Urgent! We need earnings growth

This week I am going to show my age and relate to you a lesson I learned from a stockbroker in my early years of financial journalism. And then I will take that lesson a step further into a dangerous equity situation we face in 2014 – a predicament that the old time stockbroker would never have envisaged. 

The lesson from the stockbroker in the early 1960s was that when you are investing in debt/interest bearing securities, make sure that the group you are investing in can repay the money.

Even though you may be wooed by returns 1%, 2% or 3% higher than market interest rates, when you invest in debt securities you do not share in any of the equity upside. And so if you make a mistake you could lose all your money but if the company does well your rewards are small in relation to the risk you were taking.

We are now in a period of very low interest rates and all interest bearing investors are searching for ways to increase their yield to 4%, 5%, 6%, and 7%. There is nothing wrong with that but if you are taking very big risks with your principal then the small amount of extra interest is simply not worth it. 

In the 1960s we had groups like Reid Murray and the Korman Group raising vast sums in interest bearing deposits from investors. The public losses were heavy. Cambridge and other crashes followed later, which ultimately created a much stricter environment in issuing debt securities to the public. But the stockbroker’s lesson remains – be careful of high-risk debt securities and understand they may come in many guises.

We recently saw the Commonwealth Bank hybrid go to a small discount because although the Commonwealth Bank is a fantastic organisation it was issuing second grade securities. Frankly I am not that worried about Commonwealth Bank hybrids. I am much more worried about debt securities that creep into the market from much less stable companies. (To read more on hybrids, see Steven Wright's article Bank hybrids: A reality check.)

The market is telling us that in 2016 we are going to see a considerable rise in US interest rates and that will flow on to Australia unless our dollar falls very sharply. Westpac chief economist Bill Evans (who was one of very few economists to predict big falls in interest rates that would come to Australia and the world) is now predicting that the official Reserve Bank cash rate will reach 4 per cent by the end of 2016 and the rise will come from higher American rates. Even if Evans’ prediction is too high, it is likely that if American rates rise there will be some relief from the punishingly low rates local depositors have suffered.

And so if you are investing in shorter term interest bearing securities, consider ensuring security and a lower rate rather than choosing high-risk returns.

I am very much afraid that the Americans have made exactly this mistake. We are now getting reports from the US that there has been a huge increase in dubious loans. The latest securities markets risk outlook issued by the International Organisation of Securities Commissions (IOSCO) says that this year high-yield American bond issues will reach an historic high of $US617 billion. Subordinated bond issues will be close to pre-crisis levels at about $US297 billion. So-called covenant-lite issues will be about $US177 billion and issues of “payment-in-kind” debt (“repaying” debt by issuing more debt) and contingent capital have also increased to levels well ahead of those experienced pre-crisis.

High leveraged lending has also returned to pre-crisis highs, with about $US1.8 trillion originated this year. Margin debt in the US hit a record $US1.4 trillion in the first quarter of 2014. Leveraged financing via junk bond markets is also at pre-crisis levels of about $US119 billion this year.

When US interest rates rise a lot more pressure will be put on these securities. The simple fact is the legislatures did not purge Wall Street of the bonus-motivated investment bankers who are incentivised to create suspect securities and usually make sure they leave the enterprise, cash in hand, before the risks they have taken turn nasty.

The yield trap that is endangering many investors in the current environment is of course not new and we are merely repeating what has happened many times before. What is new in Australian equity investing is the fact that the lower interest rates have pushed a vast number of people who would have otherwise relied on bank deposits into the share market to gain their returns via yield. This has happened right across the board with individual investors, self-managed funds and the big professional funds. 

And this process of course has been greatly enhanced by franking credits. When Paul Keating originally allowed franking credits it was envisaged that companies who wanted to expand would raise capital from their shareholders. But that is not happening. Instead, companies have now lifted their dividends to levels that are beginning to harm businesses. (To read more on the hidden power of franking credits on the overall market see Scott Francis' article PE ratios: The missing link.)

Boston Consulting Group’s latest annual Australian Value Creators Report shows Australian businesses paid out almost twice as much in dividends (as a percentage of earnings) as global peers in FY14, despite falling further behind in growth in earnings per share.

The consultancy group says that investors were demanding higher dividend yields on equities and rewarding companies with higher valuations for returning capital to shareholders.

“But climbing dividend payout ratios cannot be sustained for long, and only postpone an inevitable crunch ... The growth-versus-dividend debate in Australia has lost sight of the fact that growth is a prerequisite of sustain­able dividend increases. Even the Governor of the Reserve Bank Glenn Stevens recently expressed his frustrations at the lack of investment in growth,” Boston Consulting says.

In my view enterprises from the smallest to the largest need to use some of their profits to keep up with the marketplace and if they pay out dividends at too high a level for too long a period they endanger the position of the enterprise in the market.

We are entering a period of unprecedented changes as the new waves of internet development transform the way everybody from consumers to small and large businesses work. Enterprises need to adapt and that adaptation needs investment. 

But the required investment is not taking place because, at least in the top 200 companies, directors are frightened to endanger their dividends. They know that if they do, their share price will be sacrificed and there may be wholesale retrenchment of top executives and board members.

We are seeing private equity companies that don’t have the same pressures looking to buy companies that need investment, where the public shareholders are not prepared to make it. 

We are also seeing companies that disappoint the market absolutely trashed and all these things make directors nervous. 

In the small business arena, very often banks don’t have the experience to evaluate smaller scaled operations and are nervous about losses because of the effect it might have on bank dividends. And so we have a development in the share market a few of us predicted which has added to the risks created by this period of low interest rates. At some point we are going to need directors who are prepared to communicate with smaller shareholders to promote to them the growth story rather than the dividend increase story.