Hugh Dive, Head of Listed Securities

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Tales from the Trenches - Searching for Yield to Pay the Bills

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Last week the RBA cut their target cash rate to 2.25% in an effort to boost consumer and business confidence and arrest growth in the unemployment rate. Whilst this move was positive for equity investors – and saw the ASX hit a six and a half year high as well as the domestic housing market – it was a negative for savers, especially retirees living off the income generated by their term deposits. On Monday ANZ cut its one year TD rate to 2.6% and with the inflation rate for 2014 running at 2.5%, savers are receiving close to a zero percent real return (after inflation) on their term deposits.

The result of this rate cut will be that investors who rely on the income produced by their portfolio will be forced to move up the risk curve into riskier investments just to maintain their standard of living. In this piece we are going to look at the pitfalls when investing in higher yielding securities.

Millionaires eating baked beans on toast!

Earlier this week I met with a well-respected fund manager who raised an interesting point. He said that Historically a retiree would feel secure in funding their retirement if they had, through a lifetime of careful saving and judicious investing, amassed $1 million dollars in their superannuation account. Indeed in 2008 this investor would have received a risk free income of over $80,000 from investing their portfolio in term deposits, enough to cover a comfortable existence without risking their nest egg.

Currently that same strategy would deliver just $26,000 for the retiree with $1 million dollars, effectively the "poverty line" in 2014 of $25,896 calculated by the Melbourne Institute for a couple with no dependants that own their own home. I found this observation very interesting as in the funds management world, the vast majority of our focus is on growing the capital, rather than thinking about the ongoing income that this capital is often required to deliver.

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The Australian banks have been significant beneficiaries of falling term deposit rates, not only through the declining cost of capital, but also due to the increase in retail appetite for bank hybrids. This retail interest has allowed the banks to build their capital bases in the lead up to Basel III, without issuing equity that would dilute earnings (and compromise bank CEO’s earnings per share growth targets). In the last three years Australian banks have raised $20.4 billion in hybrids and subordinated debt from mostly retail investors at pretty attractive margins for the banks. These issues have been sold to yield-hungry investors primarily based on the headline rate and the name recognition of the big bank issuing them, often with little regard to the actual terms and conditions of the issue.

For example in January, ANZ ‘s Capital Notes 3 raised over $750M at a margin of +3.6% or a current coupon rate of 5.85%. Not only was this margin too low given the ten-year term of the issue, but also in a “worst case scenario” investors are no better off than ordinary shareholders, despite owning these ‘preference shares’.

ANZPF holders will receive a pre-tax distribution of 5.85%, whereas ANZ common stock holders are looking at a grossed up dividend of 8.3% (which can grow) for facing pretty similar risks.

A more extreme variation on this theme of investors not getting compensated for the risks they are taking is the continuing success of finance companies raising money from investors. Companies like Fincorp and Westpoint offered investors interest rates of 9.25% and 12% respectively, which sounded very attractive and almost double the prevailing interest rate. Unfortunately these funds were used to make mezzanine finance loans to property developers, so investors really should have been demanding double this interest rate!

High yielding equities

Over the last few years among the most common questions that I have received from investors are around the theme of "juicing up" distributions by picking higher yielding stocks. Typically this comes in the form of a list of the highest yielding ASX200 that the investor has obtained from a website and questions as to why these stocks are not in the portfolio.

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Basic high yield strategies tend to underperform and have done so on the ASX over the past 20 years. We see that this is due to the characteristics of companies that tend to pay high dividends, namely a) mature companies in decline, b) companies in industries with low growth and c) companies where there is some risk that the dividend will be maintained. Looking at the above table of the large listed companies ranked by dividend yield, a number of them have all three dividend risk characteristics. Arrium's steel and Metcash's supermarket businesses could be characterised as being in decline and the market has concerns about both companies' ability to pay dividends in the future. Duet's energy utility business is low growth and faces upcoming regulatory risk, which could impact distributions especially in light of the very high payout ratio (Duet pays out more in distributions that it currently receives in profit). The future of Cabcharge's payments business is opaque with their monopoly on taxicab payments processing being undermined by technological developments such as Uber. Whilst investors may be able to temporarily generate a high yield from owning a basket of these stocks, there is not a great chance that these companies can maintain their dividends, let alone grow them ahead of inflation.

In next week's piece Searching for Yield Part 2, we will look at building a high yield portfolio focusing in on the dividend sustainability and growth factors that we look for in a security.

Disclaimer

This article has been prepared by Philo Capital Advisers Pty Ltd ABN 70 119 185 974 AFSL 301808 (Philo) and contains general investment advice only. The information in this article does not take account of your objectives, financial situation or needs or those of your client. Before acting on this information readers should consider whether it is appropriate to their situation. We recommend obtaining financial, legal and taxation advice before making any financial investment decision. To the extent permitted by law, neither Philo nor any of its related entities accepts any responsibility for errors or misstatements of any nature, irrespective of how these may arise, nor will it be liable for any loss or damage suffered as a result of any reliance on the information included in this article. The information in this article is based on information obtained from sources believed to be reliable and accurate at the time of publication but we do not make any representation or warranty that it is accurate, complete or up to date. We accept no obligation to correct or update the information or opinions in it. Opinions expressed are subject to change without notice. Past performance is not a reliable indicator of future performance. Any forecasts included in this article are predictive in character and may be affected by incorrect assumptions or by known or unknown risks and uncertainties. Nothing in this article shall be construed as a solicitation to make a financial investment

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Hugh Dive, Head of Listed Securities


Prior to joining Philo, Hugh was Head of Basic Materials Group Investment Research; covering the chemicals, building materials and steel sectors. In the 2011 Reuters StarMine Equity Analyst Awards, he was rated 5th overall in Australia for stock picking and first in the Diversified Industrials and Chemicals sectors. Hugh has extensive portfolio management experience gained at Investors Mutual, with a successful track record managing both small and large cap value funds. In 2009, one of the funds he helped manage, the IML Future Leaders Fund, won the AFR Smart Investor Award for the best Australian small cap fund.


Hugh started in funds management with CC&L Investment Management in Vancouver; Canada’s largest independent fund manager with C$37B under management. At CC&L he focused on asset allocation and then Canadian equity analysis. Hugh holds bachelor’s degrees in both Economics and Law from Sydney University and the University of British Columbia, Canadian Securities Course (Honours) and is a CFA charter holder.

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