Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 176

High yields may ignore fundamental weakness

There’s a misperception that equity income investing is as easy as ranking the market’s highest-yielding stocks and building a portfolio from that basis. While on the surface stocks that yield in excess of 7% might look attractive, it may be a complete illusion if one looks closely at the market’s fundamentals. It is what we refer to as an 'income trap' or an 'income illusion'.

There are countless examples of ASX100 companies that trade on attractive dividend yields. Often investors support these stocks based on yield alone, compounded further by passive 'equity income' ETFs.

In investing parlance, a 'value trap' refers to a stock that looks cheap on the surface, but the trap springs into action when the fundamentals continue to deteriorate and investors lose patience and sell out.

Watch for the 'income trap'

We call it an 'income trap' when a stock may look attractive from the headline dividend yield alone, yet is unsupported by robust company fundamentals. As a bottom-up value manager, fundamentals are crucial to us, be it the quality and transparency of the earnings, cash flow generation, gearing levels or balance sheet strength. When the fundamentals are weak or challenged for a prolonged period, more often than not a dividend cut is inevitable, springing the 'income trap'.

Additionally, while passive ETFs can play a role in equity investing, investors should be cautious when investing from a headline yield perspective. A look at 50 of the most widely-held names on the ASX ranked for yield in the table below shows the vast majority of companies yield over the ASX300 headline yield, which currently stands at approximately 4.5%. While attractive on the surface, this does not justify constructing an income-generating portfolio around these seemingly high-yielding companies.

Companies yielding over the ASX300 headline



Source: Factset, 12 August 2016

Questions to ask when investing for yield alone

Before investing in an equity for income alone, ask:

  • Why is the yield at an elevated level?
  • Has the stock fallen and is this a potential value trap?
  • Is the company’s payout ratio too high?
  • Is the company putting its balance sheet at risk by maintaining the dividend?
  • Do cash flows reconcile with underlying earnings?

The two most important attributes of a retiree’s stock portfolio are high levels of income and lower absolute risk than the overall market. By investing in a portfolio of quality companies, drawdowns are reduced with a higher probability of capital preservation.

Companies ranked by their absolute historical volatility



Source: Factset, June 2016

The left-hand side of the chart represents those companies with meaningfully higher historical volatility on an annualised 10-year basis, symptomatic of the curse of either being value traps or simply too expensive. Beholden to exogenous shocks or wider economic shifts, these companies have shown over the longer term to be much more volatile, given the cyclicality of their business or financial models. While the investment case for a number of these stocks can be made for those in the accumulation phase chasing capital growth, in our view they are simply not suitable for retirees.

Retirees have special needs

So what should we invest in on behalf of retirees? A portfolio of companies with recurring earnings that provide a healthy, consistent dividend trading at reasonable valuations can significantly reduce aggregate volatility.

The table below shows a number of blue chip companies that are well represented in retiree portfolios. When a company cuts its dividend it is a clear signal to the market that its earnings are challenged. The implications for retirees holding these stocks is bad – generated income is falling while the share price is also under duress.


These companies have cut their dividends due in part to a low-growth environment but also because of problems with their business models. Mining-related companies are suffering from low commodity prices and supermarkets and banks are suffering from margin pressure and increased competition. Investors need to pay greater attention to the company’s fundamentals and its earnings sustainability before jumping on board because it appears attractive on a dividend yield basis.

In minimising volatility within your stock portfolio, avoiding both income traps and overvalued stocks is paramount. Being aware of what cues to look for in individual companies and understanding trends of underlying fundamentals can assist greatly in picking stocks for your retiree portfolio.

Case study: BHP Billiton (BHP)

In 2015, BHP traded with a perceived healthy dividend yield of 7-8%, seemingly attractive from a retiree’s perspective. However, as commodity prices collapsed through 2015, the company’s fundamentals continued to deteriorate, their earnings fell and gearing levels increased. The unsustainable payout ratio reached almost 400% as the company tried to maintain its promise of increasing dividends over time. It was unsustainable.

In February 2016, the company took the prudent step of cutting their 'progressive dividend' to protect the company’s balance sheet, reduce its gearing and thus preserve its credit rating. The decision was encouraging from a capital management view as it will help BHP stabilise its balance sheet. Yet, from a retiree’s perspective, a cut of this nature can have a significant impact on the dividend income received as an investor.


Source: Factset

Conversely, Spark Infrastructure is an owner of regulated electricity transmission and distribution assets, primarily located in South Australia, Victoria and New South Wales. Like BHP, Spark also had a strong CAPEX programme over the past five years. However, unlike BHP, Spark took the prudent measure of de-gearing its balance sheet, whilst maintaining a low pay-out ratio, in order to assist in funding the company’s growth projects. Ultimately, Spark has a stable earnings profile given it operates as a regulated monopoly. When the CAPEX programme slowed down, Spark decided it was in a position to reward investors by raising the dividend.

Fundamental analysis is paramount when building retiree portfolios. We have always believed that companies that can grow their earnings through their own initiatives, that offer a degree of immunity to the economic cycle, and are backed by robust fundamentals are best suited for retirees.


Anton Tagliaferro is Investment Director at Investors Mutual Limited. This article is for general educational purposes and does not consider the specific circumstances of any individual.

October 17, 2016

I am a self-funded retiree who depends on dividend income to pay the bills. I don't like the idea of selling shares to raise income because that would be selling my income producing capital. Buying shares and hoping their price rises in order to make a profit is just speculation.
So what I look for when choosing a company to invest in is:
1. a decent dividend yield of more than 4% on funds invested. Hopefully this dividend yield will increase each year as dividends increase and as I reinvest surplus income.
2. reliable dividends, as indicated by consistent dividend growth over the past 10 years.
3. sustainable dividends as indicated by a dividend cover ratio of at least 1.3 ie EPS/dividend pa
4. Other factors such as a long term rising share price, P/E ratio, the nature of the company etc to indicate the likelihood of getting my money back.
No check can be failsafe, but so far these criteria have produced more hits than misses. Comments and criticisms on this approach welcome.

Warren Bird
October 10, 2016

I agree with Ashley in one way. Retirees don't need income as such, they need cash flow. The best way to get the cash flow you need is to make regular withdrawals from your portfolio.

These may or may not be simply taking the dividends, rent, interest or distributable income from a managed fund. These will vary over time and may not align with your needs. If they do then that is a terrific, simple automatic way to get the cash flow you need. But you could elect to reinvest all such income payments and instead set up a regular process of selling shares, fund units or whatever.

Many investors would be better off doing this and should ask their adviser to help them set up such processes.

And you don't have to agree with some of Ashley's more extreme opinions to think like this either!

October 07, 2016

It's a myth that retirees should focus on ‘íncome’ – give me Berkshire or Google over Telstra any day. When a company gives back money to shareholders as a ‘dividend’ it is an admission it has run out of ideas about how to invest it for a return greater than the cost of capital. "You can probably use it better than we can!”. A company paying dividends suggests it has a limited future. Good case studies but never keen to see BHP as an income stock.

October 08, 2016

That baffles me,I am a retiree and live off dividends.The GFC taught me I needed more cash so I hold more cash than I am happy with, but it buys peace of mind...

To live you need income.Selling down BRK and google would produce that income.If you are old like me and own 20 Shares in BRK then you do not have a problem.Sell a share every 2-3 yrs.

Was BRK not built on dividends,the dividends from GEICO buy WFC,the divi from WFC buys KOK , which buys JNJ, and so on.

There is a very useful book by S+P called the dividend rich investor,I'm not sure if it is available in Australia as I read it some 25 yrs ago in the US.A list of companies that have paid out dividends for over 100yrs if my memory is correct.How did they have a limited future by paying profits back to the owners?The owners can then reinvest in other shares as Buffett did or use the DRP in the companies.

Closer to home WES was 100 yrs old last year,during the depression it missed paying a divi for around 8 yrs.When does the limited future opinion kick in?

Cashflow is very important,you cannot live without income.Whether it is derived from the sale of shares or dividends does not matter.

To further expand on it 400 shares in CBA using the DRP is now approx worth $135K,for an outlay of $2200 rounded.Take a 40 year short term view on it and see what they are worth in 2032.

The 50 yr view on BRK is approx. US$7 a share in 1965 to (I have not looked) to around US$220K today.Time is money ,Rome wasn't built in a day.

Reality is how many people do you think bought 400 shares in the CBA IPO and did that.The annual report tells you that less than 1% of the population directly own over 1000 shares in CBA.

How many people do you think own BRK?


Leave a Comment:



Market psychology, emotions and ... more emotions


Most viewed in recent weeks

Who's next? Discounts on LICs force managers to pivot

The boards and managers of six high-profile LICs, frustrated by their shares trading at large discounts to asset value, have embarked on radical strategies to fix the problems. Will they work?

Four simple things to do right now

Markets have recovered in the last six months but most investors remain nervous about the economic outlook. Morningstar analysts provide four quick tips on how to navigate this uncertainty.

Welcome to Firstlinks Edition 374

Suddenly, it's the middle of September and we don't hear much about 'snap back' anymore. Now we have 'wind backs' and 'road maps'. Six months ago, I was flying back from Antarctica after two weeks aboard the ill-fated Greg Mortimer cruise ship, and then the world changed. So it's time to take your temperature again. Our survey checks your reaction to recent policies and your COVID-19 responses.

  • 9 September 2020

Reporting season winners and losers in listed property trusts

Many property trust results are better than expected, with the A-REIT sector on a dividend yield of 4.8%. But there's a wide variation by sector and the ability of tenants to pay the rent.

Have stock markets become a giant Ponzi scheme?

A global financial casino has been created where investors ignore realistic valuations in the low growth, high-risk environment. At some point, analysis of fundamental value will be rewarded.

Every SMSF trustee should have an Enduring Power of Attorney

COVID-19 and the events of 2020 show why, more than ever, SMSF trustees need to prepare for the ‘unexpected’ by having an Enduring Power of Attorney in place. A Power of Attorney is not enough.

Latest Updates

Weekly Editorial

Welcome to Firstlinks Edition 376

The US tech index, the NASDAQ, peaked on 2 September 2020 at 12,058 and three weeks later closed at 10,632. On the same days, Apple hit US$137.98 and then fell to US$107.12. These falls of over 10% and 20% seem high but both were simply returning to their early August levels. It's hardly a rout when a month's gains are given back. The bigger issue is whether such stock corrections will scare off the retail 'Robinhood' traders.

  • 24 September 2020
  • 2

Interview on new technologies with more potential to grow

For many global tech companies, COVID has boosted their revenues and pushed share prices to all-time highs. We are on the cusp of amazing technical advances and there are plenty of new opportunities.


Five reasons why Tesla is the everything bubble

As fewer professionals actively research the merits of a company’s prospects, stocks become disproportionately driven by capital flows. Prices disconnect from fundamentals and there's no better example than Tesla.


Three retirement checks for when you have enough

Not every retiree needs to gun for higher returns, but a conservative portfolio can court its own risks, especially with bond rates so low. But some retirees prefer to settle for a lower income.


Hide and seek: the FX impact on global equity investments

As more Australians tilt their investments to global equities, they often overlook the exchange rate risk and fees. The move from US57 cents to US73 cents in six months shows the unhedged impact.


When America sneezes, the world catches a ...

The recovery from COVID-19 is looking more like a K-shape, with some companies doing well while others struggle. The pandemic seems more akin to a black swan, exogenous shock than a structural downturn.


How the age pension helps retirees cope with losses

It's often overlooked how wealthier couples can fall back on the age pension if a market loss hits their portfolio. The reassurance is never greater than in a financial (and now epidemic) crisis.



© 2020 Morningstar, Inc. All rights reserved.

The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use.
Any general advice or class service prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, has been prepared by without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG) for more information. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.