Are we in the last days of ASX dividend dominance?

In September of last year the AFR published an article suggesting the days of dividend dominance from the ASX may be coming to an end. The article cited “rising costs, slowing demand and a deteriorating Chinese economy.”

I’ve been thinking about that article lately. I recently put together two articles that included 13 shares and ETFs for income investors to consider when building a portfolio balanced between income growth and higher yields.

I struggled to find ASX listed shares to include on the list. I have nothing against investing in local companies although I am more inclined to invest globally given that I moved to Australia from the US 10 years ago. But I found this troubling as I am writing for a local audience who naturally gravitate to local shares.

The precurser to my 13 picks was an exploration of why there were no dividend artictocrats in Australia. A dividend aristocrat is a company that has managed to raise dividends for 25 straight years. I cited four reasons ASX listed companies didn’t make the list:

The dominant sectors in Australia are cyclical
Dividend payout rates are higher in Australia
Dominant sectors are capital intensive in Australia
Investor expectations in Australia and the US are different

The dividend aristocrats list is based on the past. What matters for investors is the future. It is worthwhile exploring the dividend prospects for many of the local companies that Australian income investors gravitate towards. As many of these companies make up a disproportiante amount of a top-heavy ASX 300 their prospects will drive the overall yield and dividend growth of the index.

This is far from an academic exercise. There are countless Australians who rely on dividend payments as a means of paying for their life. Countless others are sacrificing to build a future income stream.

A dividend is more than a perfunctory item on a board agenda. Dividend growth that outpaces inflation means a better standard of living. Growth that lags inflation or a shrinking dividend represents future sacrifice.

My exploration of the largest ASX listed dividend payers

I went through the top 20 holdings in the ASX 300 and looked at each share with a dividend yield over 3%. That leaves 15 companies.

Our analysts estimate dividend payments five years into the future for each share within their coverage universe. The following chart outlines the current dividend yield and the estimated compounded annual growth rate (“CAGR”) of dividends over the next five years.

There are some bright spots on the list. Macquarie and QBE have strong projected growth. Transurban, CBA, Coles and Woolworths have decent growth that should exceed inflation if the RBA can get it back to historic levels.

Yet the overall picture is bleak. The three largest miners BHP, RIO and Fortesque are all projected to have significant drops in dividends. Woodside and NAB dividends are also expected to drop. Santos, ANZ, Westpac and Telstra are projected to have anaemic growth.

The impact for each investor will vary based on the composition and weighting of individual portfolios. However, we can explore scenarios which may shed some light on the overall impact.

The first scenario is an investor with $100,000 divided equally between the 15 shares in the previous chart. Last year this hypothetical investor would have generated $5,049 in income before the impact of franking credits. That is an impressive amount and shows why income investors would gravitate to these large companies paying healthy dividends.

However, if our analyst projections of dividends are correct total income would fall by close to 5% in 5 years’ time. This may not sound like a lot. But if inflation is 3% annually over the next 5 years the purchasing power of the income stream would drop by over 20%. That is meaningful. And it has real life implications for investors trying to live off income.

Many investors choose not to select individual investments and gravitate towards ETFs and / or passive investing. The 15 shares on the chart make up more than 46% of the total index. That does not bode well for the overall dividend yield of the index.

I looked at the top 10 holdings of three of the most popular Australian income ETFs. The 13 shares made up 57% of the Vanguard Australian Shares High Yield ETF (ASX: VHY), 76% of the iShares S&P/ASX Dividend Opportunities ESG Screened ETF (ASX: IHD), and 69% of the SPDR MSCI Australia Select High Dividend Yield ETF (SYI).

The holdings of these ETFs will change over time based on index weightings for the ASX 300 and the methodology of the income ETFs. But the current weightings don’t provide a good deal of comfort for investors.

What should an income investor do?

I recently wrote an article outlining the four biggest mistakes an income investor can make. One mistake is falling for a dividend trap. The concise definition of a dividend trap is an investment that has a high yield based on dividends over the past 12 months with future dividends dropping.

If our analysts are correct with their forecasts the ASX 300 qualifies as a dividend trap. As income investors we want to avoid dividend traps. However, for passive income investors simply avoiding the ASX 300 is not necessarily the answer.

The overall income generated may drop but the ASX 300 has a significantly higher yield than corresponding global indexes. For example, the S&P 500 is currently yielding around 1.3%. This difference is amplified when franking credits are included.

I believe the prospects for dividend growth are higher for the S&P 500. But an investment in the ASX 300 is still likely to generate more income in 5 years’ time given the yield differential. We can’t discount the desirability of higher yields.

Instead I would focus on another income mistake which is focussing too much on current yield and not enough on growth. Income investors should strive for balance between higher yields and future growth.

Growth matters for both retirees who may be living off income now and investors trying to build an income stream for the future. One of the most important things for all investors is to focus on purchasing power which means keeping up with - and ideally exceeding - inflation.

I outlined some suggestions in my article on 7 income growth ideas but want to emphasize one idea that may appeal to both investors who are focused on selecting individual holdings and passive investors.

If the prospects of future dividends for the largest ASX shares are concerning an investor can instead turn to the VanEck Australian Equal Weight ETF (ASX: MVW).

This ETF provides equal weighted exposure to ~80 of the largest shares in Australia. I’ve outlined a more robust argument for this ETF in the previous article but the hypothesis of selecting MVW over a market capitalisation weighted index like the ASX 300 is that mid-cap shares will grow dividends faster.

Historically this has played out. The compound annual growth rate (CAGR) of MVW distributions has been 10.62% since 2015. Over the same time period VAS has had a distribution CAGR of just 1.15%.

Final thoughts

Given that 70% of Australian dividends in 2022 were from financials and resources we must consider the aggregate prospects for the sectors.

The banking sector in Australia has coalesced into an operating environment where 4 banks control 75% of market share. It is hard to imagine a scenario where this collective market share would increase. Even if this was possible it is unlikely that regulatory authorities would allow it.

Each of the big four has structural competitive advantages that prevents smaller banks from meaningfully increasing market share. But these same competitive advantages limit relative market share at the expense of other members of the big 4. Macquarie is the only bank that has proved adept at global expansion. I see the big 4 as collectively stuck in a holding pattern where earnings growth will be limited to overall loan volume increases in a heavily leveraged domestic market.

The other big component of the local market are resource shares. I just don’t love the business from a dividend 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.

Ultimately the biggest contributor to mining profits is China. 60% of BHP and RIO sales are to China. Close to all of Fortescue sales are to China. Will the 20-year China boom continue? Stranger things have happened. But urbanisation has likely peaked and infrastructure has caught up to standards in developed countries. The property industry is a mess. Local debt levels are high and the population started shrinking in 2022.

Investing would be easy if the future simply mirrored the past. And even the most thoughtful analysis of likely future pathways are derailed by unforeseen events.

While acknowledging uncertainty we must remain cognisant that investing is a probabilistic exercise. We want to explore the probabilities of long-term future outcomes and prudently position our portfolios accordingly.

I would love to hear your thoughts at mark.lamonica1@morningstar.com