Dividend stocks: a typical income portfolio

Investment Committee, Switzer Dividend Growth Fund
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A dividend strategy for your equity portfolio is a traditional defensive strategy that worked well in 2011. In the current environment, there are opportunities to have exposure to quality companies offering a quality dividend before the franking credit. The key for investors is to have exposure to those companies that can pass on the dividend.

Targeting a double-digit dividend for each holding is an unreasonable expectation; it’s the quality of the income that is key. So which 10 stocks would qualify for a dividend strategy in 2012 for your self-managed super fund (SMSF)?

Building blocks of an income equity portfolio

The core aim of an equity portfolio is to target a dividend strategy that provides a yield that is higher than the benchmark (S&P/ASX200), without necessarily being exposed to greater levels of risk and earnings uncertainty. It is a traditional defensive equity strategy, and therefore tends to outperform the index when equity markets are subdued.

The aim is to have exposure to companies that have a lower correlation to the broader equity market (that is, a beta less than one). Some other basic filters to look for are stocks with a dividend cover ratio greater than one and consistent payout ratios over time. Further, one must compare the yield being targeted versus other alternatives, which are clearly cash and fixed income.

Cash rates have been falling recently and while the Reserve Bank of Australia (RBA) currently appears to be on pause, the market is still pricing in another 25 basis point rate cut over the coming months. So it is clear the return on cash will be lower in 2012 versus 2011.

Also, Australian Government bond yields are very low versus historical levels. The Australian 10-year Government bond yield is just under 4%. This implies the dividend yield looks compelling from an earnings yield versus bond yield perspective.

Dividend paying stocks

What type of stocks should you have and what yield should you target? Let’s look at 10 stocks that would be part of a building block for a dividend strategy. It is no surprise that the sectors that tend to meet the filters addressed above are Telco’s, Utilities, Infrastructure, A-REITs, Gaming, and Financials. A portfolio strategy also helps reduce the risks and volatility.

Table 1 shows the 10 stocks that meet the requirement for our income equity portfolio. For simplicity, we have weighted them equally. The average dividend yield for this sample portfolio is 7.82% and the grossed up yield is 10.39%. It is important not to target dividend yields that are unrealistically high as there is a good reason in most cases. It is better to seek out quality dividends instead.

Table 1: Core Equity Income Portfolio

In summary

A dividend strategy is a defensive one. Conversely, exposure to cyclicals is a more aggressive strategy that has leveraged exposure to future earnings and offers much lower income. But a dividend strategy must aim to deliver a more consistent income stream, with lower volatility versus the broader market. It can also utilise the franking credit, a significant benefit to any SMSF, particularly if it is in pension phase.

As always, exposure to quality dividends is the aim because a dividend is not a certainty, but a guidance. If one requires income certainty, then you need more exposure to cash and fixed income. Finally, expectations for double-digit dividends are a very unreasonable one. Building the appropriate income portfolio should reflect the filters we have addressed above. It is all about meeting one’s expectations.

This note was written on 17 February 2012. George Boubouras is the Head of Investment Strategy & Consulting at UBS Wealth Management.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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