Written by Jonathan Wilson, Analyst, StocksInValue
You may have heard Australia’s market described as a ‘dividend market’. It’s a broad trend we have discussed for some time.
Strong demand for higher yielding stocks is driven by two powerful trends in tandem. The first is Australia’s growing self-funded retiree population, and the second is government bond yields trending lower over the last five years from both domestic expansionary monetary policy and lower global bond yields resulting from QE in Europe, Japan and the US.
This has produced a growing number of yield hunters treating stocks as a proxies for fixed interest, especially large caps paying consistent dividends as Figure 1 illustrates
It is the foreword yield of the ASX’s 10 largest companies by market capitalisation. As you can see, dividend yields have converged over the last 5 years. The exception is CSL, which has a low payout ratio because it uses a large proportion of its free cash flow to buy back shares.
Figure 1. Forward dividend yields for the ten largest companies on the ASX by market capitalisation
Buying blue chips for yield is an easy strategy to apply but it can be dangerous. It assumes companies share the same risk and return profile, which is obviously incorrect. Dividends are just one component of expected return. The other is capital appreciation, which is a function of value growth and the value-price ratio.
As you can see in the Filter Screen there are significant differences between each company’s value/price ratio and value growth, in contrast to the forecast dividend yield, which varies between 4% and 6%.
Figure 2. Filter screen for the ten largest companies on the ASX by market capitalisation
This is better illustrated in the next figure, which shows the three components of expected total return for each company.
Value and value growth are based on required return, forecasts for profitability (NROE) and the split between profits distributed and reinvested. Companies that sustainably reinvest earnings at high rates of return have high value growth.
Despite having the lowest dividend yield CSL has the highest value growth, and looks attractive on a total return basis. On the other hand RIO Tinto and BHP have relatively high yields, but negative price-value ratios and low to negative value growth. In this case a purchaser is taking on more risk of capital loss to gain a high dividend.
Figure 3. Components of expected return*
The next chart compares the expected total return of each stock and the average dividend yield. Noting the variance in expected returns we should think twice before grouping them together based on yield, as the market seems to be doing. Yield is certainly an important consideration, but only after an assessment of quality, prospects and value.
Figure 4. Expected return and average forward yield*
*These figures are based on FY15 numbers for each company. Results are slightly skewed due to differences in respective full-year balance dates. CSL, Telstra, CBA, BHP, Wesfarmers, Woolworths, and Rio Tinto have 30 June balance dates; NAB, ANZ, and Westpac have 30 September balance dates.
As we touched on in my last video, Value or Value Traps? Don’t just rely on quantitative filters, we need to assess companies individually based on an understanding of their quantitative and qualitative characteristics. The best companies to own generate high returns driven by competitive advantages and operate in growing industries. These companies can compound earnings over long periods and are also more likely to converge to intrinsic value over time, which means we can more confidently take advantage of gaps between price and value.
Prices & valuations and forecasts correct as at original publish date, 3 July 2015. Clime Asset Management owns ANZ.AX, BHP.AX, CBA.AX, CSL.AX, NAB.AX, RIO.AX, TLS.AX, WES.AX and WOW.AX on behalf of various mandates where it acts as an investment manager.