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.

Read the full guide on Morningstar Investor.

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.

This section continues to explore an example of Transurban Group (ASX:TCL), and the difference an investor would see in their return when having a dividend reinvested, as opposed to receiving the dividend. Find the full guide on Morningstar Investor.

General economic outlook in the age of COVID

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—especially in light of the current unpredictability of dividends during market downturns. 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.

Find the full guide and valuation considerations on Morningstar Investor.

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.

Morningstar analyses over 180 Australian companies, assigning a ‘moat rating’ to each (there are wide, narrow and no moat ratings).

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.  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. 

Switching costs: Switching costs refer the inconveniences or expenses associated with a customer switching from one product to another.

Network effect: The network effect occurs when the value of a particular good or service increases as more people use the good or service.

Efficient scale: Efficient scale applies to companies that serve limited markets where there are a small number of competitors.

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.

The payout ratio can be found through the ‘dividends’ tab on a stock page. 

Understand how to interpret a dividend payout ratio, and what constitutes as a ‘sustainable’ payout ratio through the full guide in Morningstar Investor.

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.

Conclusion

The COVID crisis, and downturns in general, are 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.

Morningstar features to assist with your investing journey

Throughout this guide, we have spoken about what you should look for in stocks that will provide sustainable income. Morningstar Investor is there to help investors through the process of selecting and maintaining a portfolio of investments through our research, ratings and tools.

Our recommendations for stocks are based on the current share price relative to Morningstar’s fair value estimate after adjusting for an appropriate margin of safety. Our equity research reports provide the following ratings:

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