Yield field has some dark horses

What a privilege it was to conduct a webcast with Eureka Report Managing Editor James Kirby and readers for just on an hour yesterday. We had almost 2,000 registered, and the range of questions was fascinating. It certainly sent me thinking in many different directions, and so today I want to devote my commentary to that webcast. You can view the full webcast by clicking on the video image above.

A number of surprises came to me in the questions from different Eureka readers. One was, why does BHP pay so little of its profit out in dividends? The Eureka reader would like BHP to be more like banks. The answer is it reinvests more of its profits back in the business, and that has been the BHP pattern for generations. Banks require far less investment. But what we have seen with fellow miner Rio Tinto is that the board and management have lost the reinvested money, and BHP had a close shave. So I think BHP is now going to have to justify the detail of any new expansion to its shareholders on a much more professional basis than it has so far done. The same applies to other miners.

But can banks continue to pay the level of dividends that has boosted their share prices? In the short term there is no doubt they can. No big variations in profits are likely in the next year or two and so the dividends look safe. Longer term the Australian banks will need to grow their profits to maintain dividends, because like all enterprises they will need to reinvest in the business.

Each of the banks is in a different situation. ANZ is thrusting into Asia and that will take funds. NAB is looking to exit the UK, which will require write-downs. But it will also release capital. UK nervousness is a factor boosting NAB's yield, but I would be very surprised if it affected the dividend. The Commonwealth is the largest and strongest, and has attracted most of the extra capital going into bank shares. But it is also the most expensive big bank in the world. Westpac is also in a strong position. I think bank shares are a part of most people’s portfolios and they’ve served Australians very well. There will only be a major problem if there is a lot more competition, which lowers the margins, or there is some catastrophic event that affects the price of Australian houses and/or business activity resulting in big write-downs. There is nothing on the domestic horizon to create such a catastrophic event.

Telstra is also a company that has risen on yield. In Tony Abbott’s latest manifestos, he mentions dramatic changes in the National Broadband Network investment on countless occasions. That means that if he wins the election he will try and re-negotiate the Telstra deal. That deal locks in substantial revenue to Telstra over an extended period as it basically cashes out its copper network. David Thodey will play hardball in any negotiation. He has done a deal with the sovereign government that was constructed to make it difficult to unscramble. Nevertheless, in the end Thodey will attempt to reach an agreement with the government if Tony Abbott wins. Telstra’s underlying strength is its enormous penetration in the mobile market and the fact that Vodafone’s difficulties have enabled Telstra to get a dominant share. This is going to be a growth business, but it will require funds. That’s why the NBN agreement was so useful because it enabled the company to continue a high distribution policy and yet have money to reinvest in the business.

One of the facts that worries me about the market at present is that two of our biggest investment companies, Australian Foundation Investment Company and Argo Investments, are selling above their asset backing. I talked about this last week (Profit season may rain on your returns), and it does mean that investors need to think about other means of equity investing including exchange-traded funds and indexed funds. When Argo and Australian Foundation were selling below their asset backing they were wonderful equity investment vehicles. There are still a number of investment companies that are selling at a discount, and the one I have bought some stock in is Whitfield, which does not have any mining stocks.

When it comes to health care there has been strong support in the market for health care stocks, and with justification. This is because the demand for services is going to increase. But longer term, hospital groups like Ramsay are going to need to modernise their hospital computer technology to increase service and lower costs. And that will take capital. Over time they will increase their returns, as it is a business sector where demand is rising all the time.

Finally, a word about hybrids – they go under different names including preference securities notes and income securities. Hybrids are valuable income stocks. They have very complex trust deeds but, in essence, they are secured on the dividend of the company involved. In other words, a bank must meet its hybrid obligations before paying an ordinary share dividend. But, in most instances, if a company cannot pay an ordinary dividend it will not meet hybrid obligations. And it does not have to. That’s exactly what happened to Elders hybrids because it received no income for many years. It would take a major event for bank dividends to be put in jeopardy, so I think the hybrids are safe, but they should only be part of an overall portfolio. Remember that as a hybrid holder you have no participation in the upside, but if something seriously bad happens then you participate on the downside. That is why I am reluctant to support hybrids in insurance companies or even industrial companies, because if they get into trouble it is the hybrid holder that will suffer and yet they have no share of the upside.

Bank deposits, which have been a fantastic avenue for superannuation investment, are now not as attractive and I am not that interested in investing long-term superannuation money at under 5%. But NAB’s Ubank stands above all banks for one-year deposits by offering 4.7%, while longer term Rabo is clearly the best with a 5% rate for five years. But other banks will also offer close to 5% if you press them hard. Longer-term money is very attractive to banks.