Telstra the signal to put yield chasing on hold

By

September 19, 2017

“More money has been lost reaching for yield than at the point of a gun,” warned Raymond DeVoe Jr. And while his point is unprovable, the recent slashing of Telstra’s dividend certainly shows what he meant.

Australian investors are particularly fond of high-yield stocks. That’s hardly surprising, given our excellent system of dividend imputation and franking credits that prevents shareholders from paying tax twice on company profits.

The propensity for high dividend payouts in Australia also means fewer share buybacks at overvalued prices, events that destroy value for shareholders while enriching management, whose bonuses are based on hurdles such as earnings-per-share, which they can manipulate.

There are downsides, too, though. Investors often get caught out focusing too much on the dividend yield at the expense of more important details, such as deterioration in a company’s competitive or financial position.

Ultimately, this can result in much lower earnings and a drastic dividend cut, and maybe a costly and dilutive capital raising. The adage that the closer the yield gets to 10 per cent, the closer it gets to zero is well worth remembering.

No one’s answering

Telstra’s share price has fallen 44 per cent since it reached a high of $6.61 in February 2015, and the company is facing more pressure than ever. It is forecasting a dividend of just 22 cents next year, down from 31 cents, for a 6 per cent dividend yield. Keep in mind, nearly a third of the 22 cents is a special dividend.

The dividend cut shouldn’t have surprised anyone. Yes, the company is receiving billions in compensation for surrendering its copper wire network, but most of those payments will eventually end. And some estimates suggest the NBN could eventually cut Telstra’s operating profit by $2 billion to $3 billion.

Though management has been increasing Telstra’s revenue in new areas such as cybersecurity, replacing such a large and profitable source of revenue was never going to be easy. Telstra also faces regulatory risks, including a decision on mobile roaming that could increase competition in regional areas, and increased mobile competition from rival TPG Telecom.

While the allure of Telstra’s high, fully franked dividend no doubt kept many investors oblivious to both the obvious and less obvious risks Telstra faces, pygmy interest rates also haven’t helped.

For many years, I’ve heard a common refrain defending high exposure to Australia’s big four banks, despite the increasing risks in the property market: If I don’t have a large helping of bank shares, where can I possibly earn a decent yield?

Unfortunately, when calling for safe substitutes for these high dividends, all I hear is a dial tone. Ankle-high interest rates have forced up the values of all assets traditionally considered safe. So far, in fact, that in many cases these safe harbours now look extremely risky. Not because there’s a threat to their revenues, but because of the price you must pay to own them. Infrastructure stocks and Australian real estate investment trusts are just two local examples. Overseas, the long list includes consumer product and food companies; for example, McDonald’s sports a price-to-earnings ratio of 27, despite reporting no change in profits since the global financial crisis.

When markets are extremely calm, as they are now, and liquidity is plentiful, it’s the perfect time to consider changes to your portfolios. Keeping in mind that an ounce of prevention is worth a pound of cure, it may also pay to remember that what’s worked since the GFC may not work over the next decade.

Interest rates can’t fall materially from where they are, and Australia certainly isn’t going to repeat both a mining and a housing boom. We should consider ourselves lucky we had both in such a short period, though I fear the legacy will be a housing bust that will leave too many people worse off than ever, as we’ve seen in the US and Europe.

Broadband bonanza

We haven’t got a high-yield replacement for Telstra, but we do own several stocks around the world benefitting from increasing broadband usage. They’re also expanding their networks to increase future revenue and buying back shares hand over fist.

Quite comically, our internet broadband companies fall under Consumer Discretionary. I challenge any parent to explain convincingly to their children that having the internet at home is optional.

The hurdle for Australian investors is that to earn a safer total return (capital gains plus dividends), you must accept a lower initial dividend yield. But what’s the point of owning a stock on a high dividend yield if the share price is going to drop 20 per cent when it’s cut?

Australians’ love of high dividends will never die, in the same way most will never give up the great Australian dream, despite it now being unaffordable for generations of Australians.

With Australia’s debt levels reaching record highs, now is a good time to educate your clients about DeVoe Jr’s axiom, so they can take advantage of Australia’s strong currency, increasing global interest rates and the current calm across global markets.

One of the biggest problems for investors is that they often wish they’d done yesterday what they want to do today. So, it’s incumbent on advisers to keep educating clients about the risks building at home after a golden 27 years of uninterrupted growth.

Over the next decade, Australia’s economy will face tougher challenges than it has for nearly three decades. With nearly half of home loans not repaying any principal, and nearly half of those speculative property loans, Telstra won’t be the only household name that disappoints careless and impatient investors.

Nathan Bell is head of research at Peters MacGregor Capital Management. For information about investing in our actively managed global portfolio, visit https://petersmacgregor.com.


TOPICS:   chasing yield,  dividends,  Peters MacGregor Capital Management,  Raymond DeVoe Jr.,  Telstra