Yield's the thing

One of the key strategic ideas of the past 12 months is that the price paid for assured fully franked dividend streams would rise, in terms of price/earnings (P/E) multiples.

The idea was based on a combination of unique Australian demographic, taxation, and compulsory superannuation structures. All forms of Australian investing reward tax-effective dividend streams. With both personal income tax rates falling, and the amount of money chasing annuity-style income streams rising, the only likely consequence was that the price paid for assured fully franked dividend streams would rise.

Since the federal budget in May, when we saw wholesale changes to the personal income tax and superannuation contribution system, the price paid for fully franked dividend streams has risen in the equity market almost daily. The following chart shows the relative outperformance of the Financial Index (XFJ) vs. the ASX200 (XJO) since the budget. (The line graph represents financial stocks, the straight line across the bottom represents the ASX 200).

Most market commentators have described the outperformance of fully franked dividend yield streams as "defensive" buying, a view I don't entirely agree with. Dividend yield outperformance has been driven by changes to the domestic tax and superannuation systems, combined with a lowering of total return expectations by institutional investors, where yield now plays a more influential role in projected total returns from a given stock.

It's not "defensive" rotation: it's investors rotating from a "growth at any price” style, which has worked for two years, to a more traditional "growth plus yield" strategy. It's not defensive, it's simply less "offensive". But that is the case for institutional investors. Retail investors are focused on one thing only: tax-effective income streams.

I have believed for many years that there are certain high fully franked yield sectors in Australia that are not priced on traditional P/E or price-to-book measures. I believe that due to the unique structure of the Australian taxation and superannuation system, many stocks are priced off a "grossed-up yield multiple", not a traditional earnings-based multiple.

The grossed up yield multiple

I believe the domestic banks, property trusts, insurers, and telcos remain priced off "grossed-up dividend yield multiples", and are not priced by institutional investors; retail investors price them. How else can you explain the P/E premium that Telstra still commands? If you are an institutional investor, then to get these stocks right you must think and act like a retail investor, because they are the ones pricing them. Sticky retail investors dominate the registers, and they are sticky because the capital gains tax system discourages trading, and encourages "buy and hold" strategies. You must also ignore the vast bulk of analyst commentary on these stocks because the analysts simply don't understand the dynamics driving the pricing.

Every Australian company that offers an assured fully franked dividend stream will trade on a P/E premium to its global peers. The P/E premium is totally driven by the unique characteristics of the Australian taxation and superannuation system. The premium is also driven by the growth of the Australian financial system and the introduction of more sophisticated financial instruments to the average household. Home equity loans, margin lending, and personal lending growth in Australia continue to increase the availability and access to credit of the average Australian. In a bizarre way this financial product growth/ credit growth also drives the earnings and dividends of the bank sector in whose shares many of the products are eventually invested. It's self-fulfilling, with the key being an underlying economy with full employment and income growth.

That access to investing capital, where the interest payments are tax-deductible, is driving the P/E of assured fully franked dividend streams higher and higher. The investors who are driving this re-pricing are not looking at the P/E, which many of you will say is dangerous, they are looking at the prospective grossed-up yield and its certainty of payment. It's about tax-effective negative gearing.

Combine this with an ageing population, which is always looking for annuity style (ungeared) investments for their superannuation funds, and the fact they can now make larger voluntary contributions to those superannuation funds, and you can see why the demand for fully franked dividend streams has never been stronger.

My view remains the companies that present as long-term growth plus tax-effective yield stories in Australia will be the ones that attract the long-term P/E premium. Your P/E premium for growth will not be sustained unless you can deliver a fully franked dividend stream to match the growth.

It's that simple in my mind, and that's why I believe it's crucially important for the resource sector to realise that the best way to head to the elusive market multiple is via paying sustainable fully franked dividend yields. Jubilee Mines has shown you the market will pay 13 times earnings for a mid-cap resource stock, but that's really because they are paying a grossed-up yield multiple of 7%, which is the same as leading banks. Surprise, surprise, Jubilee Mines and the leading banks also trade on the same P/E, yet leading resource companies trade on single digits due to their low grossed-up dividend yields.

This is part of the reason why I am cautious on many high P/E industrial companies. I believe that the Australian taxation and superannuation system are strongly geared in the long term to tax-effective dividend yield growth. It's all good to have a few years of strong earnings-per-share (EPS) growth, and the market will pay up in short-term P/E for that growth, but unless you can use that period of strong headline growth to position yourself as a consistently high dividend payer, then your P/E multiple won't be sustained.

High P/E momentum investing starting to underperform

There is no doubt the stellar performance of Australian equities over the past few years has largely been supported by a corresponding rise in earnings growth. In an environment of low interest rates, strong earnings growth and rising share prices, the easy performance was achieved by supporting an earnings growth and price momentum investment style. In a constantly rising market, chasing price momentum can be very fulfilling, particularly when the majority of broker research is structured to support the same style. However, as Warren Buffett once said: "Every theme starts with strong fundamentals but eventually speculation takes over."

The success of the earnings and price momentum growth style encouraged an increasingly bigger weight of money seeking similar returns. The result was a significant expansion of P/Es at a time of slowing earnings growth '” always a dangerous combination. Despite slower earnings growth, the market P/E expanded from 14.6 times in March to 16.3 times in early May. This was clearly an unsustainable rally, particularly for industrial manufacturing companies. Ultimately it was the expansionary budget in May that subsequently prompted the correction. Although the sell-off was across the breadth of the market, high P/E growth stocks were sold off sharply.

Despite the May correction, over the six months to June 30, "growth" has still outperformed "value" by 6%. However, this outperformance is now starting to unwind extremely quickly. Over the course of the tech boom there was a 10% performance differential of "growth" shares over "value". Following the end the tech boom, the increase in risk-aversion saw "value" significantly outperform "growth". Since 2003 the dramatic outperformance of growth over value has been nearly 13%, significantly higher than the excesses of the tech boom. The unwinding of this outperformance will be spectacular in some high P/E companies. Just look at the performance of Downer EDI this week, with the massive exodus of the quant funds. I've warned before on the dangers of the highly priced contracting/ engineering sectors, particularly those that have fixed priced contracts, and today Downer had to fall 30% before attracting value-based investors.

I think the budget represented the inflection point for the earnings and price momentum style of "growth" investing. This has been dramatically highlighted by the significant outperformance of financials over ASX200 stocks in the above chart. In an environment where earnings uncertainty and interest rates are rising, there has been a clear change in investment style. The savage de-rating at Rinker has clearly confirmed that investors have little appetite for high P/E stocks inflated by unrealistic earnings expectations from analysts writing research for hedge funds and funds-based “quant” or quantitative funds. (Quant funds focus heavily on pure numbers and trading situations). I think stocks such as CSL and the investment banks are at serious risk of similar Rinker-style de-ratings.

In an environment of earnings uncertainty, higher interest rates and rising inflation, I think investors are beginning to focus on more traditional valuation measures. In terms of my strategy, I will be recommending companies based on a "value" approach style to investment. That means low P/E stocks, based on more conservative measures such as "price to cashflow" and "price to book" but more importantly dividend yield. I think fully franked dividend yield growth will be the single most important differentiating factor in stock performance over the next 12 months.