Expecting a steady cash return from shares is sometimes a trap. Photo / 123RF
COMMENT:
We all know that Covid-19 is having a severe impact on our economy. But there is a difference between this particular recession and its predecessors: low interest rates.
This is helping to preserve asset values that might otherwise be at risk. For example, over the past few days we've heard that residential housing values have been broadly maintained at pre-Covid levels across New Zealand. Not something your average (or even brilliant) economist would have forecast a few months ago.
I've written in this column before about the likes of Fisher & Paykel Healthcare; it might look expensive on paper, but its share price reflects not only a well-managed, large company growing strongly, but also the low interest rate environment we're operating in.
For any investor (or house owner), future increases in interest rates will form a significant long-term risk — not one that is likely to materialise anytime soon perhaps, but a risk nonetheless.
Many NZX-listed entities have long been known as paying a strong dividend. Fisher & Paykel is not among them: although it pays out around 50 per cent of its net profit as a dividend, that amounts to only a 0.78 per cent return to shareholders.
A dividend is only one component of "total investor return", however. The other major return element for most investors is the increase in value of the underlying share. On that front, F&P scores rather more favourably, at least so far this year.
Sometimes it makes more sense for a company to retain its cash and use it to invest in its own growth, rather than return it to investors in the form of a dividend. A2 Milk is one example of a company that maintains a large cash investment war chest in preference to paying dividends.
In general, a dividend return provides a more "stable" cash return for investors, with dividend-paying companies preferring to maintain a steady (or slightly increasing) dividend rate. Investors don't tend to see dividend cuts as good news.
The desire for dividend stability can result in some unusual short-term movements in cashflows. For example, Tourism Holdings in 2019 raised $80 million in capital to fund its growth aspirations for its US-based joint venture, only to pay out $15m in a final annual dividend a few months later.
In a very real way, however, dividends need to match an organisation's underlying long-term profitability and cashflow. It makes no sense for a company earning, say, 5c per share long-term to be paying out a 10c per share dividend.
For investors, the past few months have highlighted the "dividend trap" — buying a share in expectation of sustainable future dividends when the organisation's future will not allow it. That may already have manifested for some, as many organisations cancelled their previously announced dividends as Covid-19 impacts multiplied quickly this year.
Air New Zealand's recent announcement that it has suspended its dividend in light of losses caused by Covid-19 reflects the company's need to preserve cash and to adjust investor expectations on the scale of future dividends. Z Energy, in its latest set of full-year results announced in May, also announced suspension of its dividend until at least September 2021 for similar reasons.
In both cases this is a sensible and prudent action for the companies to take, increasing the likelihood that they will survive the current challenge presented by Covid-19.
For investors, they highlight the need to research the strategic outlook and risks associated with sectors and organisations rather than solely focusing on numbers. Risks that turn to reality, and their associated impacts, care little for whether a company has a dividend to maintain.
Both companies were trading on a high dividend yield for investors pre-Covid-19: on January 31, Air New Zealand's share price was at $2.82 with a dividend of $0.22 paid in the previous year (7.8 per cent yield), while Z's was $4.45 (dividend of $0.47 at a 10.6 per cent yield).
How things have changed.
The trouble with calculating dividend yield is that it relies heavily on history, and that isn't a great place to start right now.
History tells us that, as of January 31 this year (a mostly pre-Covid world), around 25 listed entities on the NZX had a dividend yield of more than 5 per cent. These included a number of lesser-known investments — take a look at the names in the "top 10" table alongside.
Digging a bit deeper, the same ranking showed most of the "Gentailer" group of companies (Meridian, Genesis, Trustpower and Contact) at a yield above 4 per cent, with Mercury returning a creditable 3 per cent.
These are often regarded by dividend-hungry investors as closer to "bonds" in nature, thanks to their stable share prices and regular dividend cashflows.
Arvida and Oceania (retirement) were also over 3 per cent, and Spark (telecommunications) was returning a historic yield of 5.4 per cent.
There's no doubt that things have changed significantly. At January 31, Air New Zealand, Sky TV, Z Energy and Tourism Holdings all featured in the "top 10". All except Sky have suspended or cancelled their dividends (we'll find out about Sky as they announce their results this coming week).
For other organisations, their dividend outlook appears more stable. That may not mean that dividends are maintained at their current levels — those organisations may want to preserve cash to secure their own liquidity in the current climate.
Back to those interest rates. Let's say that NZ government bonds represent a "risk-free" investment (ie, the government can always pay its debts). It stands to reason that higher risk investments (like equities) carry expectations of a higher return for investors.
In theory, as the "risk-free" interest rate reduces, as we have seen over the past few months, that allows companies to reduce their dividends to shareholders while still meeting expectations.
For a company focused on growth, that may provide an opportunity.
Infrastructure investor Infratil raised $300m in June this year with the stated purpose of funding "growth investments across Infratil's existing portfolio of companies and taking advantage of new opportunities that may arise as a result of current market conditions".
More recently, it has announced plans to buy back up to 2.7 per cent of its own shares — a way of increasing capital returns for its shareholders. Infratil has a strong track record of dividend payments at a relatively high dividend yield.
As a hypothetical example, were Infratil to reduce dividends for investors by 2c per share (from a current 17.25c), that would provide an extra $14m to support its future growth aspirations — as well as reflecting the current lack of high-yield return alternatives available to investors.
On the other hand, maintaining a dividend would be likely to see a further increase in its share price, as interest rates continue to decline.
What does it mean for investors?
If dividend cashflow is important for you, it's always important to look at the underlying business of the company to assess the future sustainability of its dividends.
At a more systemic level, the relationship between high-yielding dividend companies and their share prices is likely to be brought into sharp focus, with a rise in share prices reducing underlying yields. That's great if you're an existing investor; less so if you're looking to buy into a specific share.
Of course, if all of this sounds too hard, then the NZX offers a convenient "NZ Dividend" exchange-traded fund (ticker: DIV) that allows investors to maximise their cash dividend returns from NZX-listed entities.
Investors also have other options to maximise cash returns, such as the listed bonds issued by companies and traded on the NZX. That's a whole other column, but if stable cashflow is your primary objective, then a position in bonds may support this more effectively in the current climate.
- Oliver Mander is not an authorised financial adviser (AFA), and nothing in this column should be construed as financial advice. Seek out the advice of an AFA to support your investment decision-making.
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