The Yield Trade Is Not Dead, It’s Transforming

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In This Week's Weekly Insights:

– The Yield Trade Is Not Dead, It's Transforming
– ASX Outlook: The Bull Case Scenario
– Radar On Buy-Backs
– Rudi On TV
– Rudi On Tour

The Yield Trade Is Not Dead, It's Transforming

By Rudi Filapek-Vandyck, Editor FNArena

Question: what do the following twelve stocks have in common (other than they are all listed on the ASX):

– Coca-Cola Amatil ((CCL))
– Fairfax Media ((FXL))
– APA Group ((APA))
– Transurban ((TCL))
– Rio Tinto ((RIO))
– CSR ((CSR))
– Orica ((ORI))
– Flexigroup ((FXL))
– Kathmandu ((KMD))
– Bank of Queensland ((BOQ))
– Stockland ((STG))
– Downer EDI ((DOW))

Don't know? They are all trading on implied forward dividend yields in between 4%-something and 5%-something.

This observation has become one of the pivotal events that has come to investors' attention post the February reporting season. In my view, this observation is going to shape and re-shape investment strategies in Australia, possibly for the remainder of calendar 2015, if not beyond.

Think about this for a few extra seconds. We all know about the thirst for yield that is drawing international investors into Australian dividend payers. We all know about the "Smurfs" (SMSF-ers, Selfies) parking their retirement funds into yield stocks. And the RBA's un-announced cash rate cut in February certainly turned yield stocks into a highly profitable momentum trade, in particular in the anticipation-period leading into the February meeting.

But now we are all waking up to this story of a big convergence that has occurred, with traditional yield stocks offering 4-5% for the year ahead and non-traditional yield stocks, which often have more growth potential under their belt, also offering 4-5%.

I can smell a change in strategies and in momentum in the works. Already, funds managers, strategists and analysts have been busy trying to separate the better quality assets from the lesser quality assets inside traditional yield sectors, but I think the search for outperformance will go beyond the traditional yield boundaries.

In essence, what investors are being faced with is increasingly the choice between yield that is fairly static and attractive because bond yields are low and the RBA (perceived as) still in stimulus mode, and yield that is not that much different, but carried by advantageous growth prospects. What investors will focus on next is the "risk" factor that comes with owning both types of assets.

The Government Bond Yields Enigma

When lower bond yields push investors into high yielding equities, those equities instantaneously turn into a momentum trade. Not everyone buying shares in CommBank ((CBA)), APA and Telstra ((TLS)) in January was looking ten years ahead. What tends to happen when long term investors and short term momentum buyers are in unison, those equity prices tend to overshoot to the upside.

It was only February and many of the banks, Telstra, property trusts and infrastructure equities had already gained close to 20% since the start of the year. Those share prices have come off since, even when taking into account many have been paying out interim dividends.

I don't think it's all related to the subsequent RBA shock surprise for not cutting the cash rate again in early March. But even if the latter does fully explain as to why those share prices are now well below their peaks from a few weeks ago, the underlying message remains the same: investors beware for when the yield trade runs temporarily out of favour.

This can happen sooner than many would think possible.

One key focus of investors in Australia so far this year has been the switch in RBA attitude from "steady as she goes" to "probably more stimulus needed". Only last week, many an economist was expecting a follow-through rate cut in March. Still, the majority believes the RBA will cut at least one more time, likely in May.

One factor that hasn't received a lot of coverage in Australia just yet is that in Canada, where the last rate cut by the central bank preceded the RBA's in February, the BoC's narrative seems to have changed and economists over there are starting to review their expectations for more rate cuts this year.

Despite the carnage in the energy sector, and the significant fall-out for the Canadian economy from a weaker oil price, it all of a sudden has dawned on many that further rate cuts are by no means set in stone. So what's the story in Australia now the RBA did not follow-through in March?

Even if the RBA is still intent on delivering more rate cuts, it may well be that if the next cut is postponed too long, the effect may largely go AWOL for the Australian share market. How come? The answer lies in the US where the Federal Reserve might be looking at lifting interest rates.

Historically, Australian government bonds do respond to (anticipation of) RBA rate cuts, but they also take guidance from US government bonds. Given the potential trade-off between a cash rate cut locally and rising yields for US Treasuries, which factor do you think will dominate?

My money will be on the US ten year bond yield.

Of course, it is not a given the Federal Reserve will start lifting interest rates from mid-year either. There are still a number of intelligent Fed watchers out there who remain of the view the next interest rate hike will be nothing more than just a token 25bp lift, and then nothing for a long while. Because the Fed is watching international developments closely, plus the US dollar is doing a lot of heavy lifting already.

Further complicating the outlook for government bond yields is that, assuming the Fed does lift interest rates this year, nobody actually has the faintest idea whether it'll happen in June, or in September, or whenever? Mind you: this is including the decision makers at the Federal Open Market Committee ((FOMC).

Bottom line: don't get lost in the noise about whether the RBA this and/or the Fed that. The outlook for yield plays in the Australian share market is getting murkier and investors with less than a ten year horizon are increasingly going to pay attention. The momentum trade has now reversed direction.

Yield Plus Growth Remains The Best Option

I am not the only one who's paying attention to all of the above. Here's the opening sentence from an update from the bond market specialists at National Australia Bank on Monday:

"The US economy increasingly looks to be in self-sustaining growth mode. Fed to drop patience guidance this month and increased chance first rate hike comes in June. This should maintain upward pressure on the US$, downward pressure on the $A and upward pressure on Australian and US term yields" (emphasis mine).

Here's a key statement from a recent strategy update from Goldman Sachs:

"Australian equity valuations have had a materially higher correlation to US rates than to domestic rates. We expect that pattern to repeat this year even if the RBA cuts while the Fed hikes".

Analysts at Macquarie used a sector update on listed property stocks (A-REITs) to express their concern. On Macquarie's calculation, property stocks are some 8% undervalued based upon the spread between dividends and bonds, however, report the analysts:

"…our economics team forecast Australian bond yields to rise over the course of 2015, likely being dragged up by the US curve as the US Federal Reserve begin hiking rates from the middle of the year and a 3% bond yield (as is forecast by our economists) would render the sector at fair value currently".

While there remains demand for yield stocks, analyst teams such as the one at Macquarie, are trying to distinguish between higher and lower quality and between higher and lower risk inside yield sensitive sectors. Inside the property sector, for example, Macquarie prefers Goodman Group ((GMG)), Westfield Corp ((WFD)) and GPT ((GPT)).

Strategists at Goldman Sachs have now changed their portfolio composition, downgrading Infrastructure to Neutral from Overweight and Banks to Underweight from Neutral.

In line with my own research since 2008, I think the best protection against a shift in the dividend yield trade is to seek out stocks that offer both yield and growth. Given the convergence in yields available on the ASX, investors don't have to go overboard in the risk compartment and they have much more choice today since the gap in yields has narrowed significantly.

Paying subscribers can easily rank stocks on prospective dividend yields via the Sentiment Indicator on the FNArena website. There are two pre-configured selections already, highest and lowest yields.

Resources Stocks Morphing Into Yield Stocks

I strongly urge everyone to absorb the above in line with their own strategies and appetite for risk, but it should be clear by now resources stocks are increasingly going to play an active role in the "must have yield" focus among investors in the Australian share market.

Both Rio Tinto and BHP Billiton ((BHP)) are today "yield" stocks with a lot of uncertainty dominating the outlook for profits, but their respective dividends look safe, at least for the medium term (multiple years ahead).

Woodside Petroleum ((WPL)), on the other hand, has over the past year shown investors both sides of the yield trade in an inherently volatile sector that is energy. Woodside first offered 7% yield, which saw the share price protected on the downside and trend towards the mid-$40s, only to dive back to the low-$30s when it became clear the dividend would have to be cut this year.

On current consensus estimates, Woodside shares are at present yielding some 4% for the year ahead, and the dividend should be fully franked. Note that Santos ((STO)) shares are offering close to 5%, fully franked. This seems but logical in comparison with the much lower risk profile for Woodside.

Origin Energy ((ORG)), which operates on a June 30 fiscal year, is offering 4.2% in FY15 and 4.4% in FY16. AGL Energy ((AGL)) is offering 4.3% and 4.4% respectively. Caltex ((CTX)) which has been one of prescient analysts' favourites to become an SMSF yield favourite post the Kurnell refinery closure, is still only offering 2.9% this year. This thanks to a Price-Earnings multiple of 19.

There are many more "attractive" looking yield plays among smaller miners and energy companies, but investors should keep in mind the level of insecurity surrounding most of these dividends is significantly higher.

Similar considerations can be made for cyclicals such as Orica, CSR ((CSR)), Downer EDI ((DOW)) and Mineral Resources ((MIN)) as well as for retailers including Harvey Norman ((HVN)), JB Hi-Fi ((JBH)), Kathmandu and Super Retail ((SUL)).

There are many more yield/risk assessments available throughout the industrials space. Carsales.com ((CAR)) offers some 4%, Nine Entertainment ((NEC)) offers nearly 4.5%, Flexigroup offers nearly 5%, Automotive Holdings ((AHE)) offers nearly 5.5%.

Eye Candy: Two Charts

Skimming through recent analysts' research reports, I selected the two charts below to complement my analysis above.

The first one shows the underperformance of traditional yield stocks in February, the second one shows the convergence in yield that has unfolded in the Australian share market over the years past.

Note that I included an overview by Macquarie showing the 4-5% yield range for sectors in the Australian share market in my dissection of the February reporting season, published on Friday.

Lower For Longer Still Applies

Weakness for yield stocks will no doubt bring out predictions about the end of the yield trade, in particular from those experts who operate on a shorter horizon. I remain of the view this is more than likely going to prove a few steps too early, too far. But there is a genuine chance it may at some point just look like it on a short term experience/observation.

Anyone can take a wild guess about the future, but I happen to think that "Lower for Longer" regarding global interest rates and government bond yields is going to stay with us for many years yet. Investors just have to make sure they do not misinterpret "Lower for Longer" in that it doesn't mean bond yields will not ever rise from their historic lows, which they will. But they won't go back to where they were pre-GFC.

Finding the equilibrium somewhere in between is going to bring along a lot more volatility, incorrect predictions and increased stress and uncertainty for central bankers and investors alike. The easy gains are now well and truly behind us.

One final thought: Global investors piling into Australian yield stocks buy banks, they buy Telstra, plus the likes of APA and Sydney Airport ((SYD)), possibly Transurban too, maybe even Rio Tinto and BHP Billiton. But they'd never consider buying a stock like Flexigroup or Asaleo Care ((AHY)).

Diversifying away from the internationally owned yield plays thus also makes a lot of sense when one considers the moment may re-appear when foreign funds start leaving Australian shores.

ASX Outlook: The Bull Case Scenario

My dissection of the local February reporting season includes an assessment by UBS strategists concluding Australian indices essentially have nowhere to go for the foreseeable future since profit forecasts and RBA cuts have already been accounted for in today's share prices.

Strategists at Deutsche Bank have been struggling with the same valuation enigmas as their peers at UBS (and pretty much everywhere else), but they decided to take a more constructive view in that PE ratios are likely to stay higher for longer. On this basis, calculates Deutsche Bank, the ASX200 is likely to experience a dip first, but it should revive the upward momentum later in the year and discover "fair value" at around 6200.

Investors should note, Deutsche Bank's valuation model signals Australian equities at present are some 10% overvalued. The difference is that Deutsche Bank strategists believe this overvaluation can stay in place for longer, hence why they are not as cautious as UBS, and others, on the outlook for equities for the remainder of 2015.

Interestingly, Deutsche Bank strategists have three preferences:

– laggards that should re-rate, including Asciano ((AIO)), AGL Energy ((AGL)), JB Hi-Fi ((JBH)) and Perpetual ((PPT))

– high PE stocks, including CSL ((CSL)), James Hardie ((JHX)), Oil Search ((OSH)) and REA Group ((REA))

– stocks offering reasonable yield plus growth, including Fletcher Building ((FBU)), Harvey Norman ((HVN)), Iress ((IRE)), Stockland ((SGP)) and QBE Insurance ((QBE)).

Radar On Buy-Backs

Companies that buy in their own stock are more often than not rewarded with share market outperformance. Below is an incomplete overview of companies buying in their own shares this year. All suggestions and contributions welcome at info@fnarena.com

– Amcor ((AMC))
– DWS Ltd ((DWS))
– Fairfax ((FXJ))
– Fiducian ((FID))
– Finbar Group ((FRI))
– GDI Property Group ((GDI))
– Logicamms ((LCM))
– Nine Entertainment ((NEC))
– Orica ((ORI))
– Rio Tinto ((RIO))
– Seven Group ((SVW))

Wants to buy in own stock (but still awaiting shareholders approval): Intrepid Mines ((IAU))

Rudi On TV

– on Wednesday, Sky Business, 5.30-6pm, Market Moves

Rudi On Tour

I have accepted invitations to present:

– Wednesday, 11 March to members of Chatswood section of AIA, in Chatswood (starts at 7.30pm at Chatswood Club, Help Street)
– August 2-5, AIA National Conference, Surfers Paradise Marriott Resort and Spa, Queensland

(This story was written on Monday, 9 March 2015. It was published on the day in the form of an email to paying subscribers at FNArena).

(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. All views are mine and not by association FNArena's – see disclaimer on the website)

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THE AUD AND THE AUSTRALIAN SHARE MARKET

This eBooklet published in July 2013 forms part of FNArena's bonus package for a paid subscription (excluding one month subscriptions).

My previous eBooklet (see below) is also still included.

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Odd as it may seem, but today's share market is NOT only about dividend yield. Post-2008, less risky, reliable performers among industrials have significantly outperformed and my market research over the past six years has been focused on identifying which stocks, and why, are part of the chosen few; the All-Weather Performers.

The original eBooklet was released in early 2013, followed by a more recent general update in December 2014.

Making Risk Your Friend. Finding All-Weather Performers, in both eBooklet versions, is included in FNArena's free bonus package for a paid subscription (excluding one month subscription).

If you haven't received your copy as yet, send an email to info@fnarena.com

For paying subscribers only: we have an excel sheet overview with share price as at the end of January available. Just send an email to the address above if you are interested.

Click to view our Glossary of Financial Terms