Why Dividends Are Leading the ASX Towards Ruin

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Australia’s dividend culture risks turning the ASX into a future global backwater. That warning, coming courtesy of consultants at AlphaBeat, is timely amid flat lining company earnings.

The concern is that Aussie companies are prizing dividends at the expense of growth. In doing so, they’re foregoing opportunities to reinvest earnings. The fear is that, in the long run, this strategy will prove self-defeating. If companies aren’t reinvesting their earnings, they’re limiting their potential for growth.

That’s enough to keep investors onside while dividends remain generous. But it could leave companies exposed in the event the stock markets undergo a sharp downturn.

What’s more, by holding back on investing, they’re hurting the economy in the process. Economic growth won’t improve unless businesses start hiring in greater numbers.

However, businesses are indicating they’ll be doing no such thing.

If you’re not already aware, corporate Australia plans massive cutbacks on spending over the next year. They’re not mucking about, either. The figures touted amount to roughly $104 billion. That’s a significant sum of money.

Companies are happy to lavish this money as dividends on investors to make up for lacklustre earnings.

But this dividend culture is part of a wider problem at heart.

It’s not something that you, as an investor, may wish to hear. But it’s worth saying. Not that any of this should come across as a criticism of investors. They may be enabling this dividend culture, but they’re not the root cause of it. The responsibility lies squarely with corporate Australia.

Too many cautious heads control the boardrooms of Australian companies. And they’re fully content to play things safe. But this risk-averse culture is harmful in the long term. It’s damaging to the sharemarket, to investors, and to companies. Above all, it’s detrimental to the Aussie economy.

If this infatuation with dividends persists, it’s not hard to see the ASX suffering in the long-run.

Temporarily, the dividend craze is understandably attractive to investors. But if growth isn’t at the forefront of corporate Australia, how long can this last?

If the economy undergoes a traumatic period, these companies will stand naked. Generous dividend payouts will become a thing of the past. Will investors be so supportive in those circumstances? Will they ever…

The companies, foregoing investment-led growth for years, will hit a brick wall.

Instead, companies ought to reinvest what’s left of the sizeable profits they continue to post.

But let’s consider the alternative.

Let’s say for a moment that companies did start investing. What are they investing towards? Growth, presumably. But the economy itself is barely growing. We’re constantly readjusting what growth targets should be.

Just this month the Reserve Bank said we’ll need to come to terms with sub-3% growth rates.

Is it any surprise then that companies aren’t reinvesting their earnings?

Well, yes and no. For one, businesses are partly responsible for the slowing growth. What’s more, the reason they’re not investing is hard to sympathise with.

Investing and hurdle rates

One of the biggest barriers to investment currently is the so-called hurdle rate.

Simply put, businesses expect a certain rate of return to greenlight investments. At the moment, most companies expect a hurdle rate of 10%. The problem is that this expectation hasn’t changed for a decade. Interest rates are much lower today than they were back then. Yet companies haven’t readjusted their hurdle rates to match lower interest rates.

That explains why corporate Australia is risk-averse.

It’s also why they’re playing it safe by rewarding investors with generous dividends. But this strategy needs a rethink.

The alternative to this is that the capital tap runs dry in the long run. Then there’ll be no dividends to go alongside what are bound to be weaker earnings.

Australian companies are the gold standard when it comes to dividends

Aussie companies are arguably the most generous when it comes to dividend payouts. Dividends aren’t problematic in isolation, provided it remains an incentive and not the strategy.

Just how generous is corporate Australia?

According to AlphaBeta, shareholders receive $0.63 for every dollar companies earn on average. Adjusting for inflation, that’s 60% higher than a decade ago ($0.40).

That might be acceptable if global markets mirrored this generosity. But that couldn’t be further from the truth.

FTSE-listed companies pay out $0.50 for every dollar of profit they make by comparison. American companies are even less liberal, paying out $0.29 per dollar in dividends.

Now consider the earnings forecasts for these markets over the next five years. Aussie companies can expect earnings to grow by 6.6% in this period. Contrast that with the S&P500 which, while paying smaller dividends, expects earnings to grow by 11%.

No prizes for guessing which companies have growth in mind, and which are pandering to investors.

ASX growth impressive despite dividend payouts

You may have already asked yourself at some point the following question. If dividends are such a problem for companies, why have returns on the ASX200 grown by 63% over the last five years?

That increase is a little misleading.

According to AlphaBeta, half of the ASX’s returns growth came from dividends. The other half, meanwhile, came from P/E ratios that were inflated by lower interest rates.

I don’t need to tell you that relying on interest rates to swell returns is not sustainable in the long term.

It’s alarming that virtually no increase in returns resulted from earnings growth. There’s no way to paint that positively.

Changing corporate Australia

Addressing the addiction to dividends doesn’t necessarily mean cutting back on them. It’s enough to change the outlook for corporate Australia. The way to achieve this effectively is to shift the risk-reward balance in favour of rewards.

Is this achievable? It is, but it’d require a lot of government foresight. We’re talking about substantial reforms to lift barriers to investments. As a quick example, it might be worth rethinking the entire corporate tax code.

But reforms aren’t the only solution.

Another way would be to invest heavily in infrastructure. That might make it easier for companies to justify their own expansionary projects. That’s especially true as far as the non-mining sector is concerned.

Getting non-resource sectors to invest is one of the biggest priorities the economy has at the moment. The mining boom is subsiding, and other sectors need to take up the slack. But it’ll require more than rate cuts and small business tax breaks to achieve this.

Finally, companies could refocus their efforts towards international markets. AlphaBeta cites the fast developing South East Asian region as a potential hotspot for investment.

This is easier to achieve now that Australia is part of the Asian Infrastructure Investment Bank. The AIIB allows Aussie companies to invest in Asia like never before.

In fact, the region is set to make up 60% of all global infrastructure spending over the next ten years. Corporate Australia has a chance to play a big role in this development.

If the hurdle rates in Australia are too low for companies, these new opportunities may spur them into action. Or maybe they won’t. It’s hard to say.

What is clear though is that this dividend culture may prove hard to change. It’ll be even harder to ween investors off the idea that dividends are detrimental to long term growth.

But if corporate Australia stands idle, then the ASX may very well become a global backwater in the future.

Mat Spasic,

Contributor, The Daily Reckoning  

PS: You may not care about the pitfalls of the dividend culture just yet. But you should be concerned about a potential stock market crash looming on the horizon. The Daily Reckoning’s Vern Gowdie believes this day is coming sooner than we all expect. He says that the ASX is heading for a major correction in the very near future.

Vern is the award-winning Founder of the Gowdie Family Wealth advisory service. He’s been ranked as one of Australia’s Top 50 financial planners. Not only does Vern predict a major crash, but he’s convinced the ASX could lose as much as 90% of its $1.8 trillion market cap.

Vern wants to help you avoid this coming wealth destruction. That’s why he’s written ‘Five Fatal Stocks You Must Sell Now’. As a bonus, this free report will show you which five blue chip Aussie companies could destroy your portfolio. You almost certainly own one of them. To find out how to  download the report, click here.

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