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While generally regarded as a last resort, slashing dividends is the first of numerous steps many companies are now taking in light of earnings downgrades.

And if former recessions are any guide, the dollar amount of Australia’s index dividends is likely to fall by around 30 per cent. Investors can expect the indicative payout ratio on yield-socks (of around 70 per cent) to be trimmed by up to 20 per cent this reporting season.

But assuming dividend yields remain around 6.3 per cent and the cash rate falls to around 3.25 per cent by Easter, Citi Smith Barney’s Justin O’Brien says equities should remain an attractive alternative to cash. “Cash rates are a good benchmark when looking at dividends, and assuming investors can get dividends that are 100-200 basis points over the cash rate, they’re still doing OK,” says O’Brien.

There’s clearly no such thing as immunity against picking high-yielding stocks today that won’t become low-yielding ones tomorrow. A growing number of high gross yielding stocks on the S&P/ASX 50 have been forced to cut dividends following the slashing of their half-year earnings forecasts, notably: Goodman Group (GMG), Westfield (WDC), Macquarie Group (MQG), Fairfax Media (FXJ), Suncorp (SUN), Rio Tinto (RIO), Wesfarmers (WES), and Tabcorp (TAH).

Given that Tabcorp had a dividend cover close to one, it had little room to move following a fall in net profit, of 3.7 per cent. For those who don’t know, dividend cover is the total earnings of the company divided by the total dividend payout for the year. In an effort to preserve capital, the gambling giant recently signaled plans to reduce its payout ratio from 90 per cent -plus to between 70-80 per cent.

In light of recent downgrades, all dividend cover ratios – which most analysts prefer to be over 1.3 – have understandably come under the spotlight. But instead of fixating on yield in this bear market, O’Brien says investors would be better served refocusing on fundamentals and capital preservation – plus a stock’s ability to deliver future capital gains. “With yield and growth both out the window, it’s all about identifying companies that can literally survive the downturn,” says O’Brien.

Within the current market, he says any stock yielding double-digits should be approached with extreme with suspicion, especially if it’s being supported by a sagging share price.

He also cautions against stocks that flaunt their ASX disclosure obligations by not signaling deteriorating earnings or making only vague reference to future earnings this reporting season. “By all means screen for dividend, but more importantly within the current market, look for clean balance-sheets that won’t require refinancing within the next 18 months – with debt-to-equity ratios below 40 per cent.”

Due to their exposure to market volatility, brokers expect REITs (or LPTs) to account for the bulk of profit warnings this reporting season. And given the magnitude of the write-down in asset values and profit downgrades experienced by REITs (LPTs) – which have an aggregate dividend yield of around 11 per cent – investors can expect payout ratios from this troubled sector to come intense pressure.

Meantime, O’Brien says stocks with quality future earnings and high barriers to entry are more likely to retain their dividend yield this year. Stocks in the consumer stables industry that are less exposed to discretionary spending such as Woolworths (WOW), Goodman Fielder (GFF) and Metcash (MTS) should.

Given that the S&P/ASX 200 Banks index has an aggregate 2009 yield of 9.3 per cent, all eyes will be on signals by the ‘top four’ to join the growing ranks of dividend-slashers. While three of these banks don’t report until March, the market will take its cue from CBA’s February’s recent announcement as what’s in store for the ANZ, Westpac and NAB.

So assuming there’s little to encourage income investors to yank their funds out of the sharemarket, and with cash rates expected to fall to around 2.25 per cent by September – is there a compelling flight from cash back into equities? While some investors will go into equities once cash comes off term deposit, Bill Bovingdon Aberdeen Asset Management’s head of fixed Income expects the more knowledgeable to look at what’s on offer in non-government bonds.

According to Bovingdon, the stronger the likelihood of further earnings deterioration, the greater the risk of additional dividend cuts. Also fueling the magnitude of cuts to pay-out ratios, he adds is the degree to which stocks require capital. And within an environment where upside for capital gains is limited, he expects dividends to increasingly struggle to deliver a 2-3 per cent premium over selected bank debt. He recommends investors take a closer look at both government-guaranteed bank debt (around 4.75 per cent), senior ranking debt (around 5.5 per cent) on three to five year terms – and sub-debt in financials and non-financials (offering around 8.8 per cent).

For those more interested in a managed fund approach, Bovingdon recommends ‘active managers’ who aren’t over-exposed to government bonds, with a good track record in managing the interest rate cycle.

A diversified spread across (non-guaranteed) senior ranking debt, adds Bovingdon minimises the risk of any single bank failing to deliver. “While cash hasn’t been a bad place to be, you don’t want to be stuck there with interest rates at 3 per cent, and now’s not the time for complacency,” says Bovingdon. “It’s a question of looking for the running-yield as opposed to capital appreciation.”

S&P/ASX50 – top ten ranked by 2009e gross yield

Company

Gross Yield (%) 2009e

Goodman Group

50.7

Mirvac Group

27.3

Bluescope Steel

23.4

Qantas Airways

21.3

Tabcorp Holdings

21.0

Suncorp Metway

19.9

GPT Group

19.8

Wesfarmers

18.1

Fairfax Media

17.4

Macqaurie Group

15.3

Source: Citi Smith Barney January 2009