I have lost count of the number of investors that have put their hand up during presentations and asked me why I bother talking to them about companies such as Ryman Healthcare and Mainfreight that pay only modest dividends, when there are so many shares offering much higher yields.
The reason is that when it comes to dividends from shares, growth is more important than yield. A share with a modest dividend, but the potential to increase it over time, will often be a better investment than one with a high current dividend yield and low growth prospects. When identifying the best shares to own, chasing those with the highest dividend yield alone is not the best strategy.
The left side of the table ranks the 10 NZX 50 shares that were paying the highest dividends five years ago. With an average dividend yield of 8.9 per cent, this may appear to be a portfolio poised to perform well. However, average earnings growth over the period was very poor from this group of shares at -48.0 per cent and the average return was -15.8 per cent.
On the right side of the table are the 10 companies within the NZX 50 that have performed the best over this period. This group averaged healthy 64.2 per cent returns over the five-year period and recorded earnings growth of 48.1 per cent. Two of the shares from the previous group were part of this group, but the rest were well off the pace. Interestingly, the average dividend yield from this group of top-performers was much lower at 5.4 per cent.
The lesson is not that high dividend-yielding shares are a bad investment - not at all. Dividends provide stability to a portfolio and account for a much greater proportion of returns from shares than many people realise. Over the past decade, the US market has returned 41.4 per cent, but when dividends are excluded, this falls to 16.1 per cent. However, many investors would benefit from giving up some of this income in favour of shares that offer a more modest yield and better growth prospects.
New Zealanders are very focused on generating income from their investments. And when it comes to shares, they are blessed with one of the highest-yielding markets in the world in this regard, with the NZX 50 providing an average dividend of around 6.5 per cent.
After paying production costs, interest and tax, companies have two options with regard to their net profit. They can either keep it, or they can give it back to shareholders by paying a dividend. Most elect to do a bit of both, using some of the profit to pay a dividend and keeping the rest within the company.
How much is paid out and how much is retained depends on a number of factors. A company with many growth opportunities may elect to only pay a small amount of this profit as a dividend, because it is using the rest to re-invest in the business and fund new projects or enter new markets. A company that is relatively mature with limited options to grow or one that doesn't require a lot of money to execute its growth strategy may instead elect to return a greater proportion of its profits to its owners, the shareholders. The proportion of profit that a company chooses to pay back to shareholders each year as a dividend is known as a company's payout ratio.
The high-dividend-paying companies on the left of the table had an average payout ratio of 81 per cent, with some paying close to all of their earnings out as a dividend. The top-performers had an average payout ratio of 63 per cent, paying a reasonable amount of earnings back as a dividend but re-investing more back into their businesses.
Mainfreight, for example, is a company that is growing by expanding its operations into Europe and increasing its presence in North America, Asia and Australia. In 2011, the company made a net profit of $48 million, which equates to 49c of profit for each share in the company. Of this 49c, Mainfreight decided to pay 20c as a dividend and keep the other 29c to help it grow.
So in the case of Mainfreight, its payout ratio in 2011 was 41 per cent. Mainfreight reported a quarterly result earlier this week that was lower than market expectations. Another benefit of a modest payout ratio is that the company will be able to maintain a steady dividend during difficult times such as these.
The Warehouse is an example of a company at the other end of the scale. Unlike Mainfreight, it is a relatively mature business with limited growth options. In 2011, it earned a net profit after tax of $78 million, or 25c for each share on issue. The Warehouse gave almost all of this profit back to its shareholders, paying 22c out as a dividend and keeping just 3c per share within the company, making for a payout ratio of about 90 per cent. This leaves little room for the company to absorb weaker trading periods and, should the company's earnings fall back, even temporarily, it would probably have to reduce its dividend.
Based on current expectations, Mainfreight shares are trading on a pre-tax dividend yield of about 4 per cent, while shares in The Warehouse are trading on a much more attractive yield of close to 10 per cent.
While an investor in The Warehouse may be able to expect a greater short-term return from dividends, they forego the growth potential that a company like Mainfreight offers over the longer term.
Two good examples of high-dividend shares that have been stalwarts of our client portfolios for years are Vector in New Zealand and APA Group in Australia. Vector has provided a return of 34.5 per cent since then, almost all of which has come from dividends. APA Group, a gas distribution company similar to Vector, has returned 82.7 per cent since 2007, which falls to 13.7 per cent if dividends are excluded.
These types of companies provide a great anchor to a portfolio and deliver a reliable income stream with a growth profile that hopefully outpaces economic growth and inflation. But investors also need to give up some income to ensure they have some growth potential within their portfolios.
The ideal dividend share may not necessarily be the one with the highest yield today, but one with a combination of attributes to offer a better yield in years to come. Companies that would make the grade might be those with a reasonable, yet more modest, current yield, but with a track record of dividend growth, a clear dividend policy, a low payout ratio (suggesting the company is reinvesting profits to generate further growth), a strong balance sheet with conservative debt levels and a high level of profitability with improving profit margins.
Mark Lister is head of private wealth research at Craigs Investment Partners. His disclosure statement is available free under his profile on www.craigsip.com. Craigs Investment Partners invests in a number of the companies mentioned on behalf of its clients. This column is general in nature and should not be regarded as specific investment advice.