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The re-emergence of the ‘yield pigs’

Recent SMSF investment strategies around equities have focused on generating yield rather than capital growth. This approach, however, may not be as prudent as many individuals think, writes David Prescott.

Many SMSF investors have recently turned their attention heavily towards reaching for yield when it comes to their Australian equity portfolio allocation. Unfortunately, in doing so they are running the risk of experiencing some potentially serious capital losses.

Economic conditions in the 1980s

The economic environment in the United States in the late 1970s was characterised by stagflation, a period of continuing high inflation, stagnant business activity and increasing unemployment. By 1980, inflation had reached a massive 14.7 per cent. In its war against this rampant inflation, the US Federal Reserve Board clamped down hard on the money supply, causing interest rates to hit 20 per cent.

In this period, investors enjoyed, and many ultimately became accustomed to, high double-digit nominal yields on their equity and bond investments.

As interest rates rose, not surprisingly, consumer spending and business borrowing slowed abruptly. The economy soon fell into a deep recession and unemployment rose above 10 per cent.

By 1983, the inflation problem had eased, the economy had rebounded, and the US began a sustained period of economic expansion that didn’t end until July 1990. The annual inflation rate remained under 5 per cent throughout most of the 1980s and into the 1990s.

With the stronger economy, interest rates started to fall sharply, as did the nominal yields on equities and bonds. Investors who had remained infatuated with the historic higher yields on offer began to sacrifice credit quality in an effort to try to maintain their yields. Investors reached for yield without giving adequate regard for the risk they were taking on. It was in this period the derisive term ‘yield pig’ was coined by Wall Street bankers and brokers to describe those investors who were lured to purchase a variety of instruments that promised high yields to investors.

It was many of these yield pigs who suffered very significant and painful losses of capital, as they bought assets at highly overinflated prices.

Current Australian market conditions

While the economic environment is undoubtedly very different today, with its own set of unique and very significant challenges, it is again the yield pigs who appear to be most exposed and vulnerable to potential painful capital loss in the Australian market.

There are, however, many parallels to the investing behaviour of 30 years ago.

The Australian equity market is currently in the midst of a yield bubble, with the mania for high-income stocks currently reaching fever pitch. While this may continue for many years to come as the world continues to grapple with a period of sustained low interest rates, we feel it is an appropriate time to express a degree of caution.

So far this financial year, the Australian stock market, as measured by the benchmark All Ordinaries (Accumulation) Index, has advanced by 23.9 per cent (as at the end of May). This is after a mini-correction with the market retreating 4.4 per cent in May. This spectacular performance, however, has not been driven by a broad market rally across all sectors. Indeed, the performance has been driven by a very narrow concentration of performance. In fact, only eight stocks have delivered all the performance of the Australian market. These eight stocks include Australia’s four largest banks – ANZ, Westpac, Commonwealth Bank of Australia and National Australia Bank – as well as Woolworths, Wesfarmers, CSL and Telstra.

We feel the pricing of many of these stocks has reached extreme levels. The significant market repricing of these stocks has been driven primarily by a significant expansion in the multiples investors have been prepared to pay for these companies. This increase in risk being assumed by investors is a direct adjustment to the pervasive lower interest rate environment and a rebalancing of their portfolios away from cash and fixed interest to certain higher-yielding areas of the stock market. The increase in share prices has not been driven by any commensurate increase in the underlying company earnings. Indeed, the earnings delivered by these companies and the underlying earnings from the majority of corporate Australia have been flat, given the subdued economic conditions. Often share prices rising strongly without any increase in underlying earnings or without any improvement in the fundamental environment can be a dangerous sign.

We consider the biggest worry is that there has been little discrimination by investors as to the underlying quality of the income or yield. Most participants in the market currently appear to be largely indifferent to key factors, such as a company’s payout ratio, the company’s underlying capital structure or the quality of their earnings. Assessing companies for investment based solely on the size of the dividend to investors again is an investment strategy fraught with danger.

Should we see any normalisation of this environment, the rush to the exits is highly unlikely to be orderly. We could see a very sharp contraction in equity prices of these companies that have been bid up by the market to satisfy their hunger for yield.

The Australian banking sector

The four major Australian banks currently represent a whopping 26.2 per cent of the S&P/ASX 100 Index.

Many investors in the Australian share market, especially those that have been investing for a long time, have a fascination with Australian banking stocks and are extremely reluctant to sell any of their Australian bank shares. Indeed, most SMSF portfolios would maintain a high weighting in their portfolio to Australian banks.

This is somewhat understandable as Australian banks, as measured over a long period of time, have delivered wonderful returns to investors from a combination of fully franked dividends and capital appreciation.

It is, however, very dangerous to value them solely on the basis of their dividend yields.

We see banks in the current environment as low-growth entities that have artificially fudged their profitability over the past two to three years by progressively lowering provisioning levels. This has left the sector extremely exposed, grossly under-provisioned and highly vulnerable to any deterioration in the quality of loan books. This is a cyclical phenomenon that has been repeated on countless occasions over the centuries, so we do not believe this view to be out of step nor as controversial as many of our peers appear to. It is simply a fact of cycles, of leverage and of poor decisions made in the good times, which invariably come home to roost in the tough times. Most certainly, the current pricing of banks and the sustainability of their dividends would come under severe pressure should we enter into a bad debt cycle.

It is a flawed investment approach for investors chasing high yield to be equating dividends from highly leveraged bank stocks to lower rates on term deposits and government bonds, which entail far lower risk. The key questions here are: Is the extra income worth the very significant risks to capital, and how sustainable are these dividends in tougher economic times when loan growth is insipid, unemployment increases, ability to service loans becomes increasingly challenging, the value of collateral diminishes and bad and doubtful debts increase from current ludicrously under-provisioned levels? It all begs the further question of whether bank bosses are being far too optimistic with respect to their provision for loan losses. They can only be basing this approach upon a view that things will not deteriorate economically in this country for the foreseeable future.

We feel those investors who have bought bank shares for their defensiveness and income better hope these bosses are correct. For what it is worth, we believe bank executives are being myopic and extraordinarily apathetic with respect to the many and very significant threats to their repeatedly spun, rosy economic scenarios.

Investing

For the majority of SMSF investors, the purpose of their fund is to generate income to fund their lifestyle, either currently or on their retirement.

No doubt, most SMSF investors are tired of hearing from investment professionals that investing conditions are challenging. The reality is, however, that these are very difficult conditions for investors, especially those investors who rely on the income generated by their assets.

Now more than ever, a sound investing strategy would be one that focuses on safety of principal first and adequate return second. Most SMSF investors who are reliant on the income generated by their portfolios strive for an investment strategy whereby they consume only the income generated by their portfolio while attempting to maintain, or even grow, the capital value of their portfolio from year to year. Possibly, these investors may be best placed to ignore conventional wisdom and to consume some of their capital base, rather than excessively reach for yield and risk permanent capital impairment.

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