SMSFs and the importance of dividend reinvestment in volatile markets

SMSF advisers need to be careful when considering the right stocks for their clients’ portfolios. Peter van der Westhuyzen takes a look at the benefits of dividend reinvestment and its new level of importance in current market conditions.

Dividend yield comes to the fore when markets are flat. But there are wide discrepancies in the yields returned by stocks in different sectors through different market cycles.

Particularly in volatile equity markets, self-managed super fund (SMSF) advisers have to be vigilant when considering the right stocks for clients’ portfolios.

Importantly, it’s essential to take into account the stocks and sectors that are likely to offer better returns to shareholders for a given set of market conditions.

Current market conditions have also given dividend yield a new level of importance. Flat markets typically result in rising dividend yields, providing investors with the opportunity to generate higher portfolio returns over time.

Here, we look at the historic returns delivered by some of the popular dividend producing shares:

• Over 10 years;
• At the peak of the market; and 
• Before the recent financial crisis. 

We also take a look at the benefits of dividend reinvestment on investment returns over time. The stocks selected for the purposes of this article have been chosen for illustrative purposes only, and are not investment recommendations.

Big four bank stocks 

It’s fair to say that well-diversified Australian share portfolios are likely to have some exposure to the big four bank stocks. Historically, these stocks have paid healthy dividends – something that is very attractive to investors.

Interestingly, average dividend yields of all four bank shares (without franking credits) are producing significantly higher annual income relative to their share price than when the All Ordinaries index peaked on 1 November 2007.

At the height of the market in November 2007, the net average dividend yield for the big four banks was just 4.19 per cent. Although this is still a healthy return, it is 40 per cent lower than the average 7.05 per cent return the banks were delivering shareholders as at January 2012.

This is significant, given that historically (on an average basis) bank stocks have rarely traded at prices that would have delivered an annual income return above six per cent.

For instance, the average dividend yield return delivered by the big four banks since 1 January 1996 is 5.24 per cent. On 1 January 1998 and 2001, this figure was sitting at 5.17 per cent and 5.33 per cent respectively.

However, since the start of the 2008 financial crisis, the average dividend yield of all four big bank stocks has trended well above six per cent and beyond seven per cent, rising to a high of 7.64 per cent in late September last year.

Past performance is no guarantee or a reliable indicator of future performance, and financial markets remain volatile.

Ongoing instability in European capital markets and new capital adequacy laws being introduced as a result of Basel III will further shift the goalposts, changing the playing field and potentially impacting future dividend yields of the major banks.

Nevertheless, Australian banks have been in a much stronger position than many of their global peers since the start of the financial crisis.

While this does not promise ongoing certainty, unlike many global banks, the Australian banks remained profitable throughout the recent financial crisis, allowing them to continue to return profits to shareholders through dividend payments. 

Taking all these factors into consideration, the big banks’ potential to deliver dividend yield remains an important factor for investors to consider at a point in the market’s cycle when capital growth of investments remains flat and income is top-of-mind.

The Telstra story 

Another stock often favoured by investors seeking income is diversified telco Telstra. An analysis of Telstra’s dividend yield paints a picture that is remarkably similar to that of the big banks.

Telstra – telecommunications

Telstra’s dividend yield was 5.94 per cent when the market reached its all-time high on 1 November 2007. And similar to the performance of the big banks’ shares, by January 2012 its dividend yield had jumped 41 per cent to 8.41 per cent.

Telstra’s average dividend yield of 5.53 per cent since 1 January 1998 is slightly higher than the 5.17 per cent averaged by the big four banks during the same period.

Further, the dividend yield offered by Telstra has steadily crept up since then as the Telstra share price has fallen. Telstra’s average dividend yield since 1 January 2001 is a healthy 6.46 per cent, or 1.13 per cent higher than the average of the big four bank stocks over the same period.

What’s interesting to note about Telstra’s yield performance over time is that unlike the big four bank shares (whose dividends hovered between four and six per cent between 1996 and 2007), the trend line shows Australia’s largest telco’s dividend yield has been on an upward trajectory since 2000.

Telstra’s dividend yield reached a peak in November 2010, when it hit 10.94 per cent.

Despite a strong rally in the Telstra share price since then, the stock is still yielding 8.40 per cent. 

There are a number of different factors influencing the telco market that have the potential to impact the performance of Telstra’s shares this year – especially the rollout of the National Broadband Network, high levels of competition in the telecommunications sector, and consolidation among smaller players.

In addition, Australia has an increasing appetite for technology and demand for broadband services (from individuals as well as businesses) – key operating trends that are likely to impact the performance of Telstra’s shares in the short, medium and long-term.

This has the potential to provide a sustainable cashflow that should underpin future dividends. 

When markets are volatile, many investors turn to consumer staple stocks.

The rationale is that when economic conditions are challenging, people still need to buy life’s basic necessities.

With this sentiment in mind, it’s worth looking at the past and present dividend yield of two examples of the major consumer staple stocks: wholesale food business Metcash and food retailer Woolworths.

Although the historical dividend performance of these two stocks has not been as high over time as that of the banks or Telstra (and the same is true at the moment), the current dividend yield of both stocks is still higher now than their historic averages and currently higher than the Reserve Bank of Australia (RBA) cash rate.

Woolworths’ average dividend yield was steadily declining up until the recent financial crisis. Its average dividend yield since 1 January 1998 has been 3.22 per cent. 

By 1 January 2001, this figure was very slightly lower at 3.21 per cent. By the time the market reached its all-time high on 1 November 2007, it was 2.22 per cent.

Woolworths’ dividend yield’s downward trend reversed at the time of the most recent financial crisis and its current dividend yield is 4.76 per cent – a difference of 2.54 percentage points since the market high.

Metcash’s dividend yield has historically been higher than Woolworths, and its yield is also higher than Woolworths’ now. Its average dividend yield since 

1 January 1998 has been 4.14 per cent – mirroring the downward trend Woolworths’ dividend yield followed until the recent financial crisis, Metcash’s average dividend yield since 1 January 2001 is 3.86 per cent.

At the time of the market’s height, its yield net of franking credits was 3.59 per cent – still higher than Woolworths’ yield at the same time.

Like the banks, Telstra and Woolworths, Metcash’s dividend yield since the peak of the market crisis has also increased markedly, jumping to 6.80 per cent as at 1 January 2012. This is a difference of 3.21 percentage points since the height of the market.

Again, past performance should not be considered as an indicator of future performance. However, what can be noted is that there has been potential to generate income yield when shares have exhibited weak capital growth.

The power of compounding

The importance of yield comes to the fore when taking into consideration the positive impact on returns from dividend reinvestment. It is worth exploring a couple of hypothetical case studies to demonstrate how this works.

Bob and Cathy 

Assumptions
Original investment: $100,000
Investment term: 10 years
Average dividend yield: 7% per annum
Average annual growth of dividends: 5%

In this example, Bob and Cathy invested $100,000 in shares 10 years ago. Let’s assume that when they purchased the shares, the average dividend yield earned was seven per cent per annum and the average annual growth of their dividends has been five per cent.

Figures show that after two years, their investment would have been worth $114,865, and the dividends earned as a percentage of their original investment would have been 7.90 per cent.

After five years, these figures would have grown to $145,136 and 11.40 per cent. After 10 years, their investment would have grown to $232,376 – or more than double its original value – and the dividends being earned as a percentage of their original investment would have risen to 22.8 per cent.

This assumes their investment had no capital growth, and also does not take into account the impact of imputation credits, taxation or inflation on the value of the portfolio. 

Jane and Terry

Assumptions
Original investment: $100,000
Investment term: 10 years
Average dividend yield: 5% per annum
Average annual growth of dividends: 5%

Even after assuming a lower average annual dividend yield, the importance of income to investment returns is still evident. Let’s say Jane and Terry also invested $100,000 10 years ago, at a time when the average dividend yield on their investment was earning five per cent.

Assuming their dividends grow at an annual rate of five per cent, after two years their investment would have been worth $110,513 and the dividends they would have earned as a percentage of their original investment would have been 5.5 per cent.

After five years, these figures would have increased to $130,851 and 7.5 per cent, respectively.

After 10 years, these figures would be $183,964 and 13.2 per cent – again, assuming no capital growth and not taking into account franking credits, taxation or inflation.

So what does this mean?

As these figures show, yield is a critical part of the solution for generating returns when share market earnings are weak.

Given the wide disparity between yield levels of stocks and sectors historically, it’s important to investigate the potential for stocks from a range of different industries for delivering high levels of yield for clients’ SMSF portfolios.

Of course, such an investment strategy must also consider a company’s ability to generate dividends, and the risk that dividend returns might fall.

These factors, amongst other things, must be considered prior to making any investment decision. 

With the current market offering high dividend yields in a number of stocks across different sectors, investors now have the opportunity to consider a diversified dividend yield portfolio.

Sometimes, it is the periods of slower capital growth that can be one of the better times to invest for future returns.

Peter van der Westhuyzen is the head of Macquarie Specialist Investments.