Morningstar Guide to Income Investing in Downturns

Introduction

My first investment in shares happened with no effort on my part—I received an employee grant from the company I was working for. Several months later, I reviewed my bank statements and saw a credit to my account—not enough to declare myself retired, but enough to get me a bottle of Piper Heidsieck. This was my first experience of passive income outside of savings accounts. Many investors seek investments specifically for income (a larger stream than a bottle of wine)—many in retirement, or to supplement income. This guide looks at opportunities that Morningstar analysts argue are positioned to provide sustainable income through competitive advantages and strong balance sheets.

Income is derived from different avenues for different people. Labour (also known as wages), and income associated with investments—rent from property, dividends from shares and interest from bonds and deposits. Regardless of the avenue, income means livelihood to many of you reading this. In this guide, we’ve chosen to focus on income from shares (dividends). We provide in-depth analysis, research and data for shares which allow us to examine the fundamentals—choosing those that are attractively positioned for sustainable income.

Unquestionably, this is a frustrating and unprecedented time for investors. COVID-19 has had a devastating human toll and will continue to disrupt financial markets and businesses. We’ve recently seen the impact on bank dividends—the deferral of ANZ Bank’s (ASX:ANZ) dividend is the first missed scheduled payment since 1982—an almost four-decade run suddenly halted. Similarly, with Westpac (ASX:WBC)—this is including the early 1990s where the bank continued to pay dividends after their massive bad debts on commercial property loans came to realisation and brought the bank to their knees. This track record has made banks an attractive haven and provided an almost guaranteed income stream for many investors.

This pandemic-induced dividend shock is not restricted to the banking sector as many companies in different sectors announce moves to scrap payments for the foreseeable future. And according to a Janus Henderson survey, it’s estimated global dividends could fall by 35% this year. Faced with this new reality, it’s worth knowing that an investor’s ability to understand a company’s balance sheet and its competitive advantages can provide insights into how to create a portfolio with sustainable income beyond the crisis.

What are dividends?

A dividend is a payment made by a corporation to its shareholders, with each share receiving an equal amount of value. Dividends can be paid in additional shares of stock (stock dividends or stock splits) or shares of another corporation (a process known as a spin-off). Some are one-time affairs known as special dividends. However, the vast majority of dividends are regular cash dividends, paid at predictable intervals—usually twice a year in Australia.

Dividends are everywhere: 90% of the companies in the ASX 200 Index make regular distributions of cash to shareholders, and many smaller companies also pay dividends. The yield of the ASX 200 is ~2.92%, which means that for every $1000 invested $29.20 of income will be generated. The yield increases to 3.58% if you exclude the 10% of the ASX 200 companies that pay no dividend. Australian companies tend to pay higher dividends than foreign companies and Australia has a higher yield than other global markets.

Common stocks derive their value from future cash flows that are generated by the company. Dividends are a component of this cashflow. This is similar to a bond that is valued according to the interest coupon payments. With a bond, the investor knows exactly what he or she is supposed to get. Interest payments are scheduled in advance, as is the return of principal when the bond matures. The only questions directly related to these cash flows are whether the issuer can pay on time and in full and how the market will value those cash flows based on inflation expectations, the prevailing interest rates, and assessments of the credit worthiness of the issuer.  

According to financial theory, when taxes are excluded there is no difference in how you would value cash flow that is either retained by the company or instead paid out by the company. However, financial theory aside, many investors exhibit a clear preference for dividends. One reason for this is that once you put some cash into a share of stock, there are only two ways you can recoup it. You could sell the stock on the open market, but then it has a new buyer, who would need another seller. Unless there is some other source of cash, this is the world’s biggest game of hot potato. The other source of cash is from the issuing corporation itself. It might take the form of a liquidating distribution (these are very rare), a cash buyout offer, or a dividend. The most useful payments for some investors—and the only practical ones for the largest companies—take the form of regular cash dividends.

The critical importance of dividends, as well as dividend growth, is easily observed in historic stock market returns. Since 2000, the ASX 200 has returned an average of 5.12% annually. The proportion of total return that comes from dividends is 60%.

So dividends are not just powerful in terms of delivering potential returns, they can also be practical in meeting investors’ real-world objectives. Dividends help give investors the ability to use corporate earnings as they see fit: to fund portfolio withdrawals during retirement, to meet other personal financial obligations, to reinvest in the company that paid it, or to invest in other areas of the market.

Dividends may not be the contractual obligations that a bond’s interest payments are, but once a dividend has been established, directors and managers have historically been reluctant to yank it away without good cause. An investor cannot take any dividend for granted, yet a dividend-paying company provides evidence, at least in part, that it has shareholders’ interests in mind.

S&P/ASX 200—DS Dividend Yield

Source: Morningstar

Income as part of your investment strategy—Dividend growth

Seeking a decent income from stocks is a good start, but it’s not the final destination. It is critical for investors—even dividend-oriented investors—to think in terms of total return. Let’s say you find a $25 stock that pays annual dividends of $1 a share. That’s a 4% yield, which isn’t too shabby. But if that dividend never grows, your income return is fixed at 4% based on your purchase price. By contrast, an increasing stream of income is far more useful than a flat one in an inflationary world, and a growing dividend is likely to result in capital appreciation over time as it will reflect growing cash flows.

In the next section, we explore financials and discuss a few ratios that can help you understand dividend growth and why it is important.

Trade-off between current yield and future growth

It's critical to understand the trade-off between current yield and future growth. Investments are sometimes made with the sole purpose of providing a passive income stream—this is a common investment strategy and can be appropriate for your individual circumstances. However, it is important to understand the impact of taking your income, instead of re-investing it (and vice versa).

Compounding is often compared to pushing a snowball down a hill. As it travels down the hill, the snowball gathers more snow. The bigger it gets the more snow it gains on each rotation. The ’snowball effect‘ shows that small actions continued over the long-term can have a big impact.

The same applies in investing. Compounding is simply the concept of earning a return on your previous returns, and if you reinvest, on your dividends as well.  If you own shares in a company that is growing its dividend and you reinvest those dividends, you can accelerate the compounding effect. To illustrate, consider the scenario whereby you buy shares in a company with a growing dividend. For instance, you buy 1000 shares in tollroad operator Transurban Group (ASX:TCL) on the first day of trading in 2009. It is a low point in the global financial crisis; Australia is experiencing the first negative quarterly GDP growth in 8 years; and it’s a month before the introduction of the $42 billion economic stimulus package by the Rudd Labor government.

We have created a chart that shows two scenarios for your investment:

1. In the first scenario, your dividend payments are deposited into your account.

As Transurban continues to raise the dividend, your passive income increases. Each year the percentage increase in the dividend compounds. As a result, your income is increasing faster than the sum of the annual totals.

In 2009, Transurban declares $230 worth of dividends on your initial investment of $5020. By 2017, Transurban declares $545 a year in dividends. If you add up each annual increase in the dividend for the period in which you have owned the stock, there is a total increase of 91.49%. That sounds great but pales in comparison to the total increase in your income, which has increased by 136.96%. That difference of 45.47% in income growth represents the compounding of each increase building on the previous one.

The day after the last dividend declared in 2017 is paid on February 19, 2018, the value of your investment has increased from $5020 to $11,650—an additional gain to the income you have earned.

2. In the second scenario, you have dividend payments automatically re-invested at the share price the day after the dividend payment date.

A dividend reinvestment plan (‘DRP‘) simply requires you to complete a form and send it to the share registry. The cash dividend will be converted to additional shares without incurring any brokerage, commission, stamp duty or other transaction costs for new shares. By using a DRP your income growth soars because you are getting the benefit of Transurban increasing the dividend and you are growing the number of shares you own.

In 2009, you will be paid $233.25 in dividends, which will grow to $807.07 in 2017. The difference between the amount you earn in the first scenario and the second scenario is the compounding effect of continually increasing the amount of shares you own and therefore increasing the amount of income you are entitled to. The value of your initial investment has now increased from $5,020 to $17,861 on the day after your last 2017 declared dividend is paid on February 19, 2018. The value of your initial investment has increased from $5020 to $17,861—a gain of $12,841.

General economic outlook in the age of COVID

To help stave off the impacts of the COVID-19 disruptions to the economy, the Reserve Bank of Australia held an unscheduled meeting in mid-March at which it lowered the cash rate from 0.5% to 0.25%. The historic fall in interest rates has only served to increase investor appeal for dividends. Why? Because investors want income and if the amount available from bonds and cash decreases, they look for alternate sources. Generally, it could be a long road back to previous dividend levels, but predictability of earnings and dividends should increase in fiscal 2021. For now, the volatility has granted opportunities, including companies with strong balance sheets, economic moats of competitive advantage that have become attractively priced.

The COVID-19 crisis and the ensuing restrictions on the economy have heightened uncertainty about the short-term outlook. However, Morningstar equity analysts view the broad sell-off as overstated and expect the pandemic to have minimal long-term implications on most companies’ outer-year earnings. Admittedly though, companies must be strong enough and properly prepared to weather the near-term storm. Next to moats, cash reigns supreme when cash flows and liquidity dry up and balance sheet strength becomes key in determining the state in which companies might come out the other end.

This is a guide about income investing and finding dividends, but investors should be aware that looking for income should not be the only priority in this market—especially in light of the current unpredictability of dividends. Sustainable income will come through focusing on valuation, strong balance sheets and economic moats—all key considerations for long term investors.

Valuations

Valuation is a critical component in successful investing. Buying stocks that are trading below their fair value can result in capital gains as the market recognises the discount and the share price returns to fair value. It can also help with income investing. As the price of a share falls the yield received by an investor rises. The higher the yield, the more that dollar you invest generates in income. Yield on shares is measured on historic dividend payments and is calculated by dividing the dividend payments received in the past year by the share price. As an investor you are not investing in the past; you are instead paying for future cash flows and dividend payments. In the current environment, these short-term cash flows and dividend payments may be disrupted. However, for many companies this disruption is likely to be short-term and cash flows may soon return and grow from pre-crisis levels. For long-term investors, the next six months of dividend payments may not be relevant to the overall income generated from buying a share at an attractive price, and which will generate a high yield once dividend payments stabilise. The key is to identify companies that will survive the crisis and sustain dividend payments over the long-term.  

Sustainability: What factors can help create a reliable stream of dividends?

An economic moat

At the heart of Morningstar’s methodology is our Economic Moat Rating, an analogy of the medieval castle defence against marauding intruders.

Popularised by legendary US investor Warren Buffett, a ‘moat’ is the ability of a business to pull up the drawbridge to defend long-term profit and market share, thus delivering excess returns above the cost of capital.

Companies with sustainable competitive advantage are able to fend off the competition and sustain excess profits over a long period of time. However, in saying this, an economic moat does not just protect 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.

Morningstar analyses over 180 Australian companies, assigning a ‘moat rating’ to each (there are wide, narrow and no moat ratings). Those with wider moat ratings will likely increase their competitive advantage and emerge in a stronger position through the volatility, increasing the likelihood of a sustainable yield—competitors will likely wane from liquidity issues and struggle in the current conditions.

Economic moat ratings of narrow and wide are one place to look when evaluating future dividend payments potential. An economic moat does not guarantee dividend safety, of course, but no-moat companies may be more likely to hold up during recessions than narrow- and wide-moat firms.

Morningstar identifies five potential sources of an economic moat.

Intangible assets: These can include brands, patents, or government licences that explicitly keep competitors at bay. We see a moat based on intangible assets in casino operator Crown Resorts (ASX:CWN). Each of Crown Resorts' properties is situated in prime locations, with a long-dated casino operating licence from the relevant state government (expiring in 2050 for Crown Melbourne and 2060 for Crown Perth). This licensing regime creates a legal barrier to entry, an intangible asset that underpins its economic moat.

Cost advantage: Firms that can provide goods and services at lower costs have big advantages over rivals as they can either undercut their rivals on price or sell at the same price and earn a higher profit margin. Generally, moats based on cost advantage are due to economies of scale—that is, saving costs by increasing production.

AGL Energy (ASX:AGL) boats a narrow moat due to its cost advantages, underpinned by its low-cost thermal generation capacity, which contributes to the vast majority of the firm's earnings. The relatively concentrated market and cost advantages from vertical integration also support excess returns.

The key driver of AGL's moat is its fleet of low-cost coal-fired power stations. Its Loy Yang A brown coal power station in Victoria, which produces about one third of AGL's electricity output, has the lowest running costs of thermal generation in the Australian National Electricity Market, or NEM. This low-cost position is unlikely to be displaced any time soon. Importantly, Loy Yang owns huge brown-coal reserves capable of powering the plant until its scheduled closure in 2048, insulating it from commodity prices

Switching costs: Switching costs refer the inconveniences or expenses associated with a customer switching from one product to another. Computershare (ASX:CPU), a stock transfer company, builds a moat by being the largest registry service in the world. The potential financial benefits of switching to another registry are almost always outweighed by the potential operational and regulatory risk of doing so.

Network effect: The network effect occurs when the value of a particular good or service increases as more people use the good or service. Social media sites are perhaps the best example as a low number of members provides less of a benefit to a user than a high number of members.

Efficient scale: Efficient scale applies to companies that serve limited markets where there are a small number of competitors. Potential competitors are discouraged from entering the market based on the small opportunity. Telstra (ASX:TLS) meets efficient scale requirements, with its extensive infrastructure assets. Telstra owns (or has large interests) in three of only five internet protocol transit (or submarine optical fibre cable) infrastructure out of Australia. It also owns one of only three national, intercity backhaul fibre networks in Australia, which connects all the metropolitan and regional communications infrastructure. The capital costs required for a new entrant to replicate even a small part of this infrastructure ownership, scale and brand power would be prohibitive, especially in a relatively small country such as Australia and in a relatively mature industry such as the Australian telecommunications market (low-single-digit compound annual growth rate over the past five years). Consequently, there are characteristics of efficient scale (mature demand, high sunk costs), with limited opportunity for new entrants to add profitable capacity.

Now that we’ve covered potential sources of economic moats, let’s move into financial ratios that can uncover strong balance sheets that can weather volatility. Strong balance sheets focus on cash and liquidity, as cash funds dividends, protects against upcoming short-term liabilities and These ratios have been calculated for you in Morningstar Investor and can mostly be found in the ‘financials’ tab, with the rest found in the ‘dividends’ tab.

Payout ratio

This may be the single most important statistic in evaluating a dividend’s stability, but there’s always a bit of tension. A payout ratio is the proportion of earnings being paid out as dividends. All else being equal, a higher payout ratio will generate a higher dividend yield, but lower payout ratios are less risky than high ones. What you should seek is balance—current yield versus stability, as well as current yield versus future growth.

The payout ratio itself is pretty simple: it’s the proportion of earnings being paid out as dividends. If a company is earning $2 a share annually and paying dividends at a $1.20 rate, the payout ratio is 60% ($1.20 divided by $2.00). The inverse of the payout ratio—40% in this case—tells you how far earnings could drop before the dividend would no longer be covered by earnings.

The payout ratio can be found through the ‘dividends’ tab on a stock page. Below shows the historical payout ratio percentage for car parts supplier Bapcor (ASX:BAP). The payout ratio shows stability, and that around half of Bapcor’s earnings are being paid out in dividends, historically. Importantly, Bapcor’s payout ratio shows a couple of insights—that there is room for growth, and the company has a margin of safety to continue paying comparable dividends. If earnings waiver (or grow), there is room to continue paying dividends to shareholders that are comparable to what has been paid historically, as only half of earnings are being paid out at the moment. There’s also room for growth—both as a company and for dividends. Half of Bapcor’s earnings are being invested back in the business—a healthy allocation that indicates that the company is rewarding shareholders, but also still investing in future growth. For dividends, Bapcor has the opportunity to raise the payout rate in the future as it still has a healthy buffer of earnings remaining after dividends are paid. In one word, flexibility. Bapcor’s payout ratio indicates flexibility and agility in a scenario where many businesses are facing some tough choices (we’ve seen this with the banks).

Source: Morningstar Investor

Our forecasts show that this should continue, with the dividend payout rate continuing at around half of earnings. These forecasts can be found for all Australian and New Zealand stocks through our stock page and are projections of financial performance by our analysts.

Source: Morningstar Investor

Bapcor’s dividend payout rate is lower than the Morningstar Australia GR AUD Index, where the payout ratio averages around 74%. This is not always a bad sign, as Morningstar director of investor education Karen Wallace explains.

"There is a margin of safety that would allow a company to miss its earnings target and still be able to pay out its dividend, and there may also be room for management to increase the dividend over time."

Especially in times of volatility and economic strain, this stability is appealing to investors seeking stable income.

Strong finances

Dividends can be paid to common stockholders only if all other financial obligations are satisfied first—banks, bondholders, suppliers, employees, pensions, the tax office, and even hybrid holders. Being last in the pay line, an investor would typically want to see that this line is not too long.

Balance sheets can provide further indicators of the ability of a company to weather turbulent conditions and return to strength post-storm—strong finances are essential to ensuring a sustainable dividend.

Even when there’s a hiatus in earnings, balance sheets can provide insights into longer term approaches to achieving income. ‘Fortress balance sheets’, a term coined by JPMorgan Chase boss Jamie Dimon, refers to companies with strong financial foundations that can withstand financial shocks such as the tremors brought on by COVID-19. Morningstar’s analysts have compiled a list of attractive stocks with fortress balance sheets, almost exclusively with companies that have an economic moat as well.

These companies range in industry and size but have a common denominator—their debt levels are manageable. A strong balance sheet can be indicated in a few ways, mainly through provides a point in time snapshot of assets and liabilities. The safest company is a company with no debt with cash on the balance sheet, or no net debt (beware—this can also go the other way. Some companies are without debt because they are unable to get it. For example, small mining companies that lenders find too risky). If a company has debt it is important to understand when it needs to be paid pack. There is a big difference between companies with debt that doesn’t mature for a while and companies that have debt maturing in the near future. Having debt mature in a bad capital market environment can be difficult to refinance. This is especially true if the cash flows are affected by lower levels of economic activity. In some cases, companies may not be able to cover their interest payments with current cashflows and can’t borrow more money to support them through the crisis.

To understand some of the indicators of balance sheet strength, we can take Telstra, a company on Morningstar’s May Best Ideas List, and examine its latest financial health indicators.

Source: Morningstar Investor

The Interest Coverage Ratio is used to determine how easily a company can pay their interest expenses on outstanding debt. Telstra’s interest coverage of 4.17—this number is calculated by dividing a company’s earnings before interest and taxes, by the company’s interest expenses for the same period. Any result below 1 indicates a company cannot meet its current interest payment obligations.

A Quick Ratio is used to gauge a company’s liquidity—as mentioned before, in times of turmoil, cash reigns supreme. This ratio is calculated by comparing the total amount of cash and cash equivalents to liabilities and reflects the company’s capacity to pay current liabilities without additional financing. Telstra’s quick ratio of 0.6 indicates that it cannot fully finance short-term liabilities if needed, but the key to quick ratios is context, which can be found through the debt maturity schedule in the case of Telstra. The debt maturity schedule is staggered and long dated, with defensive earnings bolstering its position.

Debt/Equity ratio looks at the relative proportion of shareholders’ equity and debt used to finance a company’s assets. It is calculated by dividing a company’s total liability by its shareholder equity. This ratio indicates the ability of shareholder equity to cover outstanding debts. This ratio shows that Telstra isn’t highly leveraged, or primarily financed with debt at a debt-to-equity ratio of 1.38. Ideally, debt-to-equity ratios sit between 1 and 1.5, but this can vary from industry to industry. A higher debt-to-equity ratio may indicate that the company uses debt to finance growth, and for lenders and investors this may mean a higher risk of the company failing to produce enough to repay debts during volatility or stress. Inversely, a very low debt-to-equity ratio (closer to zero) can indicate that a company isn’t realising profit it could gain by growing operations. During volatility, a stable debt-to-equity ratio can also provide more chance success upon recovery.

Ratios can act as a hand-on-the-forehead temperature check—they can give you some insights into a company's financial strength But further analysis and checks are essential. Healthy ranges for ratios can vary from sector and market and aren’t one-size-fits-all. Morningstar analysts look at the financial health of a company through balance sheet deep-dives alongside other indicators such as growth, profitability and operating performance.

Other financial factors that may warrant consideration can include tax problems, legal threats—pretty much any other potential claim on a company’s cash. Liquidity can be an important factor, too—dividends may come indirectly from earnings, but they’re paid in cash. Especially in seasonal or heavily cyclical fields, an investor should seek companies with cash reserves or suitably large lines of credit to smooth out shifts in cash flow.

One such company is Adelaide Brighton (ASX:ABC) a leading Australian construction materials and lime producer.

Source: Morningstar Investor

The Current Ratio (found in the financials tab of a stock page) gives an indicator of the company’s liquidity. Adequate liquidity is essential for stability through the turbulence we are experiencing—as mentioned before, dividends may come indirectly from earnings, but they are paid in cash. Especially in the current volatility, investors should seek companies with cash reserves, or suitably large lines of credit to smooth out shifts in cash flows.

The current ratio measures the company’s ability to pay short-term obligations, or those due within a year. It compares a firm’s current assets to its current liabilities. Adelaide Brighton’s stellar current ratio—2.69, means that they have  2½ times more current assets than liabilities to cover its debt. Similarly, the quick ratio (also known as the acid-test ratio) is also a measure of how adequately a company can meet short-term liabilities—but as the name suggests, ‘quicker’ than what you’re looking at for the current ratio. The quick ratio focuses on the most liquid assets and how well it can meet current liabilities. For Adelaide Brighton, their quick ratio is 1.70—this means that for every dollar of liabilities ABC has, they have $1.70 of very liquid assets to cover immediate obligations. This is an attractive position to be in, especially through volatility where liquidating assets may become a very real scenario.

Finally, in situations involving large debt loads, it’s important to be aware of any financial covenants with bankers or bondholders that can trigger defaults even before the firm runs out of resources. (If this seems beyond your grasp, simply avoid highly leveraged situations. Debt can be a plus if used in moderation, but there is always a point beyond which it’s much more trouble than it’s worth.)

Conclusion

The COVID crisis is a difficult situation to navigate as an investor. Stress levels are elevated due to health concerns, economic conditions are perilous and unpredictable, and we are collectively going through this when many of our primary societal coping mechanisms of coming together as a community have been disrupted. The unprecedented nature of this crisis makes it difficult to envision what society will look like on the other side. Short-term disruptions to the economy will fade over time and people and companies will learn to adjust to whatever the new normal brings. Some companies won’t make it but focusing on those with sustainable competitive advantages, strong balance sheets and enduring cash flow generation capabilities will eventually reward investors.

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