansion. So I see them kind of collectively stuck in a holding pattern where growth will be limited to overall loan volume growth in a heavily leveraged domestic market.

Jayamanne: The other big component of the local market is the miners. I just don't love the business from a dividend's perspective. Dividends will wax and wane based on resource pricing and where we are in the capital cycle as heavy expenditures are needed to maintain and expand production. Like the banks, it's hard to be enthusiastic about their prospects for long-term income growth at a rate that significantly exceeds inflation.

Lamonica: But all is not doom and gloom for Australian investors. So I wrote an article while Shani was on leave in Italy with seven dividend growth shares and ETFs for investors. But today we're just going to go through three, but the full list is available in the article. We put a link to it in the podcast notes or just send me an email and I'll send it to you. We need to hold back today because there's a limit to how long someone wants to listen to Kermit the Frog here and of course Shani who I assume everyone wants to listen to all the time and read your novel.

Jayamanne: Well, no, it's not just you. I've gotten a few emails and comments saying that I laugh too much and I have an annoying laugh and that you're not actually that funny. So I should pull back from how much I laugh.

Lamonica: Yeah, well, I mean, that's fine. You've actually, it's taken us about an hour to record.

Jayamanne: Because I can't stop laughing at the trumpet.

Lamonica: Yeah, I'm going to start quoting your book.

Jayamanne: Please don't do that.

Lamonica: The funny thing about the book is you put in footnotes.

Jayamanne: Well, you had to. It was an assignment.

Lamonica: You put in a Jimi Hendrix quote and then footnoted it. Something about how music is life. It was very profound. But anyway, all right. So here we go. We are going to get to the picks, but first we'll include a little criteria. So going for income growth means sacrificing higher current yields for that growth. But the shares and the ETFs with lower current yields, I've come up with a target of 10% annual income growth over the next five years. And the goal is to more than double purchasing power over the current inflation rate of around 4% in Australia. And if the RBA gets inflation back to the target range of 2% to 3% annually, it will be more than double. So if we think about it, growth in income of even 8% over five years, assuming inflation is 3%, would increase purchasing power close to 27% in inflation-adjusted terms.

Jayamanne: So now that we have the criteria, I can go into the first pick. VanEck Australian Equal Weight ETF, ASX MVW, which we talk about quite a lot. This ETF provides equal weighted exposure to around 80 of the largest shares in Australia. The Australian market is top heavy with 46% of the ASX 300 in the top 10 largest holdings. The equal weighted nature of MVW results in an average market cap of less than half the ASX 300. The hypothesis of selecting MVW over a market capitalization weighted index like the ASX 300 is that the largest Australian companies will not grow their dividends as fast as mid-cap shares. We've outlined why we think that's the case in our discussions about the banks and miners.

Lamonica: All right, so the next pick is Aurizon. So Aurizon operates rail haulage of coal, iron ore, and freight, and it owns a regulated rail network in Queensland. And it's been a bit of a tough run from a dividend growth perspective with a meaningful drop since 2021 as the dividend dipped from $0.29 a share to $0.15 a share. But many of the headwinds the company has faced should subside. So coal exports from Australia have been weak due to heavy rain in recent years, but volumes are increasing and Morningstar expects continued strong demand from Asian customers to drive export volumes. So China's coal usage continues to rise and due to flat internal production and quality issues, China is importing a lot of coal and volumes went up 62% in 2023 and 2024 is also likely to be strong.

So our analysts also believe that the demand outlook is positive in India and Southeast Asia. So I thought about this when I put together this list, Shani, I thought about how comfortable I was investing in a company exposed to coal in a world focused on lowering carbon emissions, but ultimately I decided that despite the best intentions, there's no feasible way to reduce coal usage in the near term. Australian coal remains some of the highest quality in the world and it's competitive from a pricing standpoint. There should be strong market for Aussie coal, even as overall usage drops. And we forecast dividend growth over the next five years of over 13% annually. This will come from growth in income of 7% and increasing payout rate as capital expenditures drop. And given the 4.9% current yield, I think Aurizon is a good opportunity for income investors interested in growth.

Jayamanne: All right, so we're going to go through a global share next. Global liquor giant Diageo, which I know Mark owns. Brands include Johnnie Walker Scotch, Smirnoff Vodka, Crown Royal, Canadian Whiskey, Captain Morgan's Rum, Casamigos Tequila, Tanqueray Gin, Baileys Irish Cream and Guinness Stout. Diageo also owns 34% of premium champagne and cognac maker Moët Hennessy and a near 46% stake in India's United Spirits. Diageo has a wide economic moat due to the strong stable of brands and to the cost advantages associated with the company's scale. There is minimal business risk, as reflected in the low uncertainty rating that our analysts have given it. The dividend payout ratio is reasonable at under 60% and the balance sheet is sound. The share prices dropped around 25% over the past year, but this provides a nice entry point for an income investor as a 3.1% yield is the highest since 2015. Concerns about consumer spending should abate and the long-term trend of premiumization should provide an earnings tailwind as consumers trade up to better quality alcohol. Our analysts expect the dividend to grow at slightly more than 10% over the next five years, based on earnings growth of 6% and increasing margins.

Lamonica: Alright, well, that whole talk about Diageo made me thirsty, Shani.

Jayamanne: It's 11 am.

Lamonica: It is 11 am, but I think we should go try a couple of their products and maybe discuss your book. I do have a lot of questions I have for you.

Jayamanne: They're going to remain unanswered Mark?

Lamonica: Well there we go. But the message for anyone interested in income is to not forget about growth. We all invest to create a better future and when it comes to income investing, that means growing income faster than inflation so you can afford to buy more of whatever you want in the future than you could today. So for the article, if anyone's interested, send me an email. My email is in the show notes and along with the article, I will include a quote from Shani's novel. Thank you very much for listening.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)