A dividend strategy for your equity portfolio is a traditional defensive strategy that has worked well in recent years. There has been significant investor demand in the traditional defensive dividend strategy as it has become clear that cash and bond rates are falling. There are still opportunities to have exposure to quality companies offering a quality dividend before the franking credit. As a rule of thumb targeting a double digit dividend for each holding is an unreasonable expectation. It’s the quality of the income that is important. Outside the big four banks and Telstra, the ultimate perpetual dividend play, which stocks would qualify for a dividend strategy for your portfolio or Self Managed Super Fund (SMSF)?

Building blocks of an income equity portfolio

The core aim of an income equity portfolio is to target a dividend strategy to provide a yield that is higher than the benchmark (ASX 200), without necessarily being exposed to greater levels of risk and earnings uncertainty. It is a traditional defensive equity strategy, 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 and are expected to go lower. Therefore Term Deposits are also expected to fall. So it is clear the return on cash will be lower in 2012 versus 2011. Also, Australian Government bonds yields are very low versus historical levels as global investors are accumulating our bonds. The Australian 10 year government bond yield is now under 3.0%. This implies the dividend yield becomes even more compelling from an earnings yield versus bond yield perspective. As a backdrop it is no surprise that the sectors that tend to meet the filters for income are Telco’s, Utilities, Infrastructure, A-REITs, Gaming and Financials. A portfolio strategy also helps reduce the risks and volatility.

Outside of Telstra and the major banks what is appropriate?

Let’s have a quick review of what type of stocks should you have and what yield should you target outside of the obvious exposure of Telstra and the major big four banks? We take a look at 14 stocks that could be part of a building block for a dividend strategy.

Table 1 shows 14 stocks that meet the requirement for our income equity portfolio excluding Telstra and the major banks. For simplicity we have weighted them equally. The average dividend yield for this sample portfolio is 5.88% and the grossed up yield is 7.25%. 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. Some of the yields are actually below the broader market average. Clearly removing these will increase your target dividend yield.

There are risks of course. For example the utilities of both AGL Energy and Origin have some upcoming CAPEX requirements and they need to navigate through various regulatory requirements at all stages of a cycle. AGL Energy is more defensive than Origin but it is important to highlight that you are getting lower yields for these utilities compared to other options such as DUET Group and Spark Infrastructure Group which have relatively high gearing that are underpinned by defensive cash flows.

For diversified financials AMP stands out and they have already trimmed their payout ratio and dividend in the previous reporting update in March. Current guidance looks more reasonable. Insurance also feature with both QBE (one of the best rated globally) and IAG (good Asian market exposure as well).

Quality infrastructure exposure such as toll road operator Transurban and the more cyclical (riskier) infrastructure, Sydney Airport also feature. We finish off with some quality gaming stocks and two large consumer staples.

Table 1: Core Equity Income Portfolio ex Telstra and major banks

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, it is 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. We have aimed to explore some additional dividend exposures outside of the major banks and Telstra. It is all about meeting one’s expectations.

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. Anyone should consider the appropriateness of the information in regards to their circumstances.