Omar´s Outlook - Sep 2017
Dividends ≠ Interest
From time to time I come across retired investors who are convinced that it is entirely OK to be fully invested in high risk, volatile assets like shares. After all, shares pay dividends, and if you for example invest in bank shares, the dividend yield will likely be well in excess of whatever rate of interest that same bank will pay you if you instead set up a term deposit with it.
This argument is a classic example of a very common fallacy investors tend to fall for – that is, extrapolating past performance forward.
There does, indeed, exist a very good reason for why diversification to fixed income assets like bonds is essential; at least for investors who rely on income from their investments to fund their lifestyle expenditures.
This reason consists of the fact that dividends are not equal to interest entitlements.
Put in another way, dividends are entirely discretionary, while interest payments are not. Consequently, the company whose shares the investor holds may, at its discretion, decide to cut the dividend significantly, or abolish it altogether, with the investor having no right of appeal.
This fact is often countered by the argument that the major companies in Australia have not cut dividends significantly in the past, even during the GFC, when their share prices dropped by a large margin.
Unfortunately once again, because something has not happened yet does not mean that it will never happen.
The recent statement from Telstra, announcing a 30% cut to their dividend payout ratio and an intention to move away from its past payout ratio of 100% of profits, is a case in point.
Telstra has in the past been viewed as a cash cow by many investors and even by market analysts. Their very generous dividend policy, which at one stage exceeded 10% (when franking credits are accounted for), has over the years helped soothe the pain of flat to disappointing share price performance. Many market research analysts therefore continued to recommend the company as a solid “Hold”.
To compound investors’ pain, and as is common on such occasions, the dividend cut was accompanied by an immediate and significant fall in Telstra’s share price.
As a result, Telstra has been one of the most disappointing blue chip performers on the domestic stock market, delivering an overall return of about 5% over the last 5 years, and minus 28% over the past 12 months:
The other notable recent example of the same issue has been BHP Billiton. For many years, BHP liked to boast that their dividend had never been cut; until last year, when it got cut by almost 75%.
The company operates in an entirely different sector to Telstra, so its 5-year performance has mainly been affected by the general slow down from the Chinese-inspired boom in the resources sector.
However just like Telstra, it has been a major disappointment to its long-term investors, the recent pull back – again more or less in line with the other resources-based businesses – notwithstanding. The dividend cut only further accentuated that pain.
So having cleared that up, I think it’s fair to say that while the Australian banks’ dividend policy has been quite generous so far, to therefore assume this will always be the case is somewhat naive.
Bank stocks in this country are far from cheap. In light of the increasing headwinds - in the residential property markets in particular - as well as the much less friendly regulatory and taxation environment (the “bank tax” announced in the last Federal Budget to name just one such initiative), should these organisations decide to cut their dividends in the future would come as hardly any surprise.
It is also no accident – as demonstrated by BHP - that dividends are most commonly cut at the same time of significant stock price falls. Such declines in prices are of course a routine matter during all major bear markets.
Thus investors, who rely on their savings in retirement, then suffer the dual horror of their investments failing to generate sufficient income and, in order to compensate, having to sell assets at depressed prices.
On a related note, the discretionary nature of share distributions applies not only to equity assets, but also to any ASX-listed, Basel III-compliant hybrid investments. This includes essentially any hybrid issued over the last 5 or so years.
I have written about the nature of these securities before at some length, for example here and here, and given that the interest rates currently on offer for most of them are not that exciting, we have refrained from recommending them to our clients.
Of course, the non-discretionary nature of bond interest payments does not necessarily mean that these securities carry no risk. The concerted effort of the major global central banks to drive interest rates ever lower has meant that in their “chase for yield”, investors are now paying more and more – and receiving less and less – from bond securities of ever more dubious quality.
A shining example of this trend has been the recent pricing of three emerging market sovereign (government) bonds from Ukraine, Belarus and Mongolia with maturities between 2019 and 2023.
These bonds have a composite rating of CCC+, that is seven levels below investment grade, and their current yields are all under 6%:
For comparison, as recently as 1999-2000, investors could obtain yields of 6% from the ultra-safe US Treasuries.
It is quite safe to say that in an environment of such crazy valuations, numerous investors will live long enough to experience a full default – that is, there will be no interest and no return of capital.
It seems the age-old lessons will have to be relearned again.
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