On the Chase for Yield
The equity market can at times seem like a creature of fashion, if not completely bipolar. Particular investment attributes, like high rates of EPS growth or resistance to economic downturn, may attract a premium for a period of time only to fade down the track as other attributes rise to prominence in the minds of investors.
One of the more dramatic examples in recent times was the way the market’s views on gearing evolved through the GFC. Before mid-2007, companies with high gearing levels did not appear to be penalised by the market for the increased risk that comes with debt. Later, when debt became harder to refinance, gearing levels and maturity profiles became primary drivers of the market’s assessment of corporate merit.
One characteristic that has risen to prominence in recent times is dividend yield. With deposit rates on cash offering very poor inflation-adjusted outcomes, investors have been motivated to find better ways of generating income, and large, well-known companies with good dividend yields have been keenly sought.
This has not been lost on boards of directors, who have felt under pressure to increase dividend payout ratios or risk the ire of shareholders. In some cases, companies that have delivered sound financial results have been marked down, apparently due to a lack of generosity in setting dividends.
In the circumstances, this focus on yield and the trend towards higher payout rates is not surprising, nor is it necessarily a bad thing. However, an astute investor needs to consider what implications this may have down the track, and whether it presents particular opportunities or threats that need to be navigated.
The first issue that springs to mind is whether higher levels of dividend payouts mean that businesses won’t have capital available to fund investment in attractive growth opportunities, thereby constraining growth down the track. If a company is able to invest additional capital into its business at a high rate of return, our preference as long-term investors is that it should do so, rather than hand the money over to us.
Of course, this can go two ways. There are plenty of businesses that can’t earn sufficiently attractive returns on additional capital, and yet invest the capital anyway. In these cases, shareholders would be better served by having the cash paid out to them.
Ultimately, we feel that the risk of good companies being starved of investment capital is unlikely to present a major threat to growth. Where an investment case is sufficiently strong, listed companies usually have the ability to raise additional capital through new equity raisings, and so it should be possible to satisfy both those shareholders who want cash out now, and those who are happy to forego the cash today in favour of better returns tomorrow.
However, while a trend towards higher dividend payouts may not present issues in terms of the long-term health of the equity market, it may well have implications for how investors should allocate their capital. When an investment attribute, such as dividend yield, is in favour, the likely consequence is a rise in the share prices of the relevant companies, potentially pushing them beyond intrinsic value.
This is an important point. Investing on the basis of dividend yield may be a sensible strategy for a single investor, and research indicates that there is probably some truth to this. However, when the market as a whole decides to invest that way, the investment merit is soon competed away.
Warren Buffett famously said that investors should be fearful when others are greedy and greedy when others are fearful, and this idea can be applied more generally. The underlying principle is that it’s often good to be doing the opposite of what others are doing, and if others are bidding up the price of yield paying stocks, there is a good chance you will find better value elsewhere.
Our analysis of value in the market bears this out. For example, Telstra, which offer a good dividend yield but limited growth prospects, appear to us to be trading at treacherous levels. At some point down the track, if interest rates rise and yield falls from favour, there is the potential for material loss of capital on an investment in Telstra at today’s prices.
Investing against the trend is not always easy to do, but one thing that we have learned over many years in the market is that the easy thing to do and the right thing to do often are different. If you have been investing with the flow recently and buying large caps with a high fully franked yield, perhaps now would be a good time to step back from the noise of the market, and think about whether a more considered strategy is likely to yield better results in the long run.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Paul Audcent
:
Roger what say you? Three economists just won the Nobel prize for forecasting a shares and returns process. Was this crystal ball gazing at its best!
gordon alford
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All of your articles are very helpful but I’m a Telstra holder and I’m not sure why you believe Telstra is at “treacherous levels”?
1. The market is so strongly focused on yields with few alternatives apart from Telstra – like div. companies for a place to park cash.
2. Is there really a likelihood of a large sudden increase in interest rates that would change these money-parking venues?
3. Telstra’s revenue has found a sweet spot in the last year or so with NBN and struggling competitors.
4. Forecasters are suggesting a div. increase.
5. A pe of 15 seems OK if the market is bullish.
Roger Montgomery
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High Gordon,
We aren’t forecasting a share price drop. Tim’s comment simply refers to the level as it relates to returns that would accrue to a new buyer. If interest rates then rallied, the return to the shareholder might not be so attractive. FInally, keep in mind one man’s trash is another man’s treasure. No transactions would ever occur if the buyer and seller didn’t have a completely different opinion.
Paul Middleton
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Thank you for the article Roger, a very timely post indeed! Dare I say, we will be able to look back to such an article in coming years as a gentle reminder that what is a fashionable investing method now – will not stand the test of time.
As I now know after reading Value.able, investing is actually simple, and doesn’t require any fastidious knowledge of transient investing fashions. All you do is find quality companies with high ROE that reinvest in their business with little need for debt. Then you work out their value, and compare that with the share price for the opportune time to invest.
The focus for investors should naturally be long term. When you refer to Telstra and its high yield – willing investors are focused on the short term (yield). Whereas willing investors in another telecommunications stock (MFN) can see that its managers are not focused on high yields, but rather are reinvesting to maintain a high ROE and high returns for its shareholders over the longer term.
Simple really. But in practise I guess the jazz musician Thelonious Monk words need to be borne in mind “Simple Ain’t Easy”.
Roger Montgomery
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Simple ain’t easy. Indeed, simplicity is genius.
leekadish
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Hi Roger, I’m pleased to see an article on “the search for yield” as it has been a (if not the) dominant theme playing out for most of the time I have been watching the market (aprox. 18 months as I’m currently a student at UNSW).
Some time ago when I was considering this as a thematic investing opportunity it occurred to me that a potential agency problem has been created for any business in which some portion of management remuneration is based on total shareholder return.
As you mentioned “companies with good dividend yields have been keenly sought” and this results in share prices being pushed up beyond intrinsic value. This artificial increase in TSR would allow management to meet performance hurdles for their remuneration. Do you think there is an agency problem here? If so what do you expect the magnitude of the problem to be?
Thanks!
Roger Montgomery
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I have always thought agency risk is higher in Australia for investors than in several other equally transparent markets…That my book Value.able is a relevation for many CEO’s is, I reckon, a testament to the issue.
Andrew Legget
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I have often wondered whether Australian companies are too focused on generating dividends to the detriment of themselves and the Australian economy. An idea come to mind that perhaps superannuation and the dominance of these businesses/funds in the market might be having a negative incentive on boards to focus on appeasing these businesses. There for they will allocate more money to dividend payouts and there for shortening the life cycle of businesses and constraining growth and reducing the influence of R&D.
Australia, as in a lot of things, when it puts its mind to it is capable of punching above its weight as we can see in businesses like CSL, Cochlear and also when you look at the various inventions that found their birth here (wifi for example).
Unfortunatley, a reduction in the payout ratio (or even the retention of all funds) tends to be punished by the market or leave it largely ignored. That can be a good thing for people like us. But if there was more focus on using retained funds to help grow the busiensses, create better products and brands etc we might find ourselves in an economy that looks vastly different and have a bigger pond of quality companies to choose from.
Paying no dividends doesn’t seem to hurt some companies overseas where investors are less concerned about dividends.