This time last year, investors saw their million-dollar term deposit earning less than the poverty line, and hurt by their own private income recession, chased high-dividend yielding blue chip stocks.
The chase pushed the shares of large but mediocre companies like the National Australia Bank to almost $40 and Telstra to $6.60; but as the more recent declines accelerated they revealed the hunt for yield was merely another one of the stockmarket’s conga-line of fads.
Where did baby boomers go wrong? And why, after so many years, has the stockmarket not risen above its pre-GFC highs? The answer to these two questions – as well as whether investing in an Australian index fund is a good idea – is the same.
Neither blue chip nor high yielding
Perhaps unwittingly, investors – in their hunger for income – chased stocks that were neither blue chip nor high yielding. And that includes Telstra and the NAB. Not only have baby boomers lost capital sufficient to wipe out years of the additional yield they’d hoped to gain, but they also missed out on capital and income gains from the businesses that were able to grow both their intrinsic value and income.
A portfolio of conventional blue chips, those that dominate the major Australian stockmarket indices, will only ever provide investors with mediocre long-term returns unless they speculate successfully on an expansion of the price-to-earnings ratio. These are mature businesses with little ability to retain any sizeable proportion of their annual profits to reinvest at an attractive rate of return.
By way of example, Telstra pays a sizeable proportion of its earnings out as a dividend. This high pay-out ratio is what has made its shares so attractive to income investors. The corollary of a high pay-out ratio however is that the company retains relatively little for growth. To illustrate, Telstra recently reported its half-yearly results for 2016. For the six months ending December 31, 2015, the company reported EBITDA of $5.4 billion, net profit after tax of $2.1 billion and earnings per share of 17.2 cents. Go back 10 years and for the six months to December 31, 2005 Telstra reported EBITDA of $5.3 billion, net profit after tax $2.1 billion and earnings per share of 17.3 cents. In other words, after a decade of operations, the company has not grown earnings.
It should come as no surprise then that Telstra’s share price is lower than it was 15 years ago. The business isn’t growing.
Even income investors need growth
This is not the best outcome for investors. Even income investors need growth. Why? Because without growth in earnings, there can be little growth in dividends and without growth in dividend, a retiree’s income will be eroded by inflation.
Only by retaining a large portion of profits and redeploying those profits at high rates of return can a business increase in value. And in the long run share prices always follow the change in value.
Take CSL as an example. Over the last decade CSL has retained $7 billion of the profits it has generated. As the equity has grown so have the returns, and the company now generates a return on owners’ equity of almost 50 per cent. As a result of retaining profits and redeploying them at very attractive rates for a decade, the company has grown profits from $116 million to $1.8 billion today. Consequently, the share price has risen from $9.00 ten years ago to over $104 today.
And those seeking income needn’t have been dissuaded by the relatively low dividend yield CSL displayed 10 years ago. An investor who put $100,000 into CSL in 2005 not only enjoys more than a million dollars of equity working for them now, but their income has grown to $18,600 – a yield of nearly 19 per cent per annum on their original investment.
By contrast, a hundred thousand dollars invested in Telstra 10 years ago is worth only $115,000 today and the $5900 of dividends being paid a decade ago on that investment have grown to just $6500 today.
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Chasing the wrong yields
What the above examples demonstrate is that yield-hungry investors have been chasing the wrong yields. Rather than pursuing the big, stable so-called “blue chips” they should be investing in companies that can grow. Find companies that can retain profits, and both capital and income will grow. But woe to you who buys a mature blue chip company with no growth – both your capital and the purchasing power of your income will decline.
And finally, what does any of this have to do with index investing? The Australian indices are made up of the big lumbering blue chips – those mature businesses paying the bulk of their earnings out as a dividend. If their equity and profits aren’t growing, neither can their shares sustainably, nor the index which is based upon them.
Want low returns? Go for the high-dividend yield.
