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Most investors are wrong on dividend yield as income

Market commentators and investors regularly use the wrong metric and distort the investment dialogue on yield and income. Let me start this by reminding everyone of my preferred definition of investing: ‘the use of money to produce a regular income'. Contrast this with the definition of speculation: ‘buying and selling in an attempt to benefit from a fluctuation in the price’.

In general, the profit of a company is split broadly in two:

  1. retained earnings for R&D, new technology etc and
  2. the balance, or payout ratio, as a dividend.

In mature, quality companies, earnings drive dividends and it is dividend growth, reflecting growing earnings, that ultimately drives share price performance.

In an article in The Sydney Morning Herald by Elizabeth Knight, she writes on CSL:

“This is an old-fashioned growth stock - one that lifts profit every year - and ploughs much of it back into research and development and boosts its capital expenditure. It traditionally spends about 10 per cent of revenue on R&D and is currently working on, among other things, a $US550 million ($810 million) clinical trial to prevent secondary heart attacks. Investors have given CSL the mandate to invest rather than reward them with hefty dividends ... The factor that sets CSL apart from its peers among the largest five Australian companies - BHP, the Commonwealth Bank, Rio Tinto and Westpac - is that investors are not buying into it to chase dividend yield ... based on Wednesday’s share price of $233, the yield is a relatively paltry 1.15 per cent.”

On these quality growth stocks, the yield never looks attractive

As an investor, I never chase current yield. It is income over time I am looking for. Yield is an abstract obtained by dividing two dollar values, the most recent dividend and the current share price. Thus, this abstract is hostage to movements in either one or both of these numbers.

CSL, like a number of other successful companies such as Cochlear and Credit Corp for example, are low yielding for the simple reason that as the profits and dividends grow, the share price goes up. Because of the phenomenal growth in share price (a result of the phenomenal growth in profits) when you divide the dividend into a rising share price, the yield never looks attractive.

Added to this, the success and strong dividends associated with these three companies ensures that the price is at a premium which naturally puts downward pressure on the abstract yield. However, unlike the journalist, you should never assume that the low yield is an indication of low dividends and therefore low income.

The three shares mentioned, despite their low yields, have produced an extraordinary income stream.

Credit Corp (ASX:CCP) is my favourite example. Since 2000 we have invested a total of $137,000. Our CCP shareholding is now worth $1.8 million. It sits on a paltry yield of 2%. Why so low? Because the share price has risen at the same stratospheric rate as the dividend. The good news for us is a current ‘yield’, as I judge it, the last dividend divided by amount invested, is 33%. If that isn’t enough, total dividends paid since 2000 now stand at $290,000, a return of more than 200% (not adjusted for inflation) on our capital in income alone.

The same applies for CSL. The following Chart 1 shows the extraordinary growth in both share price and dividends that CSL has bestowed upon its shareholders since 1994.

Ignore the spot yield quoted by many

Consider the listed property trust sector, now commonly called A-REITs (Australian Real Estate Investment Trusts). Chart 2 below compares the income from listed property trusts (S&P/ASX200 Property Index) to the dividends from industrial shares (S&P/ASX200 Industrials Index) since 1979. Clearly the shares produce a far superior income over this long term. This is why I have often written about the long-term merits of industrial companies for income versus nearly every other asset class.

Now consider Chart 3 below plotting the yield of these two sectors over the same period. There can be no doubt that property is a far superior investment for those seeking yield. Ever since I returned to Australia in 1988, I have had people, particularly retirees, telling me that property was a far better income investment than industrial shares because of its superior yield.

The reason the yield on property trusts is high is quite simple. As a result of their structure, they must distribute 100% of their income. Therefore, the vertical income bars (pink in Chart 2 above) represents a 100% payout ratio.

In contrast, the vertical yellow bars represent around 50% of the profits generated by industry. The corporate structure enables companies to retain profits without penalty for research and development, new technology etc.

Think of current yield as an abstract

The trap is baited by the fact that the yield is an abstract numeric (income divided by index value). If dividends remain stable and the share price falls, yields will rise. Conversely, if share prices rise, yields will fall. In Chart 2, the high yield of property is simply a function of the fact that the capital value line is well below the top of the dividend bars. Similarly, the industrials are low yielding because the value line is much closer to the top of the dividend bars.

Now, try and imagine the yield on shares if all companies, like listed property trusts, retained no earnings and paid out 100% of profits every year. If this happened, fewer people would buy property trusts for income rather than industrial shares.

Sadly, time and time again the yield word is used to describe income whilst the reality is that the link between the two is uselessly abstract. Experience has taught me that chasing the highest initial yield will almost certainly result in a worse income over the long term. Oh, and by the way, shares are not growth assets, they are income dynamos.

 

Peter Thornhill is a financial commentator, author, public speaker and Principal of Motivated Money. This article is general in nature and does not constitute or convey specific or professional advice. Share markets can be volatile in the short term and investors holding a portfolio of shares will need to tolerate short-term losses and focus on a long-term horizon, and consider financial advice.

 

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18 Comments

Steve K

September 18, 2019

I'm planning to retire in about 6 months and remain grateful I managed to watch one of Peters presentations about 5 years ago. I have maybe too slowly switched my share portfolio from mainly individual stocks to ETF's and LIC's. I have few reasons. Firstly I have accepted I won't beat the market, silly not to have known better! Another light-bulb moment was an appreciation of skewness, that the vast bulk of stock index returns came from a small percentage of companies, and it is a fact that the vast majority of us, professional investors included, don't know what the next winner will be. But if you own a broad index, you will have at least some exposure. This seems to be the main reason managed funds struggle to beat the index - its very hard to know what the next Netflix will be (this is I think a possible weakness in the older, larger more conservatively invested LIC's, do they risk missing some of the growth of newer businesses - after all the whole principal is based on companies reinvesting profits to grow). Second the newer ETF's allow the concentration risk which is extreme in the Aussie market to be mitigated (eg EX20 which only holds the bottom 180 stocks in the ASX200, or MVW which equal weights the top 100). Lastly and I think important is the psychology aspect. For some reason it is very hard to sell individual 'winners' but I have way less emotional attachment to an index/LIC/ETF.
But at the end of it all if you are fortunate enough to be able to provide a decent income from your investments, which grow above inflation and not have to cash-in in the bad times, isn't that the ultimate aim. One way I like to think of longer term buy and hold LIC's/ETF's and not get obsessed with capital values is to think of each of them as a kind of annuity - I buy it and it provides an income stream. Just a much better one than a real annuity. Thanks again Peter.

Kevin

September 13, 2019

Many different replies,it's all down to luck,10 years is long term etc.

I found that compounding is the key,it happens over decades,not short term 10 years.

Survival,I bought CBA at $6, everybody else chose not to do that,everybody else is 99% of people.
I chose to reinvest all the dividends for decades,nothing to do with luck .I expected CBA to still be here now,I expect them to be there in 30 years time.Time will prove if I am right or wrong .
On Monday people will be able to buy 1000 shares in CBA and compound it for 30 years .They will have 30 years to pay back a loan of $82K.They will go through booms,busts and crashes.Anytime at all they can sell them if the pressure is too great,or the noise from the crowd or the experts begins to attract their attention.

If you want to be a millionaire in 30 years time,spend$100 K on Monday.Start to learn how to work out what it will grow to at a given rate,for a given period of time.

30 years from today they will have their super.They will around 5-6000 shares in CBA or whatever company they choose.If CBA grows slowly and is worth $300 a share in 30 years time then you will have between $1.5 and$1.8 million.30 years of super @ say 10% will be a contribution of 3 years wages.If things go well after all the fees and charges over 30 years,your may retire with 4 years wages in 2049 money.

To me it depends on how you think and what you want to see .Eventually it will be down to what you do for yourself,not luck,or following the crowd,or asking everybody else what they think you should do

On Monday when 99.9% of people choose not to buy shares in CBA,it is not down to bad luck.

Just my 2 cents worth.

J.D.

September 12, 2019

You are correct that spot yield means nothing, but you are taking a truth and then leading it to a conjecture.

You mention that returns of AREITs are legally required to payout their earnings and not retain it, but there is nothing stopping an investor from re-investing it to grow their own asset base.

Some AREITs may have done poorly, but for REITs outside of Australia that is not the case, and yes they are also required to have a similarly high payout ratio.

So yes, you are right that spot yield means nothing, but your conjecture that REITs are relatively poor due to the fact that they have a high payout ratio is demonstrably false.

https://www.marketwatch.com/story/spoiler-alert-reits-have-outperformed-stocks-for-the-past-50-years-2018-11-01

Peter Thornhill

September 13, 2019

Depends on the benchmark J.D.
Reading an article post the GFC, the journalist stated that AREITS had outperformed the All Ords for 4 of the previous 5 years. Two things were not mentioned. AREITS got slaughtered in the GFC and the recovery was from an very low base. Concurrently, the All Ords was being held back by the collapse of the mining boom. A rough estimate shows the AREITS recovering by approx 70% whilst the All Ords recovered by only 35% over that 5 year period. The industrials index recovered by almost 80% without the resources drag. If, however, I am wrong and real estate is the best investment I'm damned if I know why people are stupid enough to start a business.

J.D.

September 14, 2019

Yes past 5 years is just noise. Good point.

Unfortunately so is the last 10-12 years, which by your same logic invalidates your own point of cantering on the GFC.
The benchmark I linked to above is the S&P500 vs REITs (global, not Australian), have out performed over 50 years. This included the GFC and plenty of other bear and bull markets.

You are again taking a short and insignificant time frame which is essentially noise to show mining has done poorly. Check the performance of the mining sector over the very long term (page 6 of the link below) and you will see that it is very much in-line with industrials.

https://www.rba.gov.au/publications/rdp/2019/2019-04.html

As for why people would invest in business if real estate was so good, you similarly can ask why anyone would invest in banks if IT is so good or vice versa. By your line of thinking, everyone should invest in exactly one type of business. No more healthcare, property, mining, banking, infrastructure, or anything that isn't IT. Feel free to substitute IT for whatever business you believe is the one that will out perform based on whatever time period you select, and then go ahead and say you're damned if you know why anyone would invest in any of the others.

Rad

September 12, 2019

The clarity that Peter brings to this subject is unrivalled in its insight and understanding. I highly recommend his book ‘Motivated Money’ to get a more detailed grasp on Peter’s thoughts.

AlanB

September 12, 2019

Dividend sustainability is my criteria for share selection, as measured by.
1. The percentage growth of dividends over 10 years. Must be >200% since 2009.
2. Volatility - avoid companies with fluctuating dividends.
3. Earnings per share / Dividend per share must be >1.3. DPS in excess of EPS eg through debt, is unsustainable in the long term.
4. Share price growth over 10 years. There is no point buying any shares if the price is in long term decline reducing capital value and distorting yields. As a long term investor I ignore short term price volatility.
As Peter says, the real measure of 'yield' is "the last dividend divided by amount invested" So a 3% yield on purchase should become a 33% yield after many years of rising dividends.

David Smith

September 12, 2019

Excellent article Peter.Good to see a sensible long term approach to investing.

AlanB

September 12, 2019

Dividend sustainability is my criteria for share selection, as measured by.
1. The percentage growth of dividends over 10 years. Must be >200% since 2009.
2. Volatility - avoid companies with fluctuating dividends.
3. Earnings per share / Dividend per share must be >1.3. DPS in excess of EPS eg through debt, is unsustainable in the long term.
4. Share price growth over 10 years. There is no point buying any shares if the price is in long term decline reducing capital value and distorting yields. As a long term investor I ignore short term price volatility.
As Peter says, the real measure of 'yield' is "the last dividend divided by amount invested" So a 3% yield on purchase should become a 33% yield after many years of rising dividends.

Tony Dillon

September 12, 2019

Current dividend yields are certainly relevant. Not all investors target growth, many such as retirees target income.

Suppose an investor requires $10,000 in dividend income before franking. On current dividend yields of 5.71% and 1.15% for CBA and CSL respectively, that would require $175k invested in CBA, compared to $870k in CSL. Needing to outlay five times more on the lower yielding stock to achieve the same level of income, which company do we think the income seeking investor would target?

And yes, stability in dividend yield is important, and there are a number of blue chips like CBA that fit that criterion. And low dividend yielding stocks like CSL are no less immune to volatility than higher yielding ones. With CSL's 52 week low at 74% of its current price, compared to the CBA equivalent of 77%.

CBA would appear to be your classic "income dynamo".

Peter Thornhill

September 13, 2019

Fair comment Tony. I've come across this problem many times over the last 50 years; people who retire too early with too little and then expect miracles. Today's pleasure beckons more strongly than tomorrows pain. As Kevin hints at above, start early.

Jeremy

September 16, 2019

Is there a good rule of thumb for how much capital you need to retire with to ensure an inflation proof retirement income? I.e. a multiple of the retirement income you desire? There is a lot of variance between online calculators.

Carlos

September 12, 2019

"shares are not growth assets" ? Strange comment, of course they are.

Colin

September 12, 2019

I agree with Carlos. It depends on some luck and at what stage of the company's life you happen to invest - like CSL and CBA when they were at $14

Neville Ward

September 12, 2019

Peter's article makes complete logical sense particularly when using a small sample of growth stocks. Long ago I constructed a correlation (based on a large sample of randomly selected stocks) between dividend yields (including franking credits) and future total returns (dividends including franking credits plus capital gains) discounted for time. All after an assumed tax rate. It, perhaps surprisingly, favoured the high yielders. I wonder what it would show now?

Mart

September 12, 2019

I'd distill Peter's article as saying that if you want regular / growing 'income over time' then simply focus on growing companies ('earnings drive dividends and it is dividend growth, reflecting growing earnings, that ultimately drives share price performance'). Rather than property, gold or whatever that don't have both (potential) capital and earnings growth (and the virtuous circle of both interlinked). I guess the easiest way to do this is invest / reinvest in quality LICs (but these can provide lower dividend payouts than individual shares if you pick / choose correctly?). I'm trying to convince my kids that if they follow this path from start of working life then they won't go far wrong (notwithstanding stuff like mortgages, kids, and other life events get in the way !). Given the way work is fragmenting for the next generation their focus on financial wellness will be critical and Peter's article highlights a sound, steady as she goes, way to get ahead I think

Peter Thornhill

September 12, 2019

Thanks Mart. We have encouraged our children, now adults, to use LIC's as we want them to focus on all the issues that are important to them; career, family, and dealing with the devastating legacy our generation will dump on them.
I agree, individual shares may provide a better return than a boring old LIC but I don't want our children to become slaves to money. Money must be their slave. The great thing about the older LIC's are the regular opportunities to top up holdings at no cost via share purchase plans and rights issues. It has been a great training. There is no debate about "is it the right time". Having started them early, they have just done it and amassed useful holdings that, in the case of the eldest son, have enabled him to wipe out a mortgage in 10 years.

Don Macca

September 12, 2019

Hi Peter
Your general point that one should concentrate on growth stocks is well said & backed by solid research.
But i have some doubts about Lic's.If you stick to one's indexed to major indexes or ones composed of substantial companies. Lic's where they dominate some of the market segments (IE US equities) may
have difficulties in a major market downturn.


 

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