Why we’ve changed our line on Telstra
As many readers have noted, our view of Telstra has changed quite markedly of late. The reason is simple: back in February 2015, the share price was around $6.50 and we were convinced it was unsustainably high. Now, after plummeting to $2.60, we think it’s time to re-think our position.
Share prices change and investment returns are driven by the price you pay. The higher the price you pay, the lower your return. The lower the price you pay, the higher your return – all else being equal. While share prices reflect fundamental factors in the long run, they reflect sentiment in the short run. In the past, sentiment towards Telstra bordered on unbridled enthusiasm. Today, it could be the reverse – only time will tell.
To clarify our change in view, as reflected in our most recent blog posts about Telstra, it might be worth revisiting what we said about Telstra back on 21 February 2015 with the share price 138 per cent higher than where it is today. That way you can compare and see what has changed.
Here’s what we wrote about Telstra in The Australian.
“DIVIDENDS … it seems pre-retiree baby boomers can’t get enough of them. With interest rates shrinking to sub-inflation levels, a millionaire now earns less in interest on cash than the poverty line.
“In contrast, when franking credits on dividends are taken into account, the yield on offer from some of Australia’s largest corporates looks like a no-brainer. If a business like Telstra can deliver a gross yield of close to 6.5 per cent (that is 6.5 per cent returns after tax credits are included to the investor) and there’s no reason to think its earnings are at risk of decline, why on earth would anyone in their right mind choose to leave money in cash earning less than half that?
“Well, for one I would. Let me explain why.
“When you own an appreciating, dividend-paying share for a period of time, your return has two components — the dividend yield and the capital gain. Over long periods of time, the dividend yield (excluding franking credits) tends to average somewhere near 4.5 per cent and the capital gain tends to be about 6 per cent, for a total return of around 10.5 per cent.
Excluding franking credits, Telstra offers a yield in line with that long-term market average, so if the capital gain on Telstra shares works out in line with long-run averages then the total return from today would be, hypothetically of course, somewhere close to 10.5 per cent. As well as a yield that beats cash by a handy margin, investors would enjoy a significant annual average capital gain.
“Unfortunately, averages can be dangerous things in the equity market, and on my analysis, Telstra is a far from average investment.
“Firstly, let’s consider growth. Earnings growth is the driver of that 6 per cent per annum capital gain mentioned above. Most companies achieve this growth by retaining some of their profits each year, and reinvesting them in expanding the firm’s asset base. This means that the dividend is smaller than it could have been, but shareholders are compensated by the future growth delivered via the reinvested profit.
“Telstra is a little different. It tends to pay out pretty much all of its earnings as dividends, and retains very little to reinvest in growth. This is not necessarily a bad thing — it may be that given Telstra’s size it has few opportunities left to reinvest — but it does mean two things:
- Telstra’s dividend is higher than it would be if the business were investing for growth; and
- Telstra hasn’t really grown very much.
“While it has delivered some improvements in operating performance in recent periods, over longer timeframes the growth story is unimpressive. Indeed, its current earnings are not far from where they were a decade ago.
“What this means is that Telstra probably doesn’t have the driver that fuels long-term capital growth — the 6 per cent per annum figure mentioned above may just remain hypothetical.
“But wait, you say. Telstra shares have rallied from below $3 in 2011, to more than $6.50 recently. Clearly, investors have enjoyed bucket loads of capital growth making Telstra shares a spectacular investment.
“And it’s true: Telstra’s shares have soared in recent years. Investors have done extremely well.
“However, when share prices rise strongly in the absence of corresponding earnings growth, it usually means one of two things:
- Either the shares were too cheap to begin with, and the market has merely adjusted them to the correct level; or
- They were not too cheap to begin with, and the market has now pushed the price well above intrinsic value.
“In the case of Telstra, it looks very much like the latter. More specifically, it looks like yield-hungry investors might have bought Telstra for its dividend in recent years, and turned a blind eye to the underlying value.
“The higher the shares rise presently, the more hypothetical a future 6 per cent capital gain becomes. In the long run, share prices tend to find their way back towards intrinsic value. That means that an investor buying Telstra today needs to consider that instead of that average 6 per cent per annum capital growth, they might experience something closer to zero. Or less than zero and possibly even a negative number that wipes out the positive return from dividends.
“And when that happens the fully franked dividend yield will not provide much comfort.”
The Montgomery Funds own shares in Telstra. This article was prepared 10 July 2018 with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade Telstra should seek financial advice.