Need dividends? Steer clear of cyclicals and cherish cashflow

Even the most dependable dividend-paying companies cancelled or dramatically reduced payouts in FY20 – including Australia’s big four banks.

And the downward dividend trajectory among local blue chips predates COVID-19. National Australia Bank’s (ASX: NAB) dividend peaked at $1.98 in FY14 before being chopped to $1.66 and then $1.13 in subsequent financial years – a 42% dip compounded by share price declines. Meanwhile, Telstra (ASX: TLS) and Woolworths (ASX: WOW) dividends are 48% and 32% lower, respectively, since peaking some five years ago.

But opportunities remain for investors needing reliable dividends, say Australian equity income fund portfolio managers Neil Margolis, Merlon Capital and Michael O’Neill, Investors Mutual. They recently revealed what they look for in yield stocks, which sectors hold the most income appeal, and their top ex-20 ideas for sustainable dividends and capital growth.

Energy infrastructure firm AusNet Services is a holding of the IML fund
Source: Pixabay

How to spot income stocks

When searching for reliable income stocks, both fundies reckon investors should pay attention to the following characteristics of a company:

• The sustainability of its cash flow
• Its long-term dividend track record
• Whether the core business is prone to oversupply issues

Identifying businesses whose cashflows are “under-appreciated by an overly pessimistic market” is the best approach, says Merlon’s Margolis. “Because sustainable dividends, by definition, can only be paid out of sustainable cash flow.”

The Merlon Australian Share Income Fund also ideally only invests in companies that have been in business for at least a decade.

O’Neill, who heads up the Investors Mutual Equity Income Fund, looks for companies that have strong franchises, healthy balance sheets and reliable cashflow.

“We steer clear of cyclicals and towards defensives sectors including packaging, utilities, consumer staples and healthcare,” he says. Also, on his team’s blacklist are sectors suffering from “overcapacity” – office real estate investment trusts a prominent recent example.

When to steer clear

Major banks and iron ore mining companies aren’t great sources of sustainable dividends into the future because they’re too sensitive to macroeconomic trends, says Margolis. This makes their dividends volatile, which is why the Merlon fund tends to avoid many of the largest locally listed companies.

O’Neill echoes this view, calling out the “very big structural impediments to bank dividends through falling rates, falling fees, rising remediation costs and rising capital requirements.” But he’s less dismissive of the bluest of the blue chips than Margolis, suggesting there has been an element of conservatism in the actions of many ASX company boards.

“We do see a lot of potential for recovery in the dividends of non-bank industrial stocks,” O’Neill says.

Don’t dig here for dividends

Both fundies agree investors have become accustomed to bigger dividends from the mining majors in recent years. As the iron ore price has stayed at all-time highs, miners of the steel precursor have been the biggest Australian dividend players – but expecting this to continue is risky.

“These are better companies than they were in the past because they’ve raised their capital, improved their balance sheets, and increased their dividends,” O’Neill says.

“But at the same time, if you’re investing for income, you’ve got to think about the volatility of your capital base.”

The global iron ore supply-demand imbalance, largely driven by the world’s biggest producer Vale’s Brazilian tailing dam collapse and subsequent shutdown, will eventually correct. “We see those dividends as vulnerable…and don’t need to take that level of volatility,” O’Neill says.

Merlon’s Margolis also highlights a further level of concentration risk among Australian large-cap mining companies. “The diversified miners, BHP and Rio Tinto, they’re actually not that diversified but are predominantly iron ore players,” he says.

In line with this view, they both recently called out iron ore miner Fortescue Metals Group (ASX: FMG) as a sell.

O’Neill concedes it’s a better company than it was five years ago, but says its share price is too vulnerable to the looming supply-demand correction. And Margolis believes there’s around 80% downside if iron ore price reverts to long-term levels. “Notwithstanding the short-term dividend, it’s not sustainable and we don’t own it”.

Appeal of the oil patch

There are parts of the resources sector Merlon finds appealing – including miners of aluminium and copper. “Outside of iron ore, we actually hold more investments in mining stocks than we’ve ever held,” says Margolis.

He has also increased exposure to oil stocks, as part of the COVID recovery thematic in which oil and gas are tipped to play a big role in restarting global economic growth. Whereas iron ore prices remain unsustainably high, the opposite is true for crude prices.

“Oil has obviously been quite heavily impacted by demand from COVID…the Australian oil producers are quite low cost, the American producers are quite high cost,” Margolis says.

“We think there’s going to be upside risk to oil as demand recovers, and because there’ll be some underinvestment.”

Merlon’s positions in Woodside Petroleum (ASX: WPL), Origin Energy (ASX: ORG) and more recently, Oil Search (ASX: OSH), reflect the team’s expectation that global oil markets will tighten over the medium term.

Top picks for income

When each naming a favourite ex-ASX 20 dividend-paying company of their respective funds, the selections of O’Neill and Margolis are wildly different.

O’Neill believes energy infrastructure company AusNet Services (ASX:AST) – which owns three regulated electricity and gas networks – has all the right attributes to deliver sustainable dividends.

“It’s got a yield of about 5.5%, is 50% franked and it’s growing at between 2% and 3% a year,” he says.

As a provider of essential energy infrastructure, AusNet’s returns are guaranteed on five-year windows as set by the energy regulator.

“They don’t take much in the way of credit risk and they also have some growth in their transmission asset base, as we see incremental new renewable providers attached to the grid,” says O’Neill.

Margolis selects financial advice, superannuation and investment management firm IOOF, “something maybe a little more controversial.” The diversified financial services firm was lashed during the banking royal commission and by industry watchdog the Australian Prudential Regulation Authority in 2018.

“But having just bought MLC from NAB for a pretty big price, the market value of the company is actually lower than it was before that transaction, which roughly doubled the earnings,” he says.

Having paid a dividend of 45 cents a share in fiscal 2019, Margolis believes IOOF could return to this level inside three years – potentially delivering a yield of between 15% and 20% when franking credits are included.

“It’s certainly unpopular…but you get a really good dividend and some good capital growth out of it.”

Some other companies the pair discussed in another recent Livewire interview include:

Telstra (ASX: TLS)

For Margolis, it’s a sell because of the company’s huge mountain to climb in addressing the NBN challenge: “it’s going to be hard to make money on that.”

But O’Neill views the telco as a buy, largely due to its leadership in the new 5G mobile network standard underpinning “some return to improvement in market share and margins”.

Medibank Private (ASX: MPL)

The health insurer is a hold for O’Neill, given the onset of recession and anticipated falls in membership.

Conversely, Margolis views Medibank as a buy on an expectation that health insurance is “here to stay” – but another name he prefers within the category is NIB Holdings (ASX: NHF).

AMP (ASX: AMP)

The embattled financial services firm is a buy and hold respectivey for Margolis and O’Neill.

“My beard wasn’t grey before we invested in it, so that tells you a little bit about it, but I do think it’s very cheap,” Margolis says.

“It’s been badly run, but there are some signs of improvement and renewal at the board, which I think would be a welcome change for long-suffering investors.”

Though O’Neill rates AMP as a hold, he agrees it is “starting to look interesting.” But he remains unconvinced on the back of its sale of AMP Life and the risk of further spinoffs, which can be costly and messy.