Market talk: Traps for the unwary in high-yielding stocks

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Dividend yields will continue to be a major theme in 2013, but investors need to understand that there is more to achieving good returns than simply chasing high-yielding companies, says Bob Van Munster, head of Australian equities at Tyndall AM.

“Overall, the fundamentals remain attractive for sustainable dividend yields from Australian shares. Gearing levels are at 30-year lows, pay-out ratios are conservative at around the long-term average of 60 percent, and the Australian economy remains resilient – all key ingredients for good quality companies to continue paying dividends.

“The weight of money and the ongoing attractiveness of dividend yields, compared to cash rates and bond yields, should assist the sharemarket as a whole.

“The market is currently pricing in further interest rate cuts in 2013, which will encourage investors to find higher returns by moving into higher risk assets, and this will continue to support the market.

“However an increase in company earnings will be the primary driver of any further significant uplift in the market. Earnings expectations were revised down sharply last year and are now relatively low. It won’t take much to improve expectations, such as an increase in productivity, for example,” Van Munster said.

He also warned that investors should be mindful that there can be traps for the unwary in simply chasing high-yielding stocks.

“The dividend yield is a function of the stock’s dividend and its price, and a high dividend yield could simply indicate that the stock is cheap, and cheap for a reason.  For instance, deteriorating businesses can often have a high dividend yield that proves to be an illusion.

“Therefore picking the highest yielding stocks without conducting thorough due diligence can lead to substantial underperformance. 

“When determining whether a stock is good value or just a trap, investors need to assess the underlying health of the company and the sector it operates in,” he said.

“The strength of a company’s balance sheet (particularly gearing levels), as well as franking levels, pay-out ratios, potential for share buy-backs and special dividends, are all keys to assessing the sustainability of a company’s dividend.

“There are some high-yielding companies in sectors that are facing structural challenges, for example within the manufacturing and retail sectors.

“Manufacturing is feeling the weight of the persistently strong dollar and high operating costs, reducing its competiveness against cheap imports.

“The retail sector is grappling with changing consumer behaviour, with on-line shopping increasingly growing in appeal (assisted by the strong Australian dollar).

“However, companies are endeavouring to adapt and adjust to the changes.

“One example is BlueScope Steel which has reduced its reliance on exports, hedged its iron ore exposure and entered into a joint venture arrangement in Asia to expand its business. The company is also implementing technology changes in its steel business in the US.

“On the other hand, it seems likely that banks will continue to sustain their strong dividend yield during the year ahead.

“There are always two risks to bank dividends. One risk is requiring capital to fund strong credit growth.  As long as credit growth is below, say, seven to eight percent, and dividend re-investment plans retain their appeal, banks are unlikely to reduce pay-outs.

“The other risk is that profits fall substantially due to recessionary conditions where bad debts rise and credit growth falls. Neither of these prospects are on the horizon at present, so in the near term, banks should retain their dividends,” said Van Munster.

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