Pitfalls of Yield Chasing
“We have delivered on our commitments and we are laying the foundations for future growth into the next decade”.
These were former CEO David Thodey’s comments at Telstra’s (TLS) first half 2015 results. The market lapped up his comments and the company’s PE multiple hit 18x, a level not seen since the technology boom in 2001. However, very high expectations tend to invite trouble and TLS’s share price fell 20% over the following year.
Two years later, TLS morphed from being an expensive defensive to the biggest yield trap in Australia. Many investors who depended on its dividend got whacked when the company cut its dividend. The falling share price during that period also added insult to injury.
Be careful of chasing yield
With interest rates at record lows, investors may be tempted to chase high dividend-paying stocks to replenish the lost income in their portfolios. After all, the attraction of a 5% yield with franking may be hard to resist when compared a term deposit yield of around 1%.
However, investing in high yield stocks without any objective consideration to the company’s valuation or fundamentals can be problematic and land you in hot water. That’s because without a valuation compass you may end up paying more than you should for a high yield stock. It’s what’s known as an ‘expensive defensive’. And without a quality check, you could become stuck in a ‘yield trap’. You don’t have to look far to see the Australian share market is littered with both expensive defensives and yield traps. Investors need to be wary of them.
So how does an investor know if a high dividend stock ticks the valuation and quality boxes?
BWP - expensive defensive
BWP Trust (BWP) predominantly owns Bunnings Warehouse properties. The trust has a rich history of paying reliable, growing distributions and its property assets are conservatively valued.
BWP’s fundamentals are robust and its current distribution yield of 4.5% looks enticing against a term deposit rate of around 1%. Despite BWP’s yield being sustainable it is still possible to lose money on your investment. No matter what you think about BWP’s conservative asset valuations, the trust is currently trading at whopping 45% premium to net tangible assets (NTA).
Another way to view BWP’s expensiveness is through its distribution yield over time. It is no surprise, given that its premium to NTA is at extreme highs, that its distribution yield is at record lows.
The last time BWP traded close to this extreme valuation was in mid-2016. What happened next teaches us an important lesson. When sentiment reaches dangerous levels things can quickly reverse. As 2016 has shown, it only took about six months for the share price to drop 25%. Extreme sentiment is never sustainable.
Spark Infrastructure - yield trap
Luckily, not all defensives are necessarily expensive and low yielding. If buying expensive defensives isn’t your thing, maybe you should buy a high yielding stock like Spark Infrastructure (SKI). Surely, SKI’s current distribution yield of 7% must provide some downside protection compared to expensive defensives?
Think again. While next year’s distribution seems safe at 15 cps, the following year’s distribution falls to about 12 cps based on consensus forecasts. The gigantic drop in distribution is because cash flows of regulated monopolies adjust based on a return above the risk-free rate. With falling interest rates, future cash flows are expected to fall for the regulated assets owned by SKI.
Hence, SKI’s near-term yield of 7% is an illusion. Based on the lower distribution its true yield is below 6%. Given that its sustainable yield is trading at the lower end of its historical yield range does that make SKI an expensive defensive now?
There are rare occasions where some stocks are classified as both expensive defensives and yield traps at the same time. With falling interest rates, yield investors have chased New Zealand utilities. For example, Meridian Energy’s dividend yield is trading on record lows as its seemingly stable cash flows are sought after by the market.
Perversely, as investors bid these utilities to their all-time share price highs, the foundation of their cash flow security is weakening. The cash flows enjoyed by these utilities are largely due to the high wholesale electricity price in New Zealand. Recently, RIO put the utilities industry on notice by reviewing whether to close their unprofitable Tiwai Aluminium smelter. Closure risk is very real given that aluminium prices dropped more than 30% over the past 18 months. If Tiwai closes, New Zealand’s electricity demand will drop by about 13%. This will lead to lower wholesale electricity prices and hence lower cash flows for the entire utility industry if all else is held equal.
To be clear, we don’t know the exact outcome associated with RIO’s decision as there could be many permutations. For example, in response to a Tiwai closure, some electricity generators could shutdown to reduce supply to somewhat offset the significant drop in demand. But the point is that the stable cash flows are at risk and these companies are trading with no margin of safety.
Conclusion – beware of expensive defensives and yield traps
We get it … low interest rates mean that stocks with stable cash flows that translate into reliable dividends are worth more. However, chasing yield can be problematic. It’s not simply a case of listing the highest dividend yielding stocks and picking from the top.
If you can avoid yield traps and expensive defensives in your portfolio, you may have a greater chance of meeting your long-term income objectives with lower risk.
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Jason founded Vertium Asset Management in 2017 and has around 20 years’ Australian equity investment management experience. He leads Vertium’s investment team and is responsible for the firm’s investment philosophy, process and portfolio management.