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Where do sustainable returns come from?

Share prices across the Australian market have risen by an average of 20% over the past 12 months. This looks like great news on the surface but we need to look deeper to see where those gains came from and whether they are sustainable.

People have a tendency to mentally ‘lock in’ past gains and assume they are ‘in the bank’. The problem is that almost all of the 20% share price gains over the past 12 months were probably only temporary and should not be assumed to be ‘locked in’ at all. The 20% share price gains were not underpinned by 20% higher company profits nor 20% higher dividends. Profits per share across the market actually fell over the period, and dividends per share rose by only 4% (and most of the dividend increases were due to temporary commodity price spikes from the miners).

Paying more for the same profits

Twelve months ago, investors were prepared to pay $16.25 per dollar of company profits, but over the past year, they bid the price up to $20.40 per dollar of profits. They are now paying 25% more per dollar of profit than they did a year ago.

Twelve months ago, investors were prepared to pay $23 per dollar of company dividends (i.e. dividend yield of 4.34%) but over the past year they bid the price up to $26.40 per dollar of dividends (dividend yield of 3.8%). They are now paying 14% more per dollar of dividends than a year ago.

What caused this miraculous 25% increase in the price paid for a dollar of profits and 14% increase in the price of a dollar of dividends?

The main reason is confidence levels. At the start of 2019 people were pessimistic and feared the late 2018 ‘global growth scare’ might turn into the next GFC or possibly worse, especially as the US Fed was still raising interest rates amid Trump’s trade wars. Investor pessimism quickly turned to confidence when the Fed switched from rate hikes in 2018 to rate cuts in 2019. Central banks raise rates when they are bullish on the economy and cut rates when they are bearish. The crowd (investors) do the reverse.

The charts break this down by market sector. The left chart shows price gains over the past 12 months; the middle chart splits this into changes in earnings (profits) per share and changes in the price paid per dollar of profits; and the right chart does the same for dividends:

Looking at the two big sectors:

First: Financials. Profits per share fell (across the Big 4 banks plus other disasters like AMP) but share prices rose 13%, so investors en masse boosted the price per dollar of profit by 25%, and the price per dollar of dividend by 17% (dividends also fell). The crowd assumes the current banking woes are temporary and banks will miraculously return to the golden years of double-digit profit growth. Our view has been that those golden years are gone. The banks are facing not only cyclical pressures (margin pressure from ultra-low rates, and bad debts from property developers/investors) but also more lasting structural pressures (crippling regulations, expensive remediation and compliance, higher capital costs, deteriorating demographics).

Second: Resources. Profits and dividends rose by 30%+ per share, a combination of recoveries from big write-offs from prior years, plus the fortuitous spikes in iron ore and oil prices. Investors have sensibly discounted this and only bid up share prices by 12% because they know this profit and dividend growth is not repeatable. Many of the miners are probably underpriced at current levels.

The market is now in expensive territory, with price/earnings ratios above 20 (more than $20 being paid per dollar of profits) and dividend yields below 3.8% ($26.40 per dollar of dividends). In order to hold on to the recent price gains, either profits and dividends need to rise substantially in 2020, or central banks need to keep cutting rates and buying up assets. That is, central banks need to remain bearish and pessimistic so that the crowd remains overconfident. 

 

Ashley Owen is Chief Investment Officer at advisory firm Stanford Brown and The Lunar Group. He is also a Director of Third Link Investment Managers, a fund that supports Australian charities. This article is for general information purposes only and does not consider the circumstances of any individual.

 

6 Comments
Mark
February 20, 2020

Good afternoon,

Thanks for this good article. Could you please provide some explanation of how dividend yields below 3.8% equate to $26.40 per dollar of dividends.

a owen
February 21, 2020

hi mark - if I pay $100 for a share that pays $3.80 dividend I am paying 100/3.8 = $26.40 dollars per dollar of dividend (I rounded the 3.8% div yield for the story). It is the reverse of the price/earnings ratio because the numerator and denominator are switched. If I pay $26.40 for a dollar of dividends I am hoping of course that dividends rise over time - but that is always the case whether I pay $20 or $30 or even $10.
cheers

ashley

Warren Bird
February 21, 2020

Ashley, your calculation is not the reverse of a P/E. It's still got P on the top, but you have D instead of E on the bottom.

And you don't actually need dividends to grow to justify paying $100 for $3.80 a year of income. It just means that you're discounting $3.80 a year at 3.8%.
But I understand that what you're saying is you'd rather have dividends grow so that your total return is better than 3.8% a year.

Mark
February 21, 2020

Thanks Ashley, appreciate your help.

Cheers

Mark

stefy
February 20, 2020

I believe the current share market prices and global warming are intimately related. Let me explain why. The current market prices are based wholly and solely on fiat money creation by the Fed in USA ($500 billion late last year alone). The exponential rise in fiat money has facilitated the rise of an economic backwater in China to a superpower producing every consumer good possible. It has made the world full of possibilities, exploit commodities worldwide, create new mines and industries, increase production etc etc, and allow wild asset inflation like housing and stocks. Fiat money, a world without limits, has created global climate change as sure as I am alive and breathing. So much for modern money theory.

Tony Reardon
February 20, 2020

We review our asset allocations every half year. The 2019 performance of local and international equities of 20%+ naturally led to a slightly out of balance portfolio and so we we moved a percentage out of equities into fixed interest. While this might feel like one is “selling winners”, it does lock in some of those profits.

 

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