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8 stocks in the sweet spot

This article appeared in the July 2014 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Choosing stocks only for their yield is dangerous. Instead, focus on finding exceptional companies with solid growth prospects and good balance sheets - and the potential to lift dividends over time.

Photo of Roger Montgomery By Roger Montgomery, Montgomery Investment Management

Without income how can you pay for the healthcare, lifestyle and living expenses that forever rise in price? I understand the need to generate income and also admire anyone who has managed to build a portfolio of investments that produces the returns they need to live comfortably.

I would, however, urge you to think seriously about the possibility that an even better lifestyle might be affordable with a different approach to dividends and dividend yields.

The conventional investors' obsession with dividend yield leads to a greater selection of companies with relatively poor prospects. By definition, companies that pay consistently high dividends relative to their available profit cannot reinvest large amounts of retained profits at a sustainably high rate of return.

The result to you might be an attractive yield today but a loss of purchasing power over the long run. And given that at retirement you might need to fund 30 years of spending, what you want, and really need, is the ability to maintain your purchasing power. Simply put, if you are receiving $50,000 of income on a million-dollar investment today, but you are still earning $50,000 of income on a million dollars in a decade's time, you will be much poorer.

When interest rates are so low that the real rate of return (after inflation) on cash deposits is actually negative, many investors dutifully strive to own a portfolio full of high-dividend-yielding stocks. Over the long run however, you need your income to grow at a rate above inflation. That is the only way you can maintain your purchasing power, and in the future, afford to eat at the same restaurants you can today.

The best stocks to deliver on that promise are not those paying a high dividend yield, but those generating high rates of return on incremental capital.

Investors in The Montgomery Fund know its focus is on companies that own businesses that can redeploy large amounts of incremental capital at very high rates of return, over an extended period. And there is another benefit: sustainably high rates of return on incremental capital indicate a strong competitive advantage.

Conversely, the worst business to own must do the opposite out of necessity: reinvest large amounts of capital at low rates of return. Many Australian blue-chip companies fall within this category, drawing many investors into the pit of mediocre returns because of their "attractive" dividend yield and blue-chip monicker.

Example one: Telstra Corporation

A quick investment example in two telecommunications companies over the past ten years will help illustrate this point.

In calendar year 2004, Telstra (ASX: TLS) shareholders expected to receive a dividend of $0.26 per share dividend, a yield of 5.2 per cent on the $5.02 purchase price at the time. Fast forward to today and shareholders expect a calendar year 2014 dividend of $0.30 per share or a yield on the current $5.17 of 5.8 per cent. And Telstra's share price has appreciated from $5.02 at 1 July 2004 to $5.17 today, delivering $0.15 or 3 per cent of capital growth.

Combining dividends ($2.975 per share) and capital growth ($0.15) over the 10-year period under review, Telstra's shareholders have had a total return of $3.125 per share or 62.3 per cent on the $5.02 purchase price, an average annual compounded return of just 4.9 per cent. This barely exceeds real-world inflation over the period.

Perhaps surprisingly, Telstra's normalised net profit is forecast to reach $4.05 billion for the year to June 2014, around $250 million less than was recorded 10 years earlier. Over the same period, shareholders' funds have declined by $2.3 billion to an estimated $13 billion, but net debt has jumped by $3.1 billion to an estimated $14.2 billion.

Year to June

2004

2014 (est.)
Normalised net profit ($m) 4,370 4,050
Shareholders' funds ($m) 15,359 13,028
ROE (%)  28.5% 31.0%
Net debt (Sm) 11,163 14,240

Source: Montgomery Investment Management

Given the lack of growth in profits, paying out a little over 100 per cent of Telstra's earnings in dividends over this 10-year period has probably been logical.  But for long-term, income-dependent investors, it has not been particularly useful.

Example two: M2 Telecommunications

Now let's look at M2 Telecommunications (ASX: MTU). It is unlikely to have been on any income-concerned investor's radar in 2005. M2 Telecommunications' dividend yield has been significantly below that of Telstra's throughout the 10-year review period. This is less relevant when you realise that both the dividend and the share price have grown meaningfully in that time.

M2's share price has appreciated from $0.26 to $6.00 over the past decade, and in calendar year 2014 the dividend is expected to be $0.23. This represents a current yield of just 3.8 per cent, but over the 10 years M2's aggregate dividends totalled $0.94 (and remember the purchase price was just 26 cents). Together with the capital growth, M2 shareholders have recorded a total return of $6.679 per share on a 26 cent purchase price.

That means the average annual return was $0.668 per share, or an average annual compounded return of 38.8 per cent.

More importantly a $100,000 investment in 2005 is now worth $2.7 million, easily ensuring that the restaurants you were eating at in 2005 can be afforded today.

M2's net profit is forecast at $80 million for the year to June 2014, up from $1.3 million 10 years earlier. While the number of shares on issue has grown from 48.2 million to 180.4 million over that period, primarily to fund acquisitions, it is interesting to note the forecast 2014 annual dividend will be nearly covered twice by normalised earnings.

The crucial message from this little (and rather dramatic) example is that while companies with good long-term prospects are likely to have a lower dividend yields, their strong growth in earnings and dividends will more often than not mean your total investment return, including capital growth, will easily usurp the concept of investing on a dividend-yield basis only.

To pay dividends or not to pay

This brings me to the rather controversial subject - at least in the fully franked Australian landscape - on whether companies that own businesses able to employ large amounts of incremental capital at very high rates of return over an extended period, should pay a dividend at all.

Let us analyse two businesses. One has a return on equity of 20 per cent, an annual profit of $1 million and pays out 100 per cent of its earnings to investors. The second business also achieves a return on equity of 20 per cent, also has an annual profit of $1 million, but instead reinvests all its earnings (thus paying no dividends) in its operations at returns of 20 per cent.

If we look to the future, the second company after a decade of growth will produce earnings almost 6.2 times greater than it does today, that is, $6.2 million annually. While the first company provided its investors with a regular and stable dividend cheque of $1 million, it lacked capital to reinvest and expand its profits. Investors were not served either, as it would have been difficult for them to find similar opportunities to reinvest their dividends at 20 per cent returns.

Investing in the second company has not produced any income but when management decides to start doing so, there is a lot more to be distributed than the first company. More importantly, the second company's share price will have reflected its ability to reinvest growing profits at 20 per cent.

If we assume the PE ratio remains the same, the share price will have also grown six-fold. It is highly likely, however, that the market will have expanded the price earnings ratio it is willing to pay for the shares of the second company, so it is reasonable to expect the share price will have appreciated much more than 620 per cent.

So the downside of high-growth companies paying out part of their earnings is that the shareholders cannot generally earn that 20 per cent after tax on their incremental earnings. Accordingly, why not leave all retained earnings inside the company and let it compound over a long time?

Management should retain as much profit as possible while they can redeploy profits at high rates of return. When the business matures and returns fatten, the much larger profits and accumulated franking credits can be distributed. If an investor needs some income, they can always sell a few shares or ensure they have investments in other income-producing assets (that are not going to protect purchasing power).

8 stocks in a 'sweet spot' of higher dividend yield and growth

(Editor's note: do not read the following ideas as stock recommendations. Do further research of your own or talk to a licensed financial adviser before acting on themes in this article).

Finally, I asked the team at Montgomery to provide a list of examples that might provide value investors with an acceptable forecast return on equity, solid growth prospects, a good balance sheet and a reasonable prospective dividend yield:

Company  

ASX Code

Price (20/6/14) Forecast Return on Equity (%)  Forecast net debt / equity (%)   Forecast Dividend Yield (%)
Reef Casino RCT $4.05  108  (2)  7.8
Westpac WBC $34.15  16  -  5.4
Infomedia IFM $0.74  29  (27)  5.3
Platinum Asset Management PTM $6.15 54  (91)  5.1
Commonwealth Bank CBA $81.42 18 - 4.9
Nick Scali NCK $2.58 36 (53) 4.8
Iress IRE $8.13 20 32 4.8
Hansen Technologies HSN $1.34 21 (22) 4.5

Source: Montgomery Investment Management

About the author

Roger Montgomery is Chief Investment Officer at The Montgomery Fund. To apply to invest visit the Montgomery Fund.

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