Summary: The feverish demand for high-yield shares could decline if bond yields continue to rise. Keep an eye on the bond market for future direction of these “bond substitutes”.
|Key take-out: New investors, and those investing new money, need to be extra cautious buying into high dividend companies, including banks. Catching dividend fever late could mean one day the extra income earned could be given up in a larger-than-average price fall.|
|Key beneficiaries: General investors. Category: Asset allocation.|
One of the simplest ways for companies to communicate their financial wellbeing to you is to say “the dividend cheque is in the (e)mail.”
Even John D Rockfeller is known to have said: “The only thing that gives me pleasure is to see my dividend coming in”. So it is no surprise that high dividend paying companies are highly sought after investments, especially in a low interest rate and low-growth world. Here I would like to ask the question: is it possible these companies have become too popular and hence too expensive? And, if so, what might be the trigger for prices to stall?
As an aficionado of long-term data, the following chart impressed me. It compares the price/earnings ratio of the top 20% dividend paying companies in the US S&P500 index (green line), and the subset of consumer staples, telecom and utility stocks (brown line), divided by the price/earnings ratio of all companies in the market, for the last 60 years. It shows that for the first 55 of these 60 years high dividend companies traded at a 20-30% price discount to the broader market.
This might be expected because companies that pay out most of their profits as dividends aren’t reinvesting and aren’t expected to grow as much – so why pay a premium for them? Perhaps during recessions there can be a short spike in demand, which is what the grey vertical bands are looking for. High dividend stocks are just now selling at the market average, and the subset of consumer staples (US equivalents to Woolworths), telecoms (US equivalents to Telstra) and utilities (equivalents say to SP AusNet), are trading at a 20% premium. This is at least a 20% to 40% price rise to their long-term value.
Australia, your high-yield bias is showing
In Australia, we too suffer from “Dividend Fever”.
You can see this in the chart below that compares the total return (income plus growth) from Vanguard’s Australian Shares index fund with its Australian Shares High Yield fund over the last 10 years to the end of July 2013. The Australian Shares index fund (shown in green) broadly represents the returns from the top 300 stocks traded on the local ASX including REITs, and the latter (shown in blue) is a biased mix of above-average dividend paying stocks – the top 10 holdings including Telstra, utility/infrastructure stocks Sydney Airport and APA Group, and the big four banks.
The total returns from these funds are similar except for the last two years. As expected, the high-yield fund over these 10 years paid out 14% more pre-franking-credit income, delivering an annual 4.8% income return versus 4.2% for the broader market. However, for the first eight years it underperformed the broader market by about 1% annually, counting also the growth return. This was because of lower resource company exposure and those companies’ higher capital appreciation. However, in the last two years this mix of high dividend paying companies returned 4.5% and 6% more (only 0.5% of that due to higher yield). This time it’s because of less resource company exposure, but mostly it’s because of high dividend stock and bank “appreciation”.
You can see this also at the individual stock level. Telstra and Commonwealth Bank, for instance, are two of the most loved high dividend paying stocks, paying out 90% and 75% of profits, respectively.
In fact, Australian listed companies are paying out a near record 70% of profits – compared to an about 60% average over the last 40 years (minimum 40%, maximum 72% since 1974). To explain this you have to surmise that CEOs and CFOs have run out of investment ideas to grow their businesses, or they have found a way to grow their share price and bonus by appealing to dividend fevered investors.
Maybe this isn’t such a bad thing, as you may recall many resource company investors wished BHP and Rio Tinto paid out more profits in the commodity price boom rather than invest in growing capacity or acquisitions.
The concern I have is that recent investors in high dividend paying companies might see their extra income earned (compared with lower yielding stocks or deposits) later eliminated by above average capital losses when dividend fever abates. As in all sharemarket rallies, it is often the least experienced investors who arrive late to a rally that suffer the most (recall tech stocks, REITs, resource stocks, tulips and railroads).
High dividend stocks and the market P/E is reasonable for a prolonged low interest rate and low growth environment like we have today. This means a reduction in price premium shouldn’t happen for a while, but be careful as it could happen sooner than you think or can act!
Keep an eye on the bond market
A trigger for a reduction in interest in high dividend paying companies could come from the bond market – which is where all this started.
Investors worldwide have been searching for “bond substitutes”, with bond yields depressed to unusually low levels through central bank interest rate manipulation and bond buying – funded by printed money that drives bond prices up and yields down.
Struggling to make their retirement income numbers work (see Prepare for modest medium-term growth) investors have responded logically by taking on more risk and preferentially buying assets that pay bond-like income with lower-than-average market risk. Companies that fit this brief are in the otherwise boring business of selling consumer staples like groceries, telecoms and utilities. They also include real estate investment trusts.
With talk of tapering, or reducing the rate of “quantitative easing” (electronic money printing for bond buying), the bond market is anticipating bond prices to fall (yields rise) and just recently it decided to not wait for that to happen. Bonds have been sold off such that their yield has now risen dramatically, even before tapering has happened or even been clarified. In May the benchmark 10-year US Treasury bond yield was a record low 1.6%. Now, it is within 0.01% of 3%.
US investors were clearly dumb (and sadly for many pension fund investors, institutionally mandated) to lend their money to the US Government for 10 years and only earn 1.6%. Maybe they aren’t so dumb now, doing so with new money earning 3%?
This near doubling of yield is a more reasonable reward compared with deposit rates of nil. More importantly, maybe now this is a more reasonable reward compared to the current 2% dividend yield of the US sharemarket, or 3% for high dividend stocks (based on yields of Blackrock US EUSA and HDV ETFs) with much less capital price insecurity.
In summary, as bond yields rise and recover to more fair value the need for bond substitutes declines, which would slow the rally in or could precipitate a sell-off in the overpriced subset of high-yielding shares.
In Australia the 10-year bond yield has risen more modestly, but still dramatically in bond terms, moving from 3% to 4% yield. This also pushed up the yields of better value, higher returning lower credit rated state government, bank and other corporate bonds. Likewise, this should reduce local demand for bond substitutes, and more so if yields continue to rise. Fixed-rate/fixed-term bonds (and funds) are becoming better value now. Perhaps central banks are losing control of the cost of money to the benefit of lenders, but to the worry of the great indebted.
Unfortunately term deposit investors shouldn’t expect to enjoy an increase in income as their rate is more closely driven by the Reserve Bank of Australia. However, they can still take comfort that a humble term deposit anomalously yields more than 1% above the cash rate.
So if you have been investing for a while, then by all means feast on your dividends. Remember that this income is far more stable than the share price. In fact, during the GFC dividend income was even more stable than interest rates (see Build your own hybrids), even after companies cut back payments. Yes, with more dividends being paid out from profits now than then, it will be harder for companies to repeat that. However, many companies still enjoy healthy cash flows, which this measure doesn’t exactly capture.
New investors, and those investing new money, need to be extra cautious buying into high dividend companies, including banks. Catching dividend fever late could mean one day the extra income earned could be given up in a larger-than-average price fall. Sadly, some might learn that owning CBA, for example, wasn’t as safe as depositing with them.
As part of any portfolio rebalancing strategy, it may pay you to take some risk off the table; or take profits in relatively over-appreciated high-yield companies and trade them for equity in under-appreciated growth and cyclical companies and sectors.
If you think now is not that time, get ready nevertheless one day to say hello to lower dividend paying energy, materials, industrials and consumer discretionary retailers and especially when you hear “bonds are back!”
Dr Doug Turek is Principal Advisor of family wealth advisory and money management firm Professional Wealth (www.professionalwealth.com.au).