If you’ve ever met someone who bought a car because they liked the way it smelled, or a house because it “felt right”, you’ve seen “economic law” defied. Have you ever entered a supermarket with a single purchase in mind, only to get to the check-out with a full basket of goods? If you have, you know that consumers do not always act rationally. Investors are the same.
As a student, I struggled with Economics. Bear in mind, I was admitted to a masters degree course in Applied Finance after fifteen years of working my way from booking clerk to institutional derivative dealer. The professors and text books kept making bland statements of fact that seemed ridiculous to me. The killer was “consumers act to maximise their economic utility”. This is at odds with everyday observation of the way our friends and neighbours, and ourselves, actually behave.
Themes versus Fashion
Call them investment trends, market themes, or fashion, there are drivers of investment behaviour that prevail and are then discarded. Some are based in good sense, and others are simply fashionable. Whether the prevailing theme is growth at a reasonable price, endless growth through technology, greed when others are fearful, or a rising tide lifting all the boats, it is up to us as individual investors and traders to assess whether or not this makes sense – objectively, and in our own situation.
One of the key themes driving the rise in global share markets since June 2012 is dividend yields. The evidence for this locally is strong. Since its low on June 4, the Australian ASX200 index is up by 26.3%. However, key dividend yielding stocks have outstripped this rise.
Telstra
On March 20, Telstra stood at $3.20, the low for 2012. On Friday, it closed at $4.63, a capital gain of 44.7%. Despite having already risen substantially, from June 4, it’s up 26.5%. What could possibly inspire an investor to buy Telstra at that time? (You may recall that in June 2012 the ASX200 index dipped below 4,000, with a consensus view that it was heading to 3,000).
The answer is the dividend yield. At the time, Telstra paid $0.28 per year in dividends, fully franked, giving a grossed up dividend yield of 10.9%. (At the March low, the dividend yield was 14.3%).
Investors who bought in at this time were returning to investment basics – that real assets produce returns. They take one of two forms – either income or capital. A longer time frame (say two years or more) meant that investors could wait for a market recovery and a capital gain because they were earning good income in the meantime. Even if the share price of Telstra fell, their dividend stream remained unaffected.
This is a good example of an investment theme that makes sense for some investors. The important individual factor is time – can an investor ride out the storms and wait for a capital return? If they can, investing on the basis of dividend yields is not only sensible, it’s compelling.
Of course, investment of any kind always carries risk. While time is the most important individual factor, in terms of the share selected the key factor is whether there is a reasonable basis for believing that the level of dividends is sustainable. If the company is about to take an earnings hit, if the CFO runs off with the shareholder’s funds, or if there is any reason for thinking profits are about to fall substantially, the company is not a candidate for a dividend yield based investment as the yield is unlikely to remain at the current level.
One view of Telstra is that its contract with the NBN means its income stream is assured for years to come. Concerns that a change of government could lead to Telstra losing its preferred position are offset by reports that the NBN contract contains “poison pill” provisions that mean Telstra would receive substantial compensation if the contract were broken. In other words, the revenue streams supporting Telstra’s dividend yield are, in my opinion, sustainable.
So is it worth buying Telstra now? Each individual investor must answer that question for themselves, but the following table may assist in the assessment:
The table assumes that the dividend is constant at 28 cents per share per annum, and that it remains fully franked. It is apparent that even at significantly higher share prices, the dividend yield is attractive compared to short term deposit rates around 3%.
When would an investor consider selling Telstra? Once again, the answer depends on the individual. While holding a stock for its dividend yield, the entry price is used to calculate the return (a full year of dividends, divided by the share price). However, when thinking about whether to hold or sell, using the current share price can be a useful tool.
As an example, imagine you’re holding Telstra, and the share price has risen to $6. The dividends remain 14 cents per half year, but short term interest rates have risen to 7%. Using the table above, we see that the dividend yield is now below the cash rate. Some investors could treat this as a signal to sell.
As investors and traders, it is a good idea to separate investment themes from fashion. Fashions, such as the mania for tech shares between 1998 and 2001, can lead to bubbles and capital destruction. On the other hand, investment themes such as dividend yield based stock selection may allow investors to keep their heads while all around others are losing theirs.
