ETFs that provide exposure to firms with competitive advantages.

As the ability of companies to pay dividends falls during the COVID global recession, Australians seeking income need to look carefully at a business’s financial health before investing.

Companies with firm competitive advantages will be in a much better position to overcome economic challenges and keep paying dividends than companies that can’t fend off competitors.

During the pandemic, many companies have been losing cash flow and have reduced shareholder payments. The big banks particularly have cut dividend payouts, sounding alarm bells for investors who need a reliable income to live comfortably. 

By focusing on companies with strong financial health and those with a “wide” or “narrow” “economic moat” (sustainable competitive advantage), investors have a greater chance of receiving reliable dividend income rather than having their dividend income cut back, or cut altogether. 

Explainer: economic moats

The moat metaphor for investing was created by Warren Buffet when explaining his investment philosophy. A moat offers crucial protection against competitors. The concept addresses whether a business has sustainable structural competitive advantages that make it difficult for competitors to attack its earnings.

Morningstar has adopted this concept in its equity research and assigns Morningstar Economic Moat™ ratings to companies. The companies with the strongest structural barriers are described as having “Wide Moats”. Morningstar also assigns “Narrow Moat” and “No Moat” ratings. 

As the coronavirus pandemic continues to threaten financial markets, investing in a portfolio of moat companies enjoying strong financial health could help investors continue to reap dividend income, even during these tough times.  

Morningstar assigns a “wide” moat rating to companies where it has very high confidence that excess returns will remain for 10 years, with excess returns more likely than not to remain for at least 20 years. 

Moats are rare

Of the thousands of companies globally, Morningstar analysts have only assigned a wide moat rating to just over 200.  Companies assigned a “narrow” moat rating are those Morningstar believes are more likely than not to achieve normalised excess returns for at least the next 10 years. 

A firm with either no sustainable competitive advantage or one that Morningstar thinks will quickly dissipate is assigned a moat rating of “none”.

(Editor’s note: Do not read the following ideas as stock or dividend recommendations. Do further research of your own or talk to a licensed financial adviser before acting on themes in this article).

Within Australia, Morningstar has assigned wide moat ratings to only a handful of companies.  One is Wesfarmers. According to Morningstar, Wesfarmers’ wide moat comes from two components: first, its cost advantage; and second, its intangible asset, the Bunnings brand. 

Achieving reliable income 

With interest rates expected to remain at historic lows for a long time, Australian investors will have to take more risk. A company’s income and shareholder payouts are more likely to be enduring if a company enjoys strong financial health. 

Wesfarmers’ dividend payout of around 3.6% per annum (at 30 September) provides a healthy yield for shareholders, especially compared to the average rate of 0.75% across all bank term deposits as at 30 September 2020. 

It’s important to note, however, just how far up the risk curve investors are going when they consider equities for income.  

Below is the risk/reward chart for various asset classes over the past 15 years. The reward is the returns and is plotted on the vertical axis.  Risk is measured by volatility and it is plotted on the horizontal axis.  

You can see that Australian Bank Bills, which are like cash, are not very volatile and close to zero, whereas Australian equities is an asset class among those furthest away from zero and therefore has higher risk.  

Source: Morningstar Direct, Results are calculated monthly and assume immediate reinvestment of all dividends. You cannot invest in an index. Past performance is not a reliable indicator of future performance. Indices used Australian Bank Bills – Bloomberg Australian Bank Bill 0+ Yr Index, Global Bonds – Barclays Global Aggregate Bond Index A$ Hedged, Australian Bonds – Bloomberg AusBond Composite 0+ Yr Index, Australian equities – S&P/ASX 200, Global equities – MSCI World ex Australia Index, EM equities – MSCI Emerging Markets Index, Volatility is standard deviation of returns

Importance of dividends

Dividend income is a significant contributor of equity returns in Australian shares. And it is becoming more important in investors’ portfolios as the income from term deposits has dived in recent years and investors are increasingly turning to equities for income. 

In contrast, income from shares has trended upwards since the global financial crisis (GFC), as the chart below shows.

Source: Bloomberg, APRA, RBA.  Shares is S&P/ASX 200.  Term deposit rates are RBA 12-month deposit rates. Past performance is not a reliable indicator of future performance. Investing in shares significantly increases risk. Speak to your financial adviser to determine whether investing in shares is appropriate for your circumstances.

However, it pays to be selective about which companies you invest in, as historically high dividend-paying companies do not always outperform. Investors can lose both income and capital from underperforming shares. This is especially true of Australia’s big banks this year. 

An ETF engineered to deliver income 

Fuelled by Morningstar's equity-research process, the  VanEck Vectors Morningstar Australian Moat Income ETF invests in high-dividend, quality companies with either wide or narrow moats based on Morningstar's Economic Moat analysis.

DVDY tracks the Morningstar® Australia Dividend Yield Focus Index™ and is designed to appeal to investors seeking income, as well as capital growth.  The index includes 25 Australian companies based on their quality, strong financial health and dividend payouts.

Apart from Wesfarmers, DVDY holds wide- and narrow- moat household quality names such as ASX, Woolworths, and Transurban, which all enjoy strong cash flows and sustainable competitive advantages, providing the companies with the ability to pay relatively high income and potential for capital growth even during these recessionary times.

DVDY provides investors seeking income with a quality solution, with access to quality historically high dividend-paying Australian companies with characteristics that indicate the potential to continue providing excess returns for the long-term. 

DVDY offers all the benefits of ETFs including simple trading on the ASX, liquidity and full portfolio details with transparent daily holdings disclosure. 

While there is no guarantee that the companies in the fund will continue to pay high dividends or in fact any at all, the ETF increases the potential for investors to reap a reliable income from equities and avoid dividend traps which could become more common as the COVID-19 pandemic endures.

(Editor’s note: All ETFs have risks. Investors who are new to ETFs should consider the free ASX online ETF course to learn about the features, benefits and risks of index funds.)