Ratios generous to a fault


There's been talk recently about how unsustainable dividend payout ratios have become. This results season they hit 70 per cent, beaten only by the 72 per cent struck during the 1992 recession. As now, the 1992 ratio was probably not the result of generous dividend payments, but a function of the pitiful level of earnings in the recession.

Without the backdrop of a recession, we are now experiencing arguably one of the most generous periods of dividend payments in living history. The reason? It's obvious.

With interest rates at 2.5 per cent and term-deposit rates returning nothing after inflation, we have been pressurising listed companies - equities - to pay us higher returns to compensate us for lower returns from non-equity asset classes. And listed companies have responded, not under duress but because this is their once-in-a-lifetime chance to cheaply and easily woo shareholders onto the register and stand out from the crowd simply by nudging the dividend up an almost irrelevant cent or two.

In so doing, company stocks that are used to being ignored as mature, boring and low growth are suddenly having their price-earnings ratios propelled as the income zombies drive what they have amusingly labelled ''safe income investments'' to a premium. Why? Because they are surrogate term deposits. You could never overprice a term deposit because a dollar is only worth a dollar, but their equity surrogates? Blast them to the moon. What a joke.

As one company plays the game, others follow, and the competition has begun. A host of companies have been raising their payout ratios to pander to the new mantra and some have even been offering special dividends, which is a bit of an admission that this is a fad otherwise they would simply increase their normal dividends. To replace bonds and term deposits you really want sustainably high dividends, not ''special'' dividends that you can't rely on. Whatever, let's value a company a lot higher because of them as well.

So the question to you now is whether higher payout ratios are a new culture in the equity market or a fad. Is investing in equities for income a legitimate mindset or an Australian disease? I think the latter, for a number of reasons.

As any value investor will tell you, this focus on dividends is a complete distraction from what you should be focusing on as an equity investor, which is how much money you give the company and how much they make out of the money you give them - in other words, your return on equity. The dividend decision is a bit irrelevant really when making that judgment.

  • If you're invested in a company with a high return on equity, the worst thing it could do is pay you a dividend because if it can make that much out of one of your dollars, why would you want it to give some of those dollars back so you can make 2.5 per cent? You should get excited about companies that have a high return on equity and low yields, and if your favourite high-ROE company has a high yield, you should be annoyed.

  • Companies that are paying out cash are not reinvesting in growth. It is unsustainable. Without investing in growth, earnings will fall and the dividends will evaporate. Dividends took 20 per cent of cash flow in 2008; they now take 40 per cent. Are you sure that's a good thing?

  • Ask any American and they will tell you. ''Bonds are for income; equities are for growth.'' For some reason, Australians think equities are for income and in doing so, they commit the most heinous of equity-market crimes, ignoring the capital risk. In other words, ignoring the share price, which is far more important. Compared with equity-market risk and volatility, equity yields are basically irrelevant.

    I also find it laughable that while everyone got excited about Telstra possibly upping their dividend by 1¢ next year, the share price went up 12¢ on the day of the results. And I find it laughable that while the market was disappointed by the CBA doing the prudent thing and not paying a 10¢ special dividend on top of their generous ordinary dividend payout, the share price fell 134¢. In almost every stock, the share-price risk is vastly more vital to your investment decision than the dividend benefit.

    What would you prefer to invest in, a company that doesn't pay dividends that could, or a company that does pay dividends that shouldn't?

    Marcus Padley is a stockbroker and the author of sharemarket newsletter Marcus Today. For a free trial, go to marcustoday.com.au.

    This story Ratios generous to a fault first appeared on The Sydney Morning Herald.