Banking on yields

PORTFOLIO POINT: In a low-growth environment, it is dividends that may well generate most of an equity investment return.

A comforting aspect of investing in listed hybrid and corporate debt securities is that investors do not have to put up with “high frequency” traders or consider the pricing of so called “dark pools”.

The quoted bids and offers for these securities generally indicate the true market price. Volatility caused by hedge fund activity is generally not a feature of these markets, as traders do not borrow securities to short them to unsuspecting purchasers.

Where there is volatility, it generally occurs because of Reserve Bank of Australia decisions or after a particular security goes “ex distribution”. In this later case a security may take a few weeks to find its new base. During this short period, alert investors may be able to pick up some cheap securities – but they will have to wait a while for their next distribution.

More recently we noted an increase in price volatility caused by futures markets that speculated on a succession of interest rate cuts by the RBA over the next six to nine months. A fall in forward bill markets can affect the yields on floating perpetual hybrids. This speculation has been tempered in recent weeks as the Australian economy appears to have steadied and the RBA noted a level of comfort with current settings in its recent meeting notes.

On review of our income portfolio, since both inception and more recently June 30, we can see a fairly steady return developing. The hybrid securities and debt securities have settled nicely and the portfolio has benefitted from a re-rating of the high-yielding equities. This re-rating reflects a market that has lost its obsession with growth and that has reassessed the true value of income. The questions to be considered by investors in this environment when considering the various securities include:
· Is the security offering a fixed or floating income flow to the owner?
· Is the security offering the potential for a growing income stream? and
· Is the income secure and what is the risk associated with the issuer?

In this fortnightly review I do attempt to keep readers informed of changes in the market (for example, bill rates or RBA decisions) or of company announcements, which will impact upon the value of the securities in the portfolio. However, we must remember that value and price are different concepts. The recent desire of many investors to focus on yield returns rather than potential capital gain from “so-called” growth equities is a factor that influences market price rather than investment value.

Prices will rise when there are more buyers than sellers at a given price level. If those buyers are rational (and this is not always the case) then the price will move quickly to fair value. Where speculators or traders react to price movements, independent of valuation movements, then prices will be affected by herd mentality or sentiment shifts among other obscure reasons. This is what makes markets so intriguing to watch and to be engaged in.

In this context the recent rally in the share prices of leading bank shares and Telstra (in our income portfolio) needs to be reviewed so that we can reflect upon what may be causing these moves. Is it a mad rush for yield or a sober reassessment of true value?

My valuations have continually assessed the value of both CBA and Westpac at above the current price levels. The recent rallies are justified by my valuations; however there appears to be more potential capital gain in the Westpac share price with CBA having a near-term potential to carry its next dividend (due in September). In my view investors are realising that in a low-growth environment, it is dividends that may well generate most of an equity investment return. Indeed this low-growth economic environment for Australian companies is becoming tortuous due to an inflated $A.

The above analysis may seem simple but for a long period Australian investors tended to overpay for short-term growth and to speculate on price moves unsupported by income flows. That was certainly the situation prior to the GFC and the sustained period of share price appreciation prior to 2008 bred complacency plus unreal expectations of capital gain. It appears to have taken four tough years to bring a more sober approach to mainstream investing.

Right now the banks seem set to deliver low profit growth as credit creation slows. However, low growth and well capitalised balance sheets suggest that they have sustainable franked dividends. Further, should their earnings and dividends only grow by 5% per annum over the next three to five years then dividends would be 20% to 30% higher than they are today. It is funny that now low single digit earnings growth is acceptable!

Similarly, Telstra attracts with a similar outlook. However, unlike the banks it appears that it has limited dividend growth potential unless the government’s National Broadband Network cash compensation payments flow quickly to reduce the company’s debt and therefore its interest burden. The Telstra share price is less supported by its growth outlook and is rather supported by its yield, which does not offer the growth that the banks do.

So on the analysis and valuations of the banks below we retain solid holders of both CBA and WBC in our income portfolio. I refer readers to my Eureka Report analysis of TLS of May 11, 2012. With a low-growth outlook then a share price of $4 ex the next dividend would represent full value without any new information. At that point we may have to adjust our income portfolio.

CBA and WBC price to value forecast charts

For interest I have identified a range of high yielding companies based on market consensus forecasts for 2012/13. These companies are highlighted because they rank highly in MyClime’s CQR (Clime Quality Rating).

The Income Portfolio

Start Value: $120,000.00
Current Value: $122,841.53

-Hybrids/Pseudo Debt Securities
Company	ASX	Market Price ($)	Margin over BBSW (%)	Running Yield (%)	Franking (%)	Total Return (%)
ANZ Note	ANZHA	100.85	2.75	6.22	0	0.20
Multiplex SITES	MXUPA	75.20	3.90	9.87	0	2.88
Australand ASSETS	AAZPB	89.95	4.80	9.25	0	1.03
Macquarie Group Floating Rate Note	MBLHB	64.35	1.70	8.11	0	8.96
NAB Floating Rate Note	NABHA	70.15	1.25	6.80	0	2.01
Seven Group TELYS4	SVWPA	80.00	4.75	10.33	100	2.27
Woolworths Notes II	WOWHC	104.00	3.25	6.51	0	0.38
Ramsay Health Care CARES	RHCPA	103.80	4.85	8.05	100	2.56

-High-Yielding Equities
Company	ASX	Market Price ($)	Dividend ($)	GUDY (%)	Franking (%)	Total Return (%)
Telstra Corp	TLS	3.94	0.28	10.15	100	7.12
Ardent Leisure Group	AAD	1.28	0.12	9.41	0.00	0.00
Commonwealth Bank	CBA	55.90	3.46	8.84	100	5.42
Westpac Banking Corp	WBC	22.95	1.72	10.71	100	8.03
	a
			Average	8.69	Weighted	3.44
			Yield		Portfolio Return

John Abernethy is the chief investment officer at Clime Investment Management. Use MyClime to identify high yielding equities to enhance income returns for your portfolio.

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