Why investors need to search for growing income
For the last few years, investors have made off handsomely by simply buying large cap stocks with high yields like banks and Telstra. Low yielding term deposits have plunged retirees into what can only be described as an Income Recession and their cries have been heard by company boards, who have acquiesced to their demands for more income from shares by raising their company payout ratios.
This will prove to be the great undoing for many retirees’ investment portfolios because the corollary of high payout ratios is low growth, and what retirees will need in a few years is not a high yield but growing income.
The maths is pretty simple. If a company with ten dollars of equity earns a 20 per cent return on equity every year and pays out one hundred percent, its equity doesn’t grow (assuming no more debt or fresh capital is raised). If the equity doesn’t grow and the return on equity remains constant, the earnings don’t grow either. If the earnings don’t grow, the dividends cannot.
If we make the assumption that the stock market never changes how popular the shares are and they always trade on a price earnings ratio of, say, ten times next year’s earnings, then we can buy the shares in year one for $20.00, receive two dollars of dividends each year and sell the shares at some future date for $20.00. Our internal rate of return will be 10 per cent which is precisely equal to the dividend yield at the time of purchase.
But that’s all. Unless they speculate that the P/E ratio might rise, their best return is the dividend yield.
Retirees who appear to have been smart buying stocks with yields a little higher than term deposits will soon find their income fixed by the high payout ratio and the purchasing power of their income eroded by inflation.
If the above company paid none of the earnings as a dividend, all of the earnings would be retained and the equity, the earnings and the share price would all rise by 20 per cent per annum – equivalent to the return on equity of the company – and yielding a return that was double that of the first investor.
The impact of this cannot be overstated.
In 2005 you could have invested $100,000 in the shares of Telstra – a company that was paying more than 100 per cent of its earnings as a dividend – at $4.69, paying a dividend of 28 cents for a yield of just less than six per cent or income of $5,900.
As an alternative, you could have also invested in the shares of another telco called M2 Telecommunications – a company that was retaining a meaningful proportion of its profits and compounding them at an attractive rate of return on incremental equity. M2 was trading at a bout 30 cents and was paying a dividend of about 1.25 cents, which corresponded to a yield of just 3.90 per cent.
Any dividend hungry investor would have gone for the Telstra shares.
Fast forward to 2015 – ten years later – and the $100,000 invested in Telstra has grown to about $135,000 and the $6000 of income in 2005 has grown to about $6400.
Compare this to M2, where the hundred thousand dollars has grown to over three million dollars and the $3,900 of income on your hundred thousand investment has grown to $93,750.
Chasing the dream of higher income is a good thing but it cannot be achieved by focusing on high yielding stocks in companies whose payout ratios are high. Unless these companies raise fresh capital, lower the dividend or borrow money, earnings won’t grow nearly as quickly as a company that can retain profits and compound them at a satisfactory rate of return on equity.
Investors need to stop chasing yield and start searching for growing income.
Roger Montgomery is the founder and Chief Investment Officer of Montgomery Investment Management. To invest with Montgomery domestically and globally, find out more.
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.
HOWARD MUSGROVE
:
While agreeing fully with you Roger on retained earnings in an ideal world ( I hold successfully M2) with cynicism & a less informed investor looking for income..
Fosters T Kunkel & USA
RIO. Albanese & USA/ Riversdale
Tumbrell.. AMP
Fosters Overbuying vineyards & Wine/ beer split
Goodman Fielder?? current price
Woolworths/Masters
NAB UK banks & USA investments.Total lost funds.. Countless billions waster
The list goes on Roger, no wonder there is a seachange in attitude & these are supposed to be well run b/chips. I can quote many more
Roger Montgomery
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Hi Howard, the assumption is the ability to retain and redeploy profits at a high rate. In the real world there are many reasons why this doesn’t happen. Investors employ us to find those companies that can.
howard
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You are correct, Roger, in a sane investing world with a capable CEO & board
however cynically I have observed
Rio. T Alb & Riversdale & aluminium USA Ted Kunkel & Wine USA. Fosters company takeovers then a failed separation of wine/beer. Newcest/Lihir Tumbrell AMP. ANZ into Asia.. 7 year CEO with little to show. NAB & USA and UK banks. The list goes on. Never stand between a new CEO & a bucket of money P.S. Woolworths/Masters
Richard
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Hi Roger,
Given the structural nature of our market, the ageing population and the influence Superannuation funds have on the listed market – can this desire for dividends and lack of re-investment end up becoming an economic and social issue for Australia? Do we experience our own “hard-landing” in dividend obsession or are we able to gradually transition with our index altering its composition dramatically to reflect high ROE technology based companies with low payout ratios?
It would appear that where retirees would like to earn and then spend their income, this doesnt necessarily reflect where the new employment opportunities for a sustainable future can be created?
Roger Montgomery
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They are great questions Richard and I think that the zero tax environment afforded to super funds in pension phase can provide some of the momentum needed to see companies behaving more rationally with capital. This is because in a zero tax environment the retention-of-capital>higher-share-price>capital-gain argument over franked dividends is more compelling. STill investors must give up a bird in the hand to get two in the bush.
Jon Gosewinckel
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I guess the Telstra price in 2005 is used to reflect the returns over a 10 year period. However, while it may not compare with M2, the last 5 years have been a better story for Telstra.
Roger Montgomery
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Not sure about that Jon. I think you might be forgetting the 300% growth in dividends over the last five years for MTU Jon, not to mention that in the last five years MTU’s share price has risen from $2.35 to $9.35. (TLS share price $2.66 to $5.66 and relatively little dividend growth in the last five years)
James
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Roger
I believe you’ve made a couple od dubious assumptions. Firstly, where is this inflation you predict going tocome from (as we haven’t seen it over the past 7-8 years even with the trillions of dollars which has been pumped into the system). And if a comany sees no use in keeping the earnings surely they are better off giving to the shareholder who may put it to more productive use?
Roger Montgomery
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The assumption is earnings should be retained when they can be profitably redeployed at a better rate than retirees who demand the dividend. Indeed we agree that where the company cannot achieve a high rate of return on incremental equity earnings should be paid out.
Keith
:
Well said Roger and I fully agree.
I recently asked a question of the chairman at an AGM along the lines “the company is doing well and making in excess of 15% return on equity so why don’t you reduce the dividend and invest the money in the business?” The reply was along the lines a) we need to look after shareholders and b) the company currently has enough capital for business growth and the dividend.
I guess b) is some sort of a valid answer.
Also – great video insight on Apple by Chris this week and very well articulated,
Keep up the good work.
Roger Montgomery
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Thanks Keith.
Graeme
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Few would argue that companies capable of growing dividends (ie. growing earnings) aren’t better than those with static earnings on the same PE ratio. Problem is zero or very low payout ratios aren’t much help in paying for this week’s groceries or the next quarterly electricity bill. Of course one could sell off some shares, may not be a bad idea considering the CGT 50% discount anomaly, but you’ve then reduced your equity in the company.
One also has to consider the effect of dividend reinvestment schemes. I doubt the headline payout ratios take this into account.
Roger Montgomery
:
There’s a great explanation of this the benefits of selling shares. You can end up with a smaller stake in the company but one that is worth a whole lot more and you generate higher ‘income’.