Summary: Capital management and a rising dividend payout ratio have been the central themes this reporting season, with the amount of cash distributed to shareholders reaching the national debate for the first time. Investors face a market offering negligible capital growth and an average 5% dividend yield for an ordinary one-year total potential return of 5.8%. This makes the All Ordinaries, at current levels, a yield market.
Key take-out: Very few investment grade companies are undervalued enough to buy right now. In such an environment, investors must rely on precision stock screening, patience and the ability to act quickly when adequate margins of safety (discounts to value) open up.
Key beneficiaries: General investors. Category: Shares.
As the August 2014 reporting season draws to a close, investors turn their attention to the year ahead. One thing we know for sure right now is that our All Ordinaries at current levels is primarily a yield market.
In our system (StocksInValue) the number of companies in value, or close to value, stands at 69 at the time of writing. Nine of these have poor financial health, competitive advantages or industry economics, and are therefore unattractive. The 69 figure is an intermediate number reflecting the market’s mild overvaluation. In a bear market hundreds of companies would be in value; at the top of a bull market perhaps 30-40 companies would be in value.
It is normal, outside bear markets, for there to be only a small number of investment-grade companies sufficiently undervalued to buy and own, but right now there are particularly few. Part of the explanation is the small market capitalisation of quality companies relative to the weight of superannuation money seeking quality and value. The Australian equity market is long funding and short quality assets. The answers to this investment problem include precision stock screening, patience and the ability to act quickly when adequate margins of safety (discounts to value) open up.
To generate more value we also need an increase in equity market volatility from current historic lows.
Capital management – and the market’s expectations regarding it – were central themes this reporting season. BHP shares sold off 4% after expectations for a larger dividend and/or a buyback were not met. We are positive on the demerger; the selloff indicates the degree of market disappointment with the lack of a capital management sweetener now. BHP did not quite achieve our expected net debt position at the full year and the expected capital management is now likely pushed back six months and will be subject to commodity prices and currency fluctuations.
Goldman Sachs put some parameters on the historic increase in dividend payout ratios and the resulting fall in reinvestment rates. The broker said the average Australian industrial company, over the decade before the financial crisis, reinvested 70% of free cashflow back into the business and returned 30% in dividends. Today that ratio is closer to 50%.
StocksInValue has long argued the split of earnings between dividends and reinvestment is crucial to intrinsic value, earnings and dividend growth. In contrast to the popular discounted cashflow valuation model, where capital management and its consequences for value can be less transparent, our return on equity model explicitly models the effects of changes in the dividend and reinvested proportions of profitability. Our subscribers are well aware lower reinvestment rates generally mean higher dividends now but have the tradeoff of slower growth in future dividends.
For perhaps the first time the dividend-reinvested split for the equity market as a whole entered the national debate this reporting season. Reserve Bank Governor Glenn Stevens expressed frustration at the declining corporate reinvestment rate, which is delaying the needed recovery in non-mining investment and employment. The governor said “…many businesses remain intent on sustaining a flow of dividends and returning capital to shareholders and are somewhat less focused on implementing plans for growth [which] remain hostage to uncertainty about the future pace of demand.”
The RBA board’s minutes of the August monetary policy meeting note that firms are reluctant to undertake significant investment projects until they experience sustained strong demand. This indicates the economy remains patchy and discouraging for firms two years after the end of the second stage (European sovereign debt contagion and bank bailouts) of the global financial crisis. We would argue the elevated Australian dollar, which has not depreciated despite the historically low cash rate, is part of this problem.
Deputy RBA Governor Philip Lowe commented “Culture is important here. Our society is becoming too risk averse…we are not paying enough attention to return and we are paying too much attention to risk.” We would argue the deputy governor’s comments are too general. In the real economy businesses might be averse to increasing investment and employment but in the financial markets investors are compressing, not widening, risk premiums by betting on ongoing cheap money and quantitative easing (QE) by offshore central banks. The geopolitical risks of the present day have not triggered a spike in precious metals, as one might expect, because other asset prices are supported by central banks.
A strong theme in the minutes from the August RBA meeting was historically low volatility in equity and foreign exchange markets. A telling reference was to the S&P 500 index, which only in mid-July ended its longest run of daily movements of less than 1% in nearly 20 years. No one knows how financial markets will respond to the end of QE in the US and the start of normalisation of the Federal funds rate (FFR). We can say there is no discount in markets for a disruptive rise in the FFR off its lows.
The other pressure on company boards is from yield-seeking investors forced into equities by low or negative real yields on traditional sources of retirement income like term deposits. Every week there are signs of the desperation for yield. One was the expensive pricing of Commonwealth Bank’s PERLS VII issue (see Rosemary Steinfort’s Why CBA’s PERLS VII isn’t a pealer), in which the 280 basis point premium of the 5.45% yield to the benchmark 90-day bank bill rate was the lowest of any new bank hybrid since the GFC began in 2008. Woodside Petroleum (WPL) shares rose to three-year highs on a hefty 33% hike in the interim dividend despite the outlook for falling earnings in 2014-15, flat earnings in 2015-16 and the stock’s overvaluation.
WPL’s declining NROE (red), consensus dividend (blue) and flat earnings (black) profiles
Large corporates, especially miners, are in a cycle of cost savings and capital expenditure directed at productivity gains where the net benefit is higher margins and improved dividends for shareholders. The companies investing for growth tend to be doing so overseas, like Seek (SEK), Domino’s Pizza (DMP) and Ramsay Health Care (RHC). Few large companies announced major new investments this reporting season. The lack of international growth plays on the ASX is reflected in the scarcity premiums in the share prices of stocks like Domino’s and Ramsay. Domino’s trades on a rich equity multiple of 8.6 times and more than twice its intrinsic value.
None of this is to say companies should invest capital in sub-economic projects and acquisitions. Of course we prefer the return of capital if companies cannot earn risk-adjusted returns greater than their shareholders could earn elsewhere with the same capital. Our points are investors’ expectations of value growth in ASX equities need to be realistic, and investors should not overpay for the modest growth generally available.
Clime Asset Management owns shares in BHP.
David Walker owns shares in BHP and WPL.