Investing for high-yield returns

Eureka Report special issue Investing for high-yield returns 2 Taking stock with higher-yielding shares 4 Ten stocks that deliver high-yields

2 Taking stock with higher-yielding shares By Scott Francis With the price of shares in Australia still down 30% from their highs in 2007, many investors have thought about the place and role of shares in their portfolio. One benefit of owning shares is that of the dividend income. Indeed, it is worth noting that dividend payouts from Australia s biggest companies actually increased over the period of the global financial crisis which is not a bad result. Early indications from the most recent reporting season suggests that companies have, on average, increased their dividends by about 7% - well ahead of the rate of inflation, and another satisfactory result. A few years ago the Credit Suisse/London Business School investment yearbook looked at the impact of dividends on investor returns, and found that higher dividend shares had higher total returns. This conclusion has been reached by other researchers, and provides food for thought for investors. Indeed, with the current average sharemarket yield being 4.8% (State Street Global Advisors), and a reasonable estimation of future sharemarket returns being 10% a year (based on Wharton Business School Professor Jeremy Seigel s estimate of long-run sharemarket returns of inflation 7%-plus), it is easy to see that around half of the expected returns from shares comes from dividends. The often talked about Dogs of the Dow strategy looks to select the highest-yielding shares, and reports periods of very strong performance. Leveraging franking credits The Australian environment from a dividend perspective is particularly positive. The existence of franking credits, which almost completely offsets the income tax for someone on the 32.5% income tax rate, adds to the attractiveness of dividends. Perhaps more importantly, most investors in retirement have the ability to structure their affairs such that they are paying 0% tax. This means they get a tax refund of any franking credits received. Let s consider how this works in practice, assuming a $200,000 sharemarket investment with the average dividend yield of 4.8%. The cash dividends received would be $9,600. Assuming that fully-franked dividends were chosen, the value of franking credits would be $4,114. To find the value of franking credits on fully-franked shares, you multiply the cash by three, and then divide by seven. (In this case $9,600 x 3, then 7). The total dividend benefit is $13,714. There is another particularly attractive twist to this dividend and franking credit story that is especially worthy of consideration. There is research that suggests that the return from franking credits is an unpriced bonus from owning shares. That is, if the future expected return from Australian shares is 10% a year, the franking credit return is on top of this an extra bonus for investors. There are various justifications for this not least that many overseas investors get no benefit from the franking credits, and therefore the potential benefit from franking credits is not reflected into the price these investors are prepared to pay. Put this all together and you have three strong reasons to think about the value of dividends in portfolios: 1. They make up half the value of long term sharemarket returns 2. There is evidence that higher-yielding shares have higher long term returns 3. The franking credits of Australian shares, which are usually refunded in full to people in retirement, are likely to be an unpriced bonus of owning Australian shares. The higher the dividends on a share that pays fullyfranked income, the higher the level of franking credits. A previous article in Eureka Report talked about the core and satellite approach to building investment portfolios. One of the satellite strategies to consider is investing a proportion of the portfolio in higher-than-average dividend paying stocks for the benefit of extra income and franking credits. Further, if you are investing part of your portfolio in high-yielding shares, you get rid of all costs especially if you hold them outside of superannuation. Keep in mind that most people in retirement can have significant assets outside of superannuation, still pay no tax and receive the benefits of franking credits as a tax refund giving them a tax-free and fee-free environment. Beware the value trap A word of warning here. Looking for higher-yielding shares brings us to the value trap. When we talk about higheryielding shares, we are talking about shares that are paying a higher dividend compared to their price than average and there may very well be a reason for this. As the price of banks fell during the global financial crisis they seemed to be providing tremendous dividend opportunities however, we know these opportunities were not without risk. Companies that collapsed during the global financial crisis, like ABC Learning and Allco, seemed to be paying great dividends for a while, but they had no value

3 once the company collapsed. Even in the list of stocks suggested below, Tabcorp seems to be paying an attractive yield but it is clearly exposed to business risks. So what is the antidote to the risk of holding high-yielding shares in portfolios? Diversification ensuring a spread of companies so that if one or two do collapse, there is an element of protection for the portfolio. Common sense is also important. If a company is paying a well above average dividend yield, then it will be important to have some understanding of the reason why. Choosing high-yielding shares falls into a style of investing characterised as value investing (although there are many definitions of just what this is), and there are periods of time where value companies underperform the overall market. Getting payback is important The question is, which higher-yielding shares might you consider in a portfolio? The following table shows 10 suggestions. As well as the usual calculations of franking credits and dividend yield, a payback period has been included. This is the length of time for the initial investment to repaid in the value of franking credits and cash dividends. All the shares have payback periods of between nine and 13 years. Currently it would take a cash account paying interest of 5% 20 years to pay back the initial investment. Of course, these calculations around income assume that dividends remain the same over this period. If they increase (which is the general trend of dividends), the payback period will be shorter. If they fall, the payback period will be longer. well as providing a source of diversification for a portfolio. The Vanguard Australian High Yield Fund also provides an opportunity for a diversified investment paying above market average income. Commonwealth Bank, ANZ, Telstra and GUD all have long dividend-paying histories, with AMP also providing a potential opportunity to invest in a well-known brand with an above average income stream. Toll, ASX and Tabcorp are all significant companies in the Australian landscape, rewarding investors with attractive dividends. Conclusion The evidence that higher-yield shares have a higher longterm return, along with the unpriced benefit of franking credits, makes allocating a portion of a portfolio to higheryielding shares a strategy well worth considering. The trap is potentially ending up holding shares that are not able to sustain their dividends, or that have apparently high dividends because they have fallen in value for a very good reason. Weighing both the benefits and traps, there remains a strong case for having a proportion of your portfolio in higheryielding shares. An important disclaimer the dividends are based on historical dividends, and may change for better or worse. Ten dividend stocks worth exploring Share Price Cash Dividend ($) Franking Credits Cash Yield Payback Period if Dividend and Franking Credits are Sustained AMP $4.36 0.265 0.113571 6.1% 11.52 years ANZ $24.14 1.42 0.61 5.9% 11.9 years ASX $30.30 1.85 0.79 6.1% 11.45 years Commonwealth Bank of Australia $54.20 3.34 1.431429 6.2% 11.36 years GUD $8.71 0.65 0.278571 7.5% 9.38 years Tabcorp $2.89.23 0.098 8.0% 8.75 years Telstra $3.82 0.28 0.12 7.3% 9.55 years Toll Holdings $4.62.25 0.11 5.4% 12.9 years Vanguard High Yield WAM Research (WAX) $51.50 3.00 (est) $1.03 (80% franked) 5.8% 12.8 years $0.83 0.065 0.027857 7.8% 8.94 years Summaries of each of the individual stocks detailed above are included below. WAX is a particularly interesting opportunity. As a listed investment company trading at below the value of its assets, it has an impressive history of paying strong dividends as

4 Ten stocks that deliver high-yields AMP (AMP) With a dominant financial planning and wealth management brand, AMP is a leader in financial services with size, scale and market share. Acquiring insurer and financial services firm AXA s Asia- Pacific business in 2010 has begun to pay off for AMP, and results for the first half of this fiscal year reflected this. Net profit lifted 10.7% on the prior corresponding period to $383 million. While the company s dividends slipped in the most recent half, paying an interim 55% franked dividend of 12.5c, which represented a 17% decrease on the corresponding 2011 half, the company still provides an attractive yield for investors above 6%. With a target payout ratio range of 70-80%, the forecast dividend for the full year can still be expected to be comfortably 26-27c, and if earnings growth continues, along with the AXA integration delivering financially, it could be higher. The payout ratio for the most recent half was just 73%, compared with the three prior halves between 81% and 88%. AMP has launched a push in recent months for some of the fast-growing self-managed super fund sector as well, starting with the acquisition of SMSF administrator Cavendish. This is a competitive but potentially lucrative space, and AMP would be looking to capture not only administrative fees but cross-selling opportunities. If AMP s SMSF strategy can gain traction, this is a very valuable opportunity in a sector with nearly half a trillion dollars of funds. At the September 20 close, AMP was trading at $4.41, with a market cap of $12.6 billion and a price to earnings ratio of 17.5. Australia and New Zealand Banking Group (ANZ) While Commonwealth Bank may come up ahead on cash yield and size amongst the big four banks, ANZ should not be forgotten by investors looking for returns in this space. Like Commonwealth it provides a range of retail, business and institutional banking services as well as life insurance. ANZ also has a brand licensing agreement with Etrade, and its Etrade online brokerage is strongly established as the second-largest in Australia behind the Commonwealth Bank s CommSec. Where the bank differentiates itself is through its super regional strategy, which seeks to profit from trade and growth internationally by pushing into overseas markets particularly in Asia. ANZ currently has a presence in more than a dozen Asian markets, through nearly 100 branches. Financially and operationally ANZ is also performing on key metrics. In the past 12 months, it has outperformed the other three of its peers significantly on home loan growth (9%) and business credit growth (10.4%), while trailing only NAB in household deposit growth by just 0.2% (13.4%). The company paid an interim fully-franked dividend of 66c, and full-year profit results are due in late October where a record of dividend growth is broadly expected by analysts to continue. ANZ s balance sheet is in good shape for coming regulatory reform, although capital management could see the 1.5% dividend reinvestment plan discount in coming years. At the September 20 close, ANZ was trading at $24.74, with a market cap of $65.9 billion and a price to earnings ratio of 12.0. ASX (ASX) The Australian Securities Exchange is itself a listed (and profitable) business, and though financial activity has been subdued along with consumer and investor confidence there are still some reasonable dividends on offer. One chief attraction of ASX is its secure and dominant position in providing fully integrated exchange and market services. Potential exchange competition from Chi-X, launched last year, has gained little traction to date and remains in the low-single-digit percentages of ASX volume. The exchange is actively pursuing new business options, including managed funds services, with new rules proposed for capital raising to help small- and medium-sized businesses. Net profit did slide in 2012, though, as lower share trading volumes and general global economic uncertainty led to a 3.7% dip to $339.2 million. As profit slipped so did dividends, with a final fully-franked dividend in August of 85.1c representing an 8.5% decrease on last year s corresponding payout. It took full-year total dividends to 177.9c a share, a 2.9% drop, but investors should note the high payout ratio, based on underlying earnings, of 90%. A recovery in market sentiment if the Eurozone stabilises and the US recovery continues would boost those earnings and see returns improve again for investors. At the September 20 close, ASX was trading at $30.22, with a market cap of $5.3 billion and a price to earnings ratio of 15.6.

5 Commonwealth Bank of Australia (CBA) The largest of Australia s big four banks, Commonwealth is also the most attractive of the group when it comes to yield. The bank is really a large and integrated financial services provider, so as well as providing retail deposit and lending it also functions as a business and institutional bank, an insurer, a fund manager and a brokerage, amongst other general financial services. Commonwealth Securities, or CommSec, is the company s retail brokerage and the largest online broker in Australia. In addition to booking a record $7.1 billion cash profit in its full-year earnings report in August, the bank also announced an increased dividend policy for the coming year. The final dividend of $1.97 contributed to a 4.4% increase in total dividends for FY12 to $3.34 which is good news for yield investors, but better news is the increased interim payment for the coming half. The payout ratio has been lifted from slightly more than 60% in recent years to 70% in 1H13. That ratio would have added another 22c per share to the dividend if it had applied this year. Commonwealth, along with the other major banks, has also been working to strengthen its balance sheet, building up capital for regulatory requirements, and is conservatively positioned to weather any ongoing stalling of consumer or corporate confidence. At the September 20 close, CBA was trading at $54.97, with a market cap of $87.5 billion and a price-to-earnings ratio of 12.7. GUD Holdings (GUD) A diversified industrial and consumer product designer, GUD has a wide range of brands and provides investors with some profitable exposure outside of the dominant resources and financial sectors on the ASX. What it also provides is a very healthy 7.5% yield. GUD also has limited manufacturing capacity, but the majority of its revenue comes from the design and offshore outsourcing of consumer brands such as Sunbeam, automotive brands including Ryco and water products business Davey. Offshoring much of the manufacturing load to China has boosted the company in recent years, but a turnaround in the Australian dollar could put pressure back on margins. Posting a net profit of $92.8 million for the full year in July, GUD bolstered a slightly weak underlying result with the sale of its stake in Breville (BRG). The company paid a final fullyfranked dividend of 35c a share, taking the total for the year to 65c. The FY12 dividend represented a 2% increase on the prior year, as the company s wide diversification helped buffer against some of the consumer downturn. At the September 20 close, GUD was trading at $8.52, with a market cap of $603 million and a price-to-earnings ratio of 6.5. Telstra Corporation (TLS) If there s been one hot stock for Australian income investors in 2012, it s been the former-monopoly telecommunications company Telstra. As well as providing strong share price growth through the year, peaking at more than $4 in August after having dipped below $2.90 at the same time a year earlier, the company is still maintaining an attractive yield. And there s no mystery as to why this is, with the federal government s multibillion-dollar payments linked to the National Broadband Network (NBN) and the structural separation of the company providing a major cash injection and a boon for shareholders. Depending on the government, and how or if the NBN is continued, these payments could total as much as $11 billion for Telstra. The company is performing well financially outside of this major cash boost however, largely thanks to growth in mobile revenue. Telstra grew net profit by more than 5% in the 2012 fiscal year, to $3.4 billion, and paid a total of 28c in fullyfranked dividends. At the September 20 close, TLS was trading at $3.86, with a market cap of $48 billion and a price-to-earnings ratio of 14.1. Tabcorp Holdings (TAH) Tabcorp is a business going through some major transitions, and while the outlook for the company is on the uncertain side, it is currently providing an excellent opportunity for yield investors. Echo Entertainment (EGP) was spun off from Tabcorp in the middle of last year (2011), and took with it the casinos and casino licences for New South Wales and much of Queensland. Soon after emerging from this transition, it was awarded a new 12-year exclusive Victorian wagering licence and this is important because the wagering side of the business is expected to contribute three quarters of FY13 operating revenue. The August 15 expiration of a lucrative duopoly licence with Tatts to operate pokies machines in Victoria means the end of a very secure revenue stream for the business, although it expects to retain some through providing pokies-related services to the new venue-based operators. Absent all this, full-year profit lifted almost 13% for the full year to $340 million and the company paid a final dividend of 11c per share, for a total fully-franked dividend of 23c a share or 8%. Tabcorp may be going through a period of change, but it operates in lucrative and highly regulated sectors where it has extensive experience and attractive dividends available if and when earnings settle into their new ongoing shape. At the September 20 close, TAH was trading at $2.87, with a market cap of $2.1 billion and a price-to-earnings ratio of 6.0. Toll Holdings (TOL) Toll is the major listed player in Australian logistics and freight, with an established domestic transport network and growing revenue from resources and energy sector transport services. After a string of write-downs in the past fiscal year hurt earnings for the company, new chief executive Brian Kruger faces tough conditions in the near and medium term. Strong growth from the mining transport services division over the

6 year, driven by the acquisition of Mitchell Corporation, may not continue if resources expenditure is curtailed. However Toll s revenue increased for the full year to $8.7 billion, and in spite of write-downs to the Japanese business and commercial property holdings the company still booked $64.6 million of reported net profit. The good news for yield investors was that the dividend was maintained in spite of this. A final fully-franked dividend of 13.5c took the total for the year to 25c identical to dividends paid in the three previous years. This steady maintenance of dividend payments reflects an ongoing opportunity for investors to pick up returns from a company with a strong balance sheet and dominant market presence. At the September 20 close, TOL was trading at $4.50, with a market cap of $3.2 billion and a price-to-earnings ratio of 49.6. Vanguard Australian Shares High Yield ETF (VHY) For investors looking for a yield prospect without some of the associated single-company risks, an exchange-traded fund is providing one alternative pathway. in AP Eagers (APE), Breville (BRG) and Alesco (ALS). The net value of its assets per share before tax is 89c, but at the September 20 close WAX was trading at 84c a share on a total fund size of $108.6 million. Notably, the company s investment philosophy avoids the resources sector, which the directors consider too volatile and difficult to value. Instead there is a bias toward industrial companies that have a history of both profit and dividend performance. As well as a recent track record of outperforming the All Ordinaries, by 7.7% in the past six months and 10.9% in the past year, WAX also has a stated aim of consistently growing dividends. Investors will receive 6.5c of fully-franked dividends in 2012, providing a yield of more than 7.7%, and while payouts dipped in the two years of the global financial crisis the fund has generally met that aim of steadily growing dividends since inception in 2004. That strong yield, as well as the potential for both capital growth or even just a correction upward to net asset value, make WAX a definite stock for income investor attention. Scott Francis is a personal finance commentator, and previously worked as an independent financial advisor. A dividend ETF, the Vanguard fund s aim is to reflect the FTSE ASFA Australia High Dividend Yield Index essentially an index of companies on the ASX with high expected dividend yields, excluding A-REITs. VHY was listed in May last year, and pays quarterly distributions with a dividend reinvestment plan option available. Distributions to date in FY12 have ranged from 66-81% franked, and estimates of the full-year total, assuming a roughly 80% franking rate, would see a roughly 6% cash yield. As an exchange-traded fund, VHY offers investors the ability to gain exposure to range of stocks with attractive yields, including big banks and Telstra, but also to those providing strong expected dividends that may be less desirable for company-specific reasons such as Sydney Airport (SYD), or Transurban (TCL), which are both held by the fund. The frequency of distributions may also be of use to investors and, as capital appreciation is captured as well, the fund provides a broader way into a range of ASX-listed yield stocks. At the September 20 close, VHY was trading at $51.93 with a net asset value of $51.8 million. WAM Research (formerly Wilson Investment Fund) (WAX) A Listed Investment Company (LIC) that s trading below the value of its assets, WAM Research is a promising prospect that also happens to have paid strong dividends to date. One of the Wilson Asset Management funds, it focusses on small and medium-sized ASX-listed companies with the aim of achieving strong dividends supported by the possibility of capital growth due to the smaller size of the companies invested in. At the end of August, the largest holdings were