The search for sustainable yield

Written by Head of Public Markets Todd Hoare

Selecting investments based on yield alone is an all too familiar investment strategy—and, in our view, a common mistake. Instead, we believe that owning companies that can sustainably compound earnings, and pay out those earnings, will ultimately yield better results. 

In its outlook for 2023, Keep It Simple, KKR commented on the pitfalls of investing for income based on yield alone, underscoring our own views around income and yield: 

“We have been advocating owning rising earnings and rising dividend stories over different periods over the last twenty years. Now is one of those periods, we believe. To be clear, we don’t favour just high dividend yields. Rather, we favour companies with rising free cash flow that allows them to consistently increase their dividends and earnings per share.” 

In this article, we examine the pitfalls of focusing solely on dividend income, and why this approach can lead to an investor missing out on the benefits of compounding earnings growth. We explain that companies that can grow their earnings will also likely grow their dividends and, over time, should also see their share price increase.

 The fallacy of yield

There are numerous examples in Australia, which demonstrate how an investor who focuses solely on dividend yield can miss the benefits of compounding earnings growth. In the following example, we analyse Telstra Group Ltd (TLS) and REA Group Limited (REA), which have the same sector classification. As the chart below shows, over the past 10 years, TLS has always commanded a yield premium to REA. So, an investor looking at dividend yield alone would likely opt to buy shares in TLS rather than REA, picking up, on average, an additional 400 basis points of yield over the period. However, this approach misses the impact of compounding earnings growth and the ability to pay out those earnings as dividends, which is something that REA has historically done much better than TLS.

The impact of compounding earnings growth

Over the past 10 years, TLS has delivered $2.37 in dividends versus REA, which has generated $9.73 (more than four times the income that TLS has generated). So, for an investor who bought $100 worth of REA shares 10 years ago, their cumulative income return would be approximately $71. By comparison, if an investor had purchased $100 of TLS shares 10 years ago, they would have generated around $64 in income. And this is before we factor in the capital appreciation that REA has delivered versus TLS over the same period.  

Put another way, the yield on the original REA investment 10 years ago is approximately 12% today. By comparison, the yield on the original TLS investment is still 4.5% (remember the starting yield at the beginning of financial year 2013 was 7.5% for TLS and just 3% for REA). And therein lies the key—companies that can grow earnings will likely also grow their dividends and, over time, should also see their share price increase. By comparison, companies that cannot grow earnings will likely have higher payout ratios and higher starting dividends—but because earnings are not growing, or are going backwards, in time that yield differential on the cost base will erode and eventually disappear.

Focusing on earnings first can lead to greater total returns

The benefit of focusing on earnings first, not dividends, really comes into play when looking at capital appreciation. If we take the period from 30 June 2015 until now, TLS still had a higher starting dividend yield (around 3 percentage points more) and generated approximately 25% more income (around $26.70 in dividends for every $100 worth of shares bought at the beginning of financial year 2016 versus around $21.55 for REA). It would appear at first sight that TLS was a better income investment. However, if you owned a rental property, would you be satisfied if it generated more rent than the house next door, but the house next door sold for 50% more than yours? Probably not. 

In the above example, over the 2015-2022 period, a $100 investment in TLS on 30 June 2015 would now be worth around $67. A $100 investment in REA, on the other hand, would have grown to around $318 (i.e., for a small sacrifice in upfront income, investors would have been able to generate significantly greater total returns). This example is not exclusive to TLS and REA, and currently this dynamic also exists with CSL Limited and Macquarie Group Ltd versus companies often considered traditional income stocks. 

In its outlook for 2023, KKR references ‘Dividend Aristocrats’, which are companies with a long-term track record of increasing their dividends. We believe, as KKR does, that investors would be well served to look at these stocks in the search for sustainable yield. Alternatively, an investor could simply purchase an exchange-traded fund (ETF) over those dividend aristocrats. It’s worth noting that if a company can consistently grow its dividends over long periods of time, then it is likely that:

• earnings have also grown;
• earnings have grown at a faster pace than dividends;
• the board and management are very good allocators of capital, having experienced numerous business cycles;
• the board and management are somewhat risk averse and conservative in their balance sheet management; and
• the company operates in a market or industry where it has some level of dominance, pricing power and/or predictability (although not necessarily a monopoly).

Where are the investable opportunities?

In Table 1, we have outlined various dividend aristocrat ETFs that are available to invest in. In Table 2, we have extended our analysis to the broader S&P/ASX 200 index, focusing on those companies with a minimum of four consecutive years of at least flat dividends. 11 of these names are represented in the Pan-Asian ETF, which will appeal to investors focused specifically on opportunities in Australia (Computershare is in the ETF but not in the table as it lowered its dividend in financial year 2020.) 

Table 1: Examples of dividend aristocrat ETFs

Source: S&P Global. *Denotes uninterrupted increasing dividends. Some exceptions apply

Table 2: Companies in the S&P/ASX 200 index with growing dividends

Source: Bloomberg, Company Data. *Represents at least a flat year-on-year dividend.

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