In Australia, investors and companies have become twisted in a little knot around dividends that needs to be undone. Dividends in Australia are just too high. I know no one wants to hear that but it has to be said and it needs to be discussed. More importantly, if our companies are going to remain competitive on the global stage it needs to be addressed because times have changed. The way businesses grow has changed and unless we review some of the practices that have evolved, our company’s risk being left behind their global competitors.
Over the last 30 years investors, especially self-funded retirees and SMSF investors, learned the benefits of having a portfolio of stocks paying generous fully franked dividends. It started in the 1990s as the level of share ownership in Australia started to explode. The old adage at the time relating to banks stocks was why invest money on term deposit at say 5% (remember those days!) when you could buy the same banks shares and get 6% fully franked dividends and participate in the growth in shares too. Made sense.
From there people started to understand that a diversified portfolio of blue-chip companies paying fully franked dividends was a great way to generate a retirement income. It wasn’t too difficult to construct a portfolio focused on income that could generate say 5% per annum with some growth too. For someone with say $5m in capital to generate retirement income of say $250,000 pa. It was also cleaner and neater than property, better diversification, without the headaches of tenants. This approach has been very successful and become very much mainstream. It does make sense.
But today, investors in Australia have become too focused on the dividend return instead of the overall return. The rationale is sound, but in this era of continuous innovation, it’s worth reconsidering this strategy and whether it is still as appropriate today. I am not saying company profits or cash flow are not important, in many respects they are more important. I am talking about whether investors and companies, by focusing on higher dividends is causing them to make decisions to their long-term detriment.
In many cases in the past, it has resulted in the dividend payout ratio creeping up over time. This isn’t a great sign, and it has happened more and more over the last 10 years as companies face pressure to continue paying high dividends. But it’s really important to understand that a dividend yield of 3% from a company that pays out 50% of its profits is not worse than a 4% dividend yield from a companying paying out 100% of its profits. In fact, it’s probably a better managed company. This is often overlooked by investors.
In this new era of continuous innovation, it is more important than ever for companies to reinvent themselves. That means reinvesting in their business to lead the next phase of change. ‘Blue chip’ companies in mature or maturing businesses need to recognise this and prioritise reinvesting profits back into the business to innovate or they are going to be disrupted by those who do.
That means not paying out dividends or at least paying out much less in dividends. But because these dividends are the foundations of retirement incomes, a large part of the investment market is dependent on them. The companies that pay the dividends know this. Major companies face significant backlash from self-funded retirees and large superfunds if they were to reduce their dividends.
The irony is that the shareholders will complain about companies adopting this strategy because they receive lower income, but its ultimately for the long-term benefit of those exact shareholders. The reality is that in a business environment changing at the pace that it is, paying out dividends that are too high simply doesn’t leave enough in the company to reinvest in its future. So, while in the past high dividends were a sign of good profit and stability it is increasingly becoming a sign of underinvestment and future challenges ahead.
The most innovative companies in the world are in the US and they do not pay high dividends. The average dividend of the USA Dow Jones industrial average (30 stocks) is 2.4% and for the S&P500 is 2.0% and for the NASDAQ is 1.0%. In Australia, the ASX200 payout collectively dividends that equate to well over 4% grossed up for franking credits. Though this number is somewhat skewed by higher than usual dividends from big miners, the point still stands.
If this philosophy doesn’t change soon then Australia’s leading companies, beloved by investors for their high fully franked dividends, will soon fall behind their global counterparts. As our market and investors in Australia become more sophisticated it will be important that we focus more on total returns over the long term.
This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you. Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.