A wise professional investor once said to me: "yield is never a crowded trade". He was responding to my view that Telstra was expensive for a company with lacklustre earnings growth and that investors were crazy buying it just because the yield looked attractive. I thought it was a value trap.
That was in May 2012 when Telstra's shares were trading at $3.60. Today the company is 27 per cent higher and in the meantime has paid shareholders another 28¢ in fully franked dividends. That equates to a total return of almost 35 per cent in less than a year.
During the nine-month period in focus, Telstra's dividend yield has shrunk from 7.7 per cent fully franked to 6.1 per cent. In virtually every phase of sharemarket history new terms are coined and this time around we are talking about "yield compression".
Is yield compression a permanent arrival in our sharemarket or just a response to historically low interest rates? The yield compression believers think a structural change is taking place as an ageing population hunts for as many fully franked dividends in their superannuation funds as possible After all, the population bump of baby boomers ranges from 49 to 67 years of age and they need to fund their retirements.
The army of retirees looking for tax-effective dividends doesn't have only Telstra in its sights. They have clambered after a list of defensive, high-yielding stocks, including the seemingly bulletproof banking sector.
Investors in Commonwealth Bank have enjoyed a total return of 34 per cent in the past nine months, compressing the yield of the company from 6.9 per cent to 5.9 per cent.
We should not be fooled though. Yield compression, where share prices go higher and dividends stay flat, is simply another term for price-to-earnings (PE) expansion. In layman's terms, the sharemarket - the big-yield stocks in particular - is becoming more expensive. Investors should never take a tunnel vision view of stocks. Sure, the dividend yield is critical in the decision to buy or sell a stock, but so is capital gain or loss. We tend to lose sight of the capital side of the equation when the market heads high month after month.
The overall PE of the market has expanded a whopping 30 per cent in just eight months from a lowly 10.5 times to almost 14 times. This is not ridiculously expensive and history tells us the multiple can expand by another 7-10 per cent before we get into dangerous territory. In this current run I would not only expect the PE multiple to expand by another 10 per cent but I also expect we will see overall earnings grow by about 8 per cent. That would push the sharemarket up another 18 per cent from here.
With this backdrop it is important to examine the high-yielding defensive plays. Telstra's one-year forward PE has risen from 9.1 times in early 2011 to 14.5 times today. That is a mighty price for a company generating earnings and revenue growth of about 5 per cent. A 10 per cent move in its PE to 16 times forward earnings would render the stock expensive and increase risk. In this scenario the yield would compress to 5.5 per cent.
The move has been even more pronounced with CBA. The one-year forward PE of Australia's biggest bank hit a nadir of 6.6 times in early 2009, rising to 11.4 times in July 2012 on its way to 14.5 times today. CBA's PE has been higher only twice in the past decade. To look at it another way, CBA's market value is about 2.5 times its book value, compared with a global average of closer to 1.5 times.
Is this movement a structural change or simply a normal cycle? It makes eminent sense to prefer a 6 per cent fully franked yield over a 4 per cent term deposit that will get taxed at your income rate.
I do not believe this is a permanent change. The stockmarket rally since June has been inspired by declining interest rates, forcing people out of term deposits into higher-yielding instruments such as Telstra and the banks. Many will argue that interest rates were coming down well before the sharemarket took off and yield compression took hold. That is true, but as long as a person could get 6.5 per cent for their term deposit they were happy not to take the risk of buying stocks. This opportunity evaporated in 2012.
Interest rates in Australia are unlikely to head north any time soon. But they may well spike late in 2013, causing valuations to change.
After a major sharemarket rally in 1993 Australian bank shares went through a near 30 per cent decline in 1994 as bond prices collapsed and yields jumped. It would be interesting to see who would be happy to pick up their 5.9 per cent fully franked yield as CBA's share price slumps 30 per cent.
The fact is that individual companies carry risks that can't be ignored. Otherwise they would simply be listed bonds.
It would be naive to simply concentrate on yields and ignore other time-honoured measures of value. At some stage yield will become a crowded trade just like every other booming asset class has over the past 500 years.