Don’t yield to income!

Don’t yield to income!

In recent times the market has been captivated by the ‘chase for yield.’  This phrase simply represents the symptom of the repressive money printing acting on interest rates globally. As a result of these low interest rates, funds are being ripped out of the safety of cash and poured into riskier assets in the pursuit of higher returns.

As more money leaves the safety of cash amid the search for a more prosperous home, it produces higher asset prices.

There has been a lot of talk about the impact of lower interest rates on asset prices, but precious little quantification of the impact to simply explain it.  We have taken up the challenge.

We recently asked one of the leading investment banks in the Australian market for some quantitative data on the S&P ASX 300 (ASX: XKO). A summary of this data is shown below:

The table above reveals the split between the two main drivers of aggregate stock market returns for the S&P ASX300 over a five-year period. When we look at the 26.54 per cent capital growth return, over five years to February 2015, we ask, what proportion of this is due to earnings growth and what is due simply to multiple expansion?  That latter could be attributed to the willingness to pay more for yield, itself a function of declining interest rates.

Earnings growth most recently, particularly over the first half of the 2015 financial year has, at best, been anaemic. The same can be said of the period illustrated by the table above; The earnings index for the S&P ASX300 was 343.81 in 2010 versus 362.63 today, just 5.47 per cent higher than that of five years ago. On this basis, earnings growth for companies representing 81 per cent of the Australian equity market by capitalisation, is responsible for just a fifth of the S&P ASX300’s performance. That’s a poor showing in our view.

In order to invest successfully in such a market fund managers have had to focus on quality and invest in those businesses able to grow earnings much faster than the average.  But given what we are about to reveal, much of the returns for many fund managers can only be attributed to sentiment.  A changes in sentiment is notoriously difficult to predict so managers that have built their returns only on P/E expansion may be in for a rude awakening at some point in the future.

This is because the other four fifths of the market’s capital return, or 19.97 per cent nominally, has been generated by price/earnings multiple expansion. This number is much higher than we originally expected!

In essence the market’s expansion over five years to its current level can only be described as poor quality.  of course there is the possibility that the period prior saw the market expand less than earnings growth, which would mean the recent acceleration is simply an example of investors playing catch up, but this theory is not borne out by the p/E expansion from a rational starting point.

Over extended periods of time share prices simply follow the earnings power of the business upon which they are based.  This suggests something will come along to cause P/E ratios to mean revert.

In saying this, despite the poor showing from corporate Australia’s earnings growth, and the fact that share prices have detached from the core concept, what these numbers also show is that in a rate-cut environment stocks could continue their march upwards on nothing more than investors chasing income.

Of course there is no such thing as a free lunch, investing in shares is not risk free and fads in the market are common. Yielding to income and swapping low returns for more risk, is just another fad.  This is why, one day, when interest rates invariably rise again (or even well before), so too will the end of the market’s obsession for yield.

Russell Muldoon is the Portfolio Manager of The Montgomery [Private] Fund. To invest with Montgomery, find out more.