Five questions for dividend-hungry investors

As interest rates head lower the desperate search for income heats up, but
beware: not all yield is created equal. Ilustration: Sam Bennett
Patrick Commins
Hungry for yield? Well, have we got a veritable feast for you. Forget Telstra Corp
on a piddling grossed-up dividend yield of 6.5 per cent, or that midget
Commonwealth Bank of Australia on a gross yield of 6.3 per cent.
The serious income-hunter should head straight for Fortescue Metals Group on a
yield of 12 per cent, or Woodside Petroleum at 10 per cent, and how about
Monadelphous Group, weighing in at a mighty 20 per cent?
As the Reserve Bank of Australia pushes rates lower investors will be tempted to
move further away from the safest income-producing stocks, where yields are
being pushed lower due to enthusiastic buying, towards more alluring headline
numbers.
If only it were that easy. Unfortunately, not all yield is created equal, and
investors need to do their homework to make sure the dividends they receive

today will still be there tomorrow.

"The two main issues yield investors should focus on are the level of debt within a
business and the sustainability of its cash flow to pay the dividends," explains
Neil Margolis, lead portfolio manager for the Merlon Australian Share Income
Fund.
The key word is sustainability. So here are the five questions yield-hungry
investors should ask themselves before buying that stock.

1. Will the company be making more revenue in three to five years'

time?
There are levers that a company can pull increasing the proportion of their
profits they pay out to shareholders or cutting costs, for example but long-term
investors should be focusing on finding businesses that have solid growth
prospects.
Of course, nobody knows what the future holds, but some businesses clearly have
worse prospects than others, and that will often be reflected in their share price
and, by association, their yields.
Take the aforementioned Monadelphous. It continues to struggle in an

environment where its customers mining companies are slashing their

spending. The company made $2.6 billion in revenue in the 2012-13, but that
figure had dropped to $2.3 billion a year later and is expected to be a touch over
$2 billion this financial year and $1.9 billion in the next, on Bloomberg data.
The firm will cut its dividend to 52 a share when it reports next week, once again
on Bloomberg estimates, down from the previous payout of 63 a share.
That's not to say that Monadelphous stock isn't good value now at a gross yield of
20 per cent it may be. But by buying it you have moved from being an income
investor to a value or even a contrarian one.
2. Is the dividend backed by good cash flow?
This is related to the first question, but reflects the fact that sustainable dividends
ultimately depend on how much cash the company generates. Investors should
check to see how cash earnings compare to accounting earnings.
A typical company can maintain a level of 70 per cent cash earnings to
accounting earnings ratio. Capital-light businesses such as the listed fund
managers Henderson Group or Magellan Financial Group, or digital services
providers such as ASX Ltd or SEEK, can have cash earnings closer to 90 per cent
of accounting earnings.
Those which need to reinvest heavily in their businesses to grow airlines being
the classic example will typically have a lower ratio. Miners and oil and gas
producers are also capital-intensive; they typically need to invest heavily in
exploration and development to replace depleting resource bases.
Which brings us to Woodside Petroleum. With limited growth opportunities, the
oil producer has slashed capital expenditure and, with cash to spare, chosen to
return money to shareholders. But at what point does it need to start investing in
growth? The jury is out, which is why investors need to demand a higher yield to
compensate for the higher-risk outlook.
3. Are the company's debt levels reasonable?

So you have solid top-line growth, and reliable cash flow generation. What could
go wrong? The two risks are operational and financial, and in the case of the
latter, a heavily indebted company is generally more risky than one which is less
encumbered by obligations.
Some businesses operate in inherently risky industries, and once again you need
to be compensated for that risk to future earnings.
On the other hand, companies operating in industries with limited competition
and large barriers to entry for example, the supermarket duopoly and the big
banks provide more safety and can justify paying lower yields.
4. What's the level of franking?
A fully franked dividend is more valuable than a partially franked one, obviously.
But aside from the tax benefit for shareholders, franking also tells you something
useful that the company has actually generated taxable profits. If a business
earns money in Australia but is paying only a partially franked dividend, it's
worth asking why.
The cautionary tales in this regard can be found in the listed property trust sector
in the go-go days before the global financial crisis. Back then, domestically
focused real estate investment trusts were borrowing money to pay their
shareholders unfranked dividends, only to blow up when their overly geared
balance sheets ran into the GFC.
5. Finally, a rule of thumb is the dividend yield more than 10 per
cent?
The traditional wisdom among professional investors is that a yield above that
(arbitrary, it must be said) threshold suggests a dividend that is under threat.
As for Merlon's Margolis, he's happy to plump for a yield of 5 per cent from a
company with a solid earnings outlook. For the record, he likes Tabcorp
Holdings, ASX Ltd, AMP, Aurizon Holdings and the supermarkets. And, yes, he
likes CBA.