Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 332

Focus on quality yield, not near-term income

It is the subject most share market experts and commentators would rather not talk about: buying cheaply-priced stocks works best when interest rates are higher, economic growth and cycles are relatively robust and there is no mass-disruption eroding barriers of entry and technological innovations.

The current environment is different. Interest rates are exceptionally low, and likely to move lower still. Economic growth the world around post-GFC has never been quite the same, and the overall pace remains low by historical standards. And change caused by innovations.

Cheap companies might stay cheap

The direct result is that corporate throwbacks, missteps and failures are not necessarily temporary in nature, as was mostly the case pre-2012. Cheaply-priced companies might find it hard to sustainably improve their operations and thus catch up with the prolonged bull market in equities.

It is one reason why 80 of small cap and 92% of large cap actively managed funds in Australia, according to a recent sector update by Morgan Stanley, are unable to keep pace with their benchmark, let alone decisively beat it.

There are plenty of examples to choose from. In the health care sector, far and away the best performing in Australia, plenty of funds preferred Healius (ASX:HLS) instead of the much more ‘expensive’ looking Cochlear (ASX:COH), ResMed (ASX:RMD) or CSL (ASX:CSL). Yet it's the ‘cheaper’ one out of these four that has, on balance, hardly performed on a five-year horizon.

Amongst REITs, one of the better-performing segments on the ASX, the likes of Goodman Group (ASX:GMG) have at times become the focus of short-positioning, but the share price consistently moved upwards, at least until the mini-correction in August this year.

Once upon a time, Goodman Group shares were highly sought after by income hungry retirees, but these days the shares only offer circa 2% forward looking. That can serve as an indication of how ‘expensive’ those shares have become.

Income-seeking investors have instead preferenced REITs such as Vicinity Centres (ASX:VCX), which still offers circa 6% yield. On the flip side, Vicinity shares have eroded some -23% since their peak in mid-2016 and have largely trended sideways throughout 2019 when most market indices added near 20%.

Amidst an ongoing tough outlook for industrials in Australia, the increasing number of profit warnings and negative market updates are accompanied by a reduction in the dividend for shareholders. There are predictions of a lower payout by Vicinity Centres in 2020, and, post the recent profit warning, Medibank Private's (ASX:MPL) FY20 dividend might be at risk too.

Cheap stocks might lag for good reason

Probably the most striking examples have come from the banking sector, in particular in Australia, prominently represented in investment portfolios. If it isn't because of the dividend appeal, it's because the sector remains by far the largest on the local stock exchange with all four majors plus Macquarie included in the ASX Top10.

In a recent strategy update on global banks, analysts at Citi offered the following warning for investors: Don't Buy Cheapest Banks.

Their motivation: "Pursuing a Value strategy within the global Bank sector has been an especially disastrous strategy. Cheap banks in Europe and Japan have got even cheaper. More expensive banks in the US have stayed expensive. We don't expect this valuation gap to mean-revert anytime soon."

In other words: when growth is elusive, and the pressure is on, investors should adjust their strategy and focus too. Cheap stocks might be lagging for good reasons.

With yield curves inverting for government bonds, economic momentum struggling and credit growth sluggish, banks globally have been lagging the bull market. Hence the recent reset in bond markets, whereby yield curves steepened, and triggered a renewed interest in bank shares around the world. This is part of the rotation into ‘value’ career professionals like to talk about.

But Citi analysts are not buying it. They argue valuations for bank shares should stay ‘cheap’ because the global economy remains weak and bond yields will remain low.

In Australia, it can be argued, bank shares are not particularly ‘cheap’, as they have benefited from the attraction of 5%-6% dividend yield. But they seem ‘cheap’ in comparison with stocks like Macquarie Group (ASX:MQG), Transurban (ASX:TCL) and Charter Hall (ASX:CHC). These stocks that have fully participated in the share market uptrend and contributed with gusto to pushing major indices to an all-time high this year.

Banking sector not all about yield

Yet, the October-November reporting season has left shareholders with a sour after-taste. All of Bank of Queensland (ASX:BOQ), Westpac (ASX:WBC) and National Australia Bank (ASX:NAB) announced a sizable reduction in their final dividends, while ANZ Bank (ASX:ANZ) kept it stable, but with -30% less franking. In a surprise move, Westpac raised extra capital too.

Little surprise, the local bank sector has been the worst performer of late. October delivered a general decline of -4.4% for the sector to keep the overall performance for the Australian market slightly in the negative for the month. In the words of UBS: "it appears the market is coming to terms with the outlook of decreased profitability from lower rates and increased capital requirements".

The higher yield (as implied by a ‘cheaper’ share price) does not make the better investment. It's usually the exact opposite.

Commbank (ASX:CBA) shares trade at a noticeable premium and its premium valuation is backed up by superior returns versus ‘The Rest’ over five, 10, 15 and 20 years. Occasionally, one of the laggards in the sector might experience a catch-up rally that temporarily pushes CBA into the shadows, but the two prize for consistency and performance in Australian banking are CBA and Macquarie.

This by no means implies there cannot be more negative news from CBA or the other banks. If investors want more evidence the ‘Golden Years’ for banking in Australia are now well and truly in the past, Morgan Stanley's research shows banks have noticeably underperformed five prolonged times since 2000, with two of the five periods occurring since April 2015. 

Below is the graphic depiction of the five periods since 2000 that accompanied the Morgan Stanley research report:

What the banks have once again shown to investors is that higher yield tends to correlate with higher risk. And that risk should not be solely measured in loss of capital. CBA shares have trended sideways since September 2015. Over that same period, shares in Macquarie have appreciated by some 75%.

For a slightly lower dividend yield on offer, backed by a superior growth profile, Australian income investors could have accumulated significantly better returns if only they weren't so afraid of paying a little more for it. 

Where can cash be deployed in the share market?

So what is an investor to do who today is sitting on some cash, looking to be deployed in the share market?

My advice is to look for quality yield. What exactly defines quality yield? It's a dividend that is most likely to rise over multiple years ahead. Admittedly, such a proposition is probably not available at 5.5% or 6%, but then again, investors are less likely to find themselves confronted with capital erosion or a dividend cut further down the track.

Look for research that is not solely based upon ‘valuation’, relative or otherwise. Foe example, Morgan Stanley prefers ‘manufacturers’ over ‘collectors’ and ‘creators’ over ‘owners’, with the team labelling itself ‘selective with value’. Identified property sector favourites are Stockland (ASX:SGP), Goodman Group and Mirvac (ASX:MGR). Sector exposures to stay away from, even though they might look ‘cheap’, according to the team, include Scentre Group (ASX:SCG), Vicinity Centres and GPT (ASX:GPT).

Investors should note Morgan Stanley analysts agree with the view that owners of retail assets look ‘cheap’, but they still see shopping malls coming under pressure from both tenants and consumers.

Macquarie analysts have compared infrastructure stocks with utilities and AREITs and concluded utilities currently offer the superior total income profile, with infrastructure and AREITs both equal second. Risk-adjusted, Macquarie believes, infrastructure offers the highest potential return. AREITs are seen offering 'a balanced yield exposure'.

On Macquarie's projections, utilities such as AusNet Services (ASX:AST) and Spark Infrastructure (ASX:SKI) carry the highest income potential over the next three years, but they also come with the highest correlation with the broader share market (meaning: above average volatility in share prices). This is most likely because they offer little in terms of growth. It's all high yield.

 

Rudi Filapek-Vandyck is an Editor at the FNArena newsletter. This article has been prepared for educational purposes and is not meant to be a substitute for tailored financial advice.

FNArena offers independent and unbiased tools and insights for self-researching investors. The service can be trialed at www.fnarena.com.

 

RELATED ARTICLES

Headwinds and tailwinds, a decade in review

It’s the large stocks driving fund misery

Worried about low rates, SMSFs drop banks and diversify

banner

Most viewed in recent weeks

Easy money: download Robinhood, buy stonks, bro down

Millions of inexperienced traders have entered global equity markets since the end of March, fuelled by hype in a rapidly-rising market. What is happening and how are they having an impact?

Warren Buffett's letter about new investors and speculation

A pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: speculation is most dangerous when it looks easiest.

10 reasons to sell your dud stocks for EOFY

Anyone with capital gains from property or shares should take this EOFY opportunity to find offsetting capital losses. There are many benefits from cleaning out the portfolio stuff-ups.

How much bigger can the virus bubble get?

Stocks have rallied hard creating a virus bubble, but will this run for years or collapse in a matter of months? The market is giving a second chance to leave so head for the exit before there's a rush.

Share trading is the new addiction

The ability to buy and sell cheaply and quickly in small parcels is both the biggest drawback and benefit of shares. But it encourages people who should not go near the market to use it as a casino.

The populations of key countries are shrinking

Population decline is a new, yet largely ignored, trend with underrated economic and social costs. Much of the growth that drives economies, especially in Australia, comes from population increases.

Latest Updates

Howard Marks' anatomy of an unexpected rally

Markets can swing quickly from optimism to pessimism, and while there are more positives now than in the bleak early days in March, the market is ignoring many negatives. Risk is not rewarded at these levels.  

Why are we convinced 'this time it's different'?

Investors tend to overstate the impact on investments when something significant happens and they assume the future will be different. COVID-19 has been dramatic, but is it really that unusual?   

Superannuation

Super fund performance and rank depends on risk

APRA's heatmap has profound implications as it shows which super funds are underperforming in a period. But when good markets are compared with poor markets, one in five of funds changes its assessment.    

Investment strategies

Why women are most hurt by financial pandemic

Many people were financially unprepared for a pandemic, but it is women who are suffering most because they earn less, have interrupted careers and have less risk-taking capacity.

Superannuation

What is happening with SMSFs? Part 2

The latest SMSF data shows retirees favour listed shares and cash to maintain liquidity. SMSFs continue to grow, and the new super rules led to changes in contributions, payments and lump sums.

Retirement

Retirement dreams face virus setback

A new survey of over 1,000 people near or in retirement found three in four are not confident how long their money will last. Only 18% felt their money was safe during a strong economic downturn.

Superannuation

Common confusions with death benefit pensions

Awareness of common misunderstandings in relation to the payment of death benefit pensions can assist in estate planning matters. Given the large amounts involved, seeking professional advice helps.

Sponsors

Alliances

© 2020 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use.
Any general advice or class service prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, has been prepared by without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG) for more information. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.