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of negative waves starting with those unnecessarily prudent APRA led ‘restrictive lending practices’ in 2017, now repealed.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. 

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