Rudi’s View: The Big De-Rating – A Guide Through The Minefields (5)

This story features TELSTRA GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: TLS

By Rudi Filapek-Vandyck, Editor FNArena

This is going to sound like the world's most worn out investment cliche, but what do you do when the overall climate for equity markets changes? You lengthen your horizon.

Analysts at BA-Merrill Lynch have put in the hard yakka to provide the data behind what is in all likelihood one of the most misused and abused cliches in investment circles. Time heals a lot of things, but unfortunately it seldom transforms an error into a fantastic investment. The true value of the BA-ML data analysis (see table below) is that it proves time does tend to work to the patient investor's advantage, if only because it decreases the risk of capital loss.

No doubt, this will be a welcome reprieve to many investors in today's share market.

Of course, skeptics will counter we also have to take into account inflation and the potential for missed opportunities elsewhere, but in a world wherein government debt is being de-rated, wherein yields on government bonds in many countries are at multi-decade lows (or soon will be) with property markets bubbling or having burst and with fiat currencies in a race to the bottom of relative valuations, there's a lot more that can be taken into account. Government bonds have now delivered a better return than equities over the past thirty year period, which is a rare occurrence in modern history, but does this not make equities a better option for the decades ahead? (Jeremy Siegel has already pointed out it is mathematically impossible for bonds to continue their outperformance, though this remains still possible in shorter timeframes, of course).

Another obvious observation to make is that in an overall environment of PE de-rating and ongoing growth in cash flows and earnings, backed up by healthy corporate balance sheets, corporate dividends automatically must rank relatively high in risk-reward rankings for cashed up investors. This would seem accurate on the premise that:

1. investors have the stomach to forget about volatile share prices in the short term
2. they do invest in companies that will be able to grow earnings and thus dividends (or at the very least maintain them or, worst case scenario, only cut dividends as a one-off)

One of the techniques at hand is to combine both "longer term" and "dividends". According to the data analysis by BA-Merrill Lynch, investors have an 89% certainty the share price of their investment won't be lower in five years' time. If they lengthen their horizon to ten years the accuracy rises to 94%.

Combine these statistics with cheap valuations and high dividend yields and it seems like we have found one obvious investment strategy, one that makes "dividends" the quintessential part of our outlook, regardless whether we need the cash flow or not.

One extra tool to use is the so-called rule of 72. Under this rule (which every math teacher will tell you is 100% accurate) the numbers 10 and 7.2 are inter exchangeable so if an investor decides to own a stock for 10 years he requires an absolute return from dividends of 7.2% per annum to double his initial investment, assuming no net change in the underlying share price over ten years. If the average annual return from dividends is 10% only 7.2 years are needed to achieve the same. (All other variations apply as long as the combined sum is 72).

In the pre-2007 era, it would have been a hard ask to combine those numbers, but when PE ratios have been slashed and earnings are holding up, investors will find plenty of candidates that might suit this approach. A warning seems warranted though, as investors better make sure they do not fall into the traps the share market offers them. A high dividend yield does not automatically imply "lots of value on offer", it can also signal "high risk" or "unlikely the company won't cut". As said earlier, time can do a lot of things, but it is unlikely to transform an ugly mistake into a fantastic investment. The worst mistake any investor can make is to buy into equity of a company that is about to go ex-growth, as shareholders in David Jones ((DJS)) can confirm this year.

One other obvious example of a seemingly high dividend payer that turned out a capital killer is, of course, Telstra ((TLS)). I have used Telstra for many years as the prime example of how dividend investing, done in the wrong way, can end up as a disaster for long term investors. Since February this year, however, things might have changed. It would appear the new management team at Telstra has finally achieved a fundamental turnaround. For the first time in years forward looking earnings forecasts for Telstra are no longer in the negative.

While the outlook will be no more than single digit percentage growth, this will be sufficient to stop the eternal slide in Telstra's share price. Good dividend investing is also about growth, and ideally dividends will be much, much higher at the end of the ten year period, but in Telstra's case a lot is being compensated by the 9% that is on offer from the starting point onwards. Using Telstra as an example for this investment approach is easy: 9% in dividends each year, plus your original money back at the end of the period. One can use franking or participating in the company's dividend reinvestment plan to further increase returns.

Other companies that can be considered are Ardent Leisure ((AAD)), at the time of writing offering a non-franked 11% yield, Adelaide Brighton ((ABC)) on a yield of 6.5% and, of course, the banks. National Australia Bank ((NAB)) is currently offering circa 8.3%.

The irony is that by adopting this passive approach, many long term investors might be doing themselves a bigger favour than they realise. Academic research has long ago established that investors who spend too much time in actively managing their portfolio, ultimately end up with subpar results as they more often than not sell too soon and buy too late. Peers who stick to more of a hands off approach tend to end up with better results. These conclusions, by the way, are confirmed by anecdotal evidence I have picked up from personal contacts with investors over the past years.

Last but not least, one recurring theme in analysis conducted into future investment returns seems to be that future returns will likely be lower than the returns generated from equities between 1982-2007. A number that is growing in popularity is 8% as a projection of average annual returns from equities in the decade ahead. Let's not quibble about this and for now accept this projection as more or less correct. What then is wrong about growing your dividends above this number and easily beating the market's average?

For more on dividends in the Australian share market:

– How Not To Be Your Own Worst Enemy (5 September, 2011)
– Rudi's View: Gold And Dividends (August 24, 2011)
– Rudi's View: Dividends, The New Black (22 June, 2011)
– Presentation ASX Investor Hour – Stocks That Consistently Beat The Market – or visit http://www.brr.com.au/event/frame/81534

This is the final story in a series called "The Big De-Rating – A Guide Through The Minefields". All previous four chapters can be accessed on the FNArena website – see Rudi's Views.

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)  

P.S. I – All paying members at FNArena are being reminded they can set an email alert for my Rudi's View stories. Go to Portfolio and Alerts in the Cockpit and tick the box in front of 'Rudi's View'. You will receive an email alert every time a new Rudi's View story has been published on the website. 

P.S. II – If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.

Click to view our Glossary of Financial Terms