Telstra, CBA and the changing times

Summary: The situations at Telstra and Commonwealth Bank could carry implications beyond the company, or even sectoral, level. Global investors have long chased income stocks like Telstra and Commonwealth Bank over growth stocks, but the tables could soon turn. 

Key take-out: Investors might observe we could be in the early stages of a transition away from income stocks to growth stocks. There are few large cap growth stocks on the ASX right now, with more of these opportunities found in middle-ranking or smaller companies. 

In the days that followed my commentary on Telstra and its potential for growth I have been pondering the wider implications of the Telstra situation. 

I think it is a signal that we are in the very early stages of a swing from income to growth. 

In the last 50 years, there have been very few periods when vast volumes of capital have been directed into the share market for income rather than growth. The movement is understandable given the very low interest rates being offered by banks and other lenders. Nevertheless, I think that we are coming towards the close of this era. 

And, as I was thinking about this longer-term possibility, I came across commentary from a global trader, Sean Fenton, who operates a hedge fund that likes to go short and go long – a true big speculator. He highlighted that, right now, marginal dollars are flying into the share market chasing yield. Accordingly, growth is out of fashion.  

At some time in the next year or two US interest rates will rise and that will accelerate if President Donald Trump succeeds in his plan for major tax cuts. But even without those tax cuts, the US economy is moving ahead and there is a similar trend in Europe where we are also likely to see higher interest rates. And so, at some time in the next couple of years, there will be a significant fall in bond prices and with that fall there will also be a decline in income equity investments.

The money rushing into income shares has only one place to go – growth stocks. Most of the growth isn't in the ASX 20, but in the middle-ranking or smaller companies which are harder to find and often carry higher risk. Nevertheless, this will form an important part of long-term investment strategies going forward.  

I don't think there is any urgency, particularly in Australia, given weak retail spending (largely because of stagnant private sector salaries and the higher cost of energy). But we will not be immune to the rises in global interest rates. Poor consumer demand can make companies more reluctant to invest.

The issues at Commonwealth Bank

On that note, let's draw attention to some of the remarkable conclusions from investment bank UBS about Commonwealth Bank. Like many others, including myself, UBS is nervous about CBA shares because they simply don't know what will become of the money laundering and terror financing allegations.

UBS was unique in focusing on the terms of reference in the APRA enquiry. As UBS pointed out, APRA will be focusing on whether any areas – including “financial objectives” – conflict with “sound risk management and compliance outcomes”.

CBA has never announced its internal financial objectives, but it is no secret that it aims at a return on equity of around 16-17 per cent. It's a similar target for most other banks. UBS asks whether a 16-17 per cent rate is consistent with “sound risk management” and “compliance outcomes” in an era of very low interest rates, around 2 per cent, and a market-implied 9 per cent cost of capital.  

It is possible the APRA panel will find these financial targets are not consistent with “sound risk management and compliance outcomes”. This is because, to obtain such a high return on equity when interest rates are so low, this would typically require more risk-taking. And if APRA focuses on this high rate of return required by banks, led by CBA, that could have an enormous implication on the profitability of banking in Australia. 

The focus on returns

But let's take a step back. Companies all around Australia are looking for returns of around 15 per cent on new investments. That was a perfectly satisfactory rate of return when borrowing was around, say, 7 or 8 per cent. Borrowing interest rates are now much lower though, and some companies don't seem to have lowered their expected rates of return in keeping with this.  

Indeed, a great number of executive bonuses are tied to high rates of returns, so companies are finding it difficult to achieve these high rates on new investments particularly if competition is severe. So, they don't make the investment and they build up their cash reserves and are therefore able to pay very high dividends. But it is questionable that companies should be looking for such high rates of return when interest rates are so low. 

The property market has adjusted to this but not the corporate investment market.  

If APRA takes CBA to task over its requirement to achieve such high rates it will cause a debate on satisfactory rates of return over a much wider area. Growth may return to prominence. If that happens, it will certainly stimulate the economy.  

Meanwhile it is fascinating to see the once great AMP swinging more of its investment management towards the index. That way it will reduce costs and be able to offer a low-cost product.

In theory, it's not a bad idea, particularly because too many investment managers charge high fees to be not much more than index-based managers. They base their portfolios on the index and then go underweight or overweight. That sort of management should not carry big fees.

But investment managers that go out and select great growth stocks that are not in the ASX 20 should be well paid – if they win.

The AMP move does underline just how tied investment has become to the index, which tends to push some of our largest stocks higher than they should go.