Equities

I know a lot of you hold big holdings in banks for income, so have we, but it has, in hindsight, been one of the biggest Australian investment mistakes of the last five years.

In the last five years, as you know, the banks have been pummelled. It all started with a Commonwealth Bank rights issue in March 2015 which led to $12.4bn worth of bank sector capital raisings by year-end. That first CBA issue marked the peak of the sector.

After that initial bout of indigestion came a series of negative waves starting with those unnecessarily prudent APRA led ‘restrictive lending practices’ in 2017, now repealed. They kicked off a slowdown in the bank sector’s lifeblood, the housing market, and as credit lending slowed, and as Shorten threatened measures to pique the investment lending market, we saw the first bank sector earnings downgrades in years.

Then came the Royal Commission which started with a discovery process that paralysed department after department, involving thousands of employees who were rendered unproductive and demoralised by millions of wasted hours in front of a photocopier finding, scanning and printing documents. Then came the Royal Commission itself, the loss of reputation, the brand damage, the destruction of their wealth management brands and businesses, asset sales, business restructuring, more employee demoralisation and more earnings downgrades.

And then last month, just when the sector was getting back into uptrend, the AUSTRAC revelations cratered Westpac by 14.7% in a month with the ANZ and NAB both down 11% in a month. (The CBA survived, up 0.3% in November, having already been through the AUSTRAC fiasco).

Here are charts of the individual big four banks and their performance relative to the bank sector index (red line) - CBA the clear winner, WBC the clear loser:




And this is Macquarie just for interest's sake:

All in all, since the March 2015 sector peak, when the Commonwealth Bank announced the first of the 2015 rights issues, the sector is down 27.7% against the All Ordinaries up 14.8%. Including dividends the total return from the All Ordinaries Index is up 42.51% since March 2015 with the total return of the CBA, Westpac, NAB and ANZ individually underperforming the All Ordinaries index by 34%, 59.1%, 47.2% and 52.9%.

Despite this underperformance, most fund managers, intimidated by the fact that the banks formed 25% of most benchmarks, didn’t sell. The fund managers didn’t sell because they like to hug their benchmark and getting a big sector like the banks wrong is suicide. So they, as we did for a while, sat with neutral holdings.

And retirees didn’t sell because no-one ever told them to. Few advisers would, could or will ever advise retirees to sell their banks. They are an Australian institution, an oligopoly and they’ll be alright in the end. Won’t they?

On top of that, the advice industry sees it as a value add to collect franking credits for clients, and that’s what the banks are used for, to collect franking credits. Getting a refund is clever isn't it? Taking money off the ATO an astute strategy, surely? But for the last four years, chasing a franking credit refund through banks has been a mistake. The credit still arrived, but the loss of capital more than matched it. And trying to strip the bank dividends over results has been in most cases disastrous, we have been swimming against the tide. To make money you needed impeccable timing which is only possible in hindsight.

And there are other reasons income hungry (mostly retiree) investors have not sold.

  • Because understandably, for someone who wants a stress free investment life, they have adopted a long term “buy and hold forever” approach.
  • Because they would rather lose two dollars than pay the government a dollar of capital gains tax.
  • Because they don’t care what the share price is - they intend to pass their assets on - “its my kid’s problem”.
  • Because they cannot find investments with high yields. Even now, after the underperformance and some dividends cuts, the banks are still offering some of the highest yields in the Australian market.

But the truth of the matter is that a dollar is a dollar whether it comes from dividends, a cash refund from the tax office, or a capital gain, and whilst I wouldn’t want to burst the bubble of the traditional yield reliant retiree, chasing income stocks has not only cost money because of the pitiful bank sector performance, it has always cost you money because it corrals you into low growth mature companies with few growth options and nothing better to do than return money to shareholders.

And more expensive than all that has been the opportunity cost (lost) of not holding quality growth companies with high returns on equity just because they had low yields.

CSL for instance (in hindsight its easy) has returned 216.9% since the bank sector peak in March 2015. But it yields 0.7%. Focus on yield and you'd never invest in CSL. ROE of 32.6%.

Aristocrat Leisure has delivered a total return of 371% since the bank sector peak in 2015. Yield 2.6%. ROE of 17.4%.

Cochlear has returned 175.8%. 0.7% yield. 25.9% ROE.

And so it goes on...Treasury Wine Estates 296%. ResMed 156%. ASX 127%. Even Woolworths 60.7% and Wesfarmers 70.6%. To name a few. 

None of these companies yield more than the market average but you could pick them all out, and many more, on the basis of consistent earnings growth and high ROE.

The conclusion is that you'll get a superior total return from companies with a high ROE and low yield, than you will from mature companies with few growth options, low returns on equity, high payout ratios and high yields. 

It's obvious, reinvesting profits at high rates of return will build an asset (and a share price). Cash cows that pay all their profits to shareholders can do no more than maintain an asset. 20% compounding growth and no yield beats a 9% yield and no growth.

In the United States they will tell you that bonds are for income and equities are for growth. The American equity market culture is to reinvest for growth all the time, which is why Microsoft and Berkshire Hathaway resisted paying dividends for decades. In the US paying a dividend is seen as failure, the sign of a company lacking ideas and ambition. That culture is why the US market yields 2.5% whilst Australia yields 4.5% plus franking or around 5.89% on average. Because Australian CEOs pander to the siren-like obsession of their Australian shareholders with fully franked yields.

But with term deposits paying around 1% it just doesn’t make sense for companies to give money back to a shareholder, not when the company’s return on equity is 20%. Far better they keep it and reinvest it at 20%.

The bottom line is that if you are bothering to take the risk in equities you would be far better to focus on total return rather than dividend yield. Yields, franking and the cash refund in particular, are distracting retirees from the best stocks in the market. You would be better to filter for high ROE and low yield than a high payout ratio and a high yield.

Of course, you will have to sell shares to buy groceries, but if you can get your head around that little conundrum you’ll be eating avocado smash for breakfast in your nursing home and going to bed dunking chocolate digestives not plain.

Reliable Growth Stocks with high ROE 

This list is a good place to start. It is a list of stocks with an unblemished 5 year earnings growth outlook (one year of history four years of forecasts). 

These are what the market considers to be growth stocks. This list shows growth stocks with a return on equity of 20%. They are in ROE order - you might pay attention to the market cap column...I don't want you filtering out of banks into small caps.

ROE or return on equity is effectively what a company earns each year if you give them a dollar. This is the number that value investors are obsessed with. Some of these ROE numbers can get pretty “dirty” (they need to be cleaned up for one-off items and accounting sleights of hand) but at the headline ROE is still a pretty good filter. 

Why for instance would you want LOV or NWL, who are earning 66.9% and 63.4% returns each year on every dollar you give them, to pay a dividend at all. It is clearly better to let them invest the money at a 66.9% and a 63.4% annual return than it is to have it returned to you now. 

There are some interesting stocks on this list, stocks you already intuitively know, some of the best stocks in the market, stocks like COH, CSL, RMD. 

Read more from Marcus

Marcus Padley is the author of the Marcus Today stock market newsletter. To sign up for a 14-day free trial please click here.



Comments

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Harry

Well written and sounds logical. The problem I have with investment is a thing called variables. I held CSL and Cochlear at one stage and then a legal firm in the US looked like taking a class action against these companies and they both tanked and stayed at that level for 5 years. I sold. I also held WOW which went from $36 to $20 in about a year. It took them almost 4 years to recover. Its called timing and luck. The banks in Australia must be the most profitable in the world. When I look at NAB earned $13 bln in income and Net Profit of $5 bln even after all their stuff ups and to be sure the banks over time stuff up regularly. However NAB bounced around from $22 to $36 then down to $24 then up to $34 and back to $24 to $30 and now being shorted in a big way down to $25. I don’t want to hog this space so I won’t linger on why I consider banks to be a necessary part of my portfolio. All the graphs and tables don’t tell you when to get in and get out of a stock they only tell you what happened yesterday. Now for retirees in all that up and down of NAB only the heirs could tell you whether they made a bonza !

Marcus Padley

Hello Harry - Maybe I should have written that the article is not a comment about the future price of the bank stocks (they have simply been a convenient example) it is an article about not being blinkered just because you are a retiree that needs an income - the main point is that income can come from capital gains not just a dividend and you will get the best capital gains in growth stocks not mature stocks. As for the banks - if interest rates bottom and profit growth reappears they might prove to be fabulous investments from these lows (but not if interest rates go to zero - they won't have a margin) - I also enjoy identifying sentiment peaks and troughs and doing the opposite (...but only when everyone else starts to). I'll be the first to buy the banks when everyone peaks out on their media induced "horror". Its a beat up - there will be a bottom.

Harry

As alaways Marcus you make sense.

Praful Desai

Brilliant article and opens my eyes as I am big fan of Banks stocks Praful

Harry

Another point Marcus which you have hinted at recently but gets very little coverage. The following is a short summary: Have a look at the Funds Management business and the enormous margins these managers make . Heres an example of a big fund: Management fees $467 m Performance fees $83m Service Fees $ 4.7m Interest Income $5.2m That’s $561 m in Revenue from investing other people’s money which in some funds its mainly Institutional money which these so called institutions are unable to manage so they farm it out but still get paid for farming it out. Now on $561 m in revenue their costs to run the business is $63 m to employees $16 m in Admin costs other costs run to about $20m. So there Net Profit is $459 m! That’s a NET MARGIN of 81%. Astonishing profit and used to be called usury. Isn’t there something competitively wrong with an industry that makes 81% NET?

Alex Hay

Well done Marcus, never to late to add some parameters to investing with discipline. Three rules of investing MONITOR MONITOR MONITOR, no body looks after your investments better than your self, so if you have not got the ability read and listen and make your own judgment . Alex

Michael Young

Great article Marcus, as always. I do find it hard to sell my CBA, despite the fact that I have been aware of the downside of continuing to chase the franking credits for years. I have picked up some growth stocks this year & I will steel myself to sell some of my CBA & purchase more in the near future. Keep up the good work.

Mark Dawson

Nice article thanks Marcus. I owned stock in Moelis or little Macquarie bank as some like to call it. Unfortunately for me I sold out after a few years of downward sloping prices and zero return. Maybe this company has turned the corner and will start making a profit for its shareholders. Similar story with another company I see in your list Praemium (PPS). I't's price tracked sideways and downwards after I purchased. Maybe I should be holding onto these shares for 5 years or more? Saracen (SAR) on your list is going through a capital raising to pick up 50 percent of the super pit. Current shareholders can pick up a few more shares at $2.95, but really any price below $3.00 should be considered a bargain. There'll be great ROE here. Think I'll get back to my Café Latte, minus the digestives. They don't taste good in either plain or chocolate.

Geoff Bryce

Very well presented and food for thought. My 5 banks show (since 2012) a capital loss of $18,500, Div + Credits of $68,300 = net $49,800. I have a SMSF in pension phase, so no taxation issues. The capital losses have, as Marcus stated, occurred mostly after 2015, when I noticed the banks slipping. I thought then, ummm, income great, but at the expense of capital. I need a solution. Is what I did do was become an Active investor. I started to trade shares. Though, I did not apply the same rules to the Banks. (my thoughts were/are, they are greedy #$%, so they will find a way upward. A costly mistake. While I will make a capital loss getting out of the banks, net I am in front, so should get on with it. Marcus's growth stocks list will be a start. Active trading is more income/growth earning than set and forget/dividends. And Harry, fully agree about the the Funds Management business models. When I did dip my toe into a few of them, my unit price's were dropping (capital loss) at the expense of the fund paying dividends, yet they still took their fees up or down.

Marcus Padley

Mark - The Digestives comment comes from my Mother who moved from Derbyshire to London in 1952 with a couple of girlfriends and lived in abject poverty in their rush to be independent and away from the North. She said they were so poor that they used to put an empty plate in the middle of the table when they had a cup of tea and pretend it had chocolate digestive biscuits on it...and that they didn't want any.

A. Ozaydin

Despite all the negativity expressed towards the banking sector during the current down cycle, I see a rising long term (11 year) trend line evident from your weekly "Banking Sector" chart you pasted above. To me, the Banking Sector have bottomed late 2018 and is on a Mean Reverting cycle to the upside and I am not disappointed to this day. A comparable down cycle occurred during GFC (2008-09) and the sector resumed its uptrend thereafter. And as long as 2018 low remains intact, I would hold my CBA shares along with its franked dividends.

Robbert van den Bogaardt

Well done Marcus. In my view , given that management’s long term goal is to maximise shareholder wealth, theoretically they should only declare a dividend if they believe you as an individual shareholder will reinvest the dividends more profitably then the company could reinvest the funds in growth opportunities itself. In other words, significant dividends should only be paid when the company runs out of long term profitable growth opportunities/ ideas. I also think that franking credits have encouraged management to pay out dividends because the share market demands it. This has led to our companies being focussed on the short term, to the detriment of looking for growth opportunities. This cycle also feeds into our very short term ceo tenure. This in turn has resulted in our companies falling behind in key growth sectors and our economy now lacking real growth per capital. ( we may have had over 20 years of gdp growth but per capital we are now going backwards.) The proof of all this can clearly be seen in the ASX- it has finally reached the Pre GFC level in Nov- Nasdaq is circa triple the pre GFC level. I sold all my bank stocks in 2015 and every yield investment that I had at the time. I invested everything in different growth sectors in the US and here on the ASX. My portfolio is now growing at over 20% compounded p.a. net of all costs, over the last 4 years. This year it is up 35% to date.

D Lee

Thanks for the article. At what point do you think growth stocks like CSL become too expensive to own?

D Lee

Thanks for the article. At what point do you think growth stocks like CSL become too expensive to own?

John O'Neill

Thanks Marcus for your insightful article. US stocks pay low dividends in part because they are subject to double taxation, not just because of an invest for growth mindset. US stocks can be an Aussie retiree's growth strategy, while milking divs/franking for income from boring low/no growth Aussie banks or ASX Top 20. The long term split adjusted total returns from the widish moat too big to fail cash rich likes of MSFT, AAPL and even sluggish ORCL are impressive. e.g. AAPL trades circa 70 times higher than 20 years ago with about 20% of its cap in tax paid cash/bonds.