Investing for income isn't flashy. People are eager to boast about how they bought into Afterpay at $5, or spruik the latest investing craze. They're probably not crowing about their holding in a big bank that's just hiked its dividend.

But investing in dividend payers can be a clearer route to long-term returns, says Morningstar Indexes strategist Dan Lefkovitz.

"The most obvious appeal of dividend-paying stocks is a cash payout," he says, "magnified by the confluence of rock-bottom interest rates and investors looking for retirement income". Favourable tax treatment of franking credits doesn't hurt either.

The dividend yield on Australian shares has consistently been among the highest in the world, Morningstar product manager Mark LaMonica writes in the Morningstar Guide to Income Investing. Ninety per cent of companies in the ASX 200 Index make regular distributions of cash to shareholders.

But Lefkovitz says total-return story is more compelling.

"Research shows that a substantial portfolio of the long-term returns from equities comes from reinvested dividends and dividend growth," he says.

"Dividend-paying stocks also possess a performance advantage, with the high-yield segment of the market delivering the best returns."

Yet equity income investing is far from risk free. Investors can easily fall into dividend traps – a stock that lures in investors with a juicy yield, only to cut the dividend when the company falls into distress.

"Chasing short-term yield at the expense of long-term total return can lead investors into dangerous segments of the market,” Lefkovitz says. “The past decade is littered with cautionary tales."

Lefkovitz also says investors who rely on backward-looking indicators or passive equity income strategies which rely on these historical measures have also been burned.

Securities with a high dividend yield can also lead investors to be concentrated in a few, or a single sector such as financial services, says Morningstar Spain senior editor Fernando Luque in his article 7 golden rules of dividend investing.

For these reasons, Morningstar believes a selective approach to equity income investing is optimal.

Hunting for sustainable dividends

So how can investors target companies with competitive advantages and healthy balance sheets? LaMonica says those investing in dividend-paying stocks should be asking three questions:

  1. Is the dividend safe?
  2. Will it grow?
  3. What is the potential return?

LaMonica says economic moats play a critical role in a company's ability to grow its dividends. An economic moat refers to a company's sustainable competitive advantage that allows it to earn excess returns on capital over a long period.

"An economic moat doesn't just protect existing profitability; it also suggests that additional investments of retained earnings for expansion – however modest – should earn a good return that will be reflected through enlarged dividend-paying power," he writes.

Morningstar analysts cover around 1500 companies and assign moats to almost 60 per cent. To earn a wide or narrow moat rating, companies must possess a structural feature that prevents excess returns from quickly eroding. The five sources of an economic moat are intangible assets, switching costs, network effect, cost advantage and efficient scale.

Another thing to watch is the payout ratio, which helps investors evaluate a dividend's stability, and a stock's dividend record (10-year history), as this signals the willingness of management to rewards shareholders.

Our best ideas

One source of investment ideas is the Morningstar Australia Dividend Yield Focus Index. This index focuses on high quality dividend-paying stocks that have grown their dividends and are poised to continue going so.

The key pillars of the Index methodology are the Morningstar Economic Moat (discussed above) and Distance to Default. Lefkovitz says this metric is the gauge of the financial health of a company and the likelihood of bankruptcy.

"Distance to Default uses option pricing theory to evaluate the risk that the value of a company’s assets will turn out to be less than the sum of its liabilities. It considers equity value and share price volatility and is therefore responsive to market fluctuations," he says.

Additional index criteria include:

  • Morningstar Australia Index - be a security from the Morningstar Australia Index, an index which targets the top 97 per cent of stocks by market capitalisation
  • Dividend screen - the company should have paid a dividend in the last 12 months
  • Liquidity - the index constituents should have a three-month average daily traded volume of at least $2 million

Then, Morningstar selects the top 25 securities by trailing 12-month dividend yield in descending order.

For more information about the construction rules for the Morningstar Australia Dividend Yield Focus Index, you can view the fact sheet and the methodology sheet.

Here are the six names among the 25 in the index that are trading below their fair values.

Sustainable dividend

Source: Morningstar Direct

Here's more on two stocks listed which have been placed on the Morningstar Best Ideas List.

Link Administration Holdings (ASX: LNK)

Morningstar equity analyst Gareth James says Link's share price has been affected by investor concerns about superannuation regulation reform, which will hurt the company's superannuation business in the short term. Link provides administration technology to large companies, asset owners and trustees. The winter chill struck Link in late May after the company revised its guidance and warned of tough trading conditions, which caused the share price to fall nearly 25 per cent to around $5.96. The stock has climbed steadily since August, peaking at $6.05 on Friday.

James believes the market overreacted and expects the Australian superannuation sector to increasingly depend upon Link's relatively low-cost administration services. He also thinks the likely consolidation of superannuation funds will benefit the company.

Telstra Corp Ltd (ASX: TLS)

Morningstar equity analyst Brian Han says shares in narrow-moat Telstra are trading at an attractive discount to our fair value estimate, with investors preoccupied with several risks facing the group.

Firstly, he acknowledges that competition is intense in Australian telecom across all segments. However, he believes Telstra boasts the strength to compete, given:

  • a sustainable cost advantage from unrivalled scale,
  • its infrastructure footprint, and
  • consistent capital spending to maintain this competitive edge

Second, Han says the market is assuming that Telstra fails to plug much of the $3 billion earnings hole from the National Broadband Network.

"This is a bearish view, given the group’s competitive position, its solid record of replacing lost earnings over the past decade, and the significant room for cost cuts/productivity gains."

Third, he says the threat of a new entrant in the Australian mobile market has faded, with TPG Telecom abandoning its network rollout plans.

Finally, Han thinks his revised dividend estimates are sustainable, providing investors with an attractive fully franked yield at current prices.