Should you buy cyclical growth stocks for yield?

Photo of Ken Howard By Ken Howard

min read

There are two reasons to own any investment: today’s income and tomorrow’s income. And while some investors may split these categories into income and capital growth, if the growth is to have any value it is in the higher future income. Otherwise the growth is illusory and it would be better to redefine it as popularity and optimism.

Another point to make is that the yield is either high or low, based on the price paid for the asset. Take Telstra Corporation as an example. Five years ago you couldn’t give it away, and the yield was 10 per cent fully franked (14 per cent pre-tax) and investors were worried about the future.

Today, investors are not worried about the future (although it is no more discernible) and the yield is closer to 5 per cent fully franked. There are two simple ways to explain the change in Telstra’s yield. Either the dividend has halved (it hasn’t and has actually increased by 10 per cent in the past two years) or the share price has doubled (which it has).

A third point is that “defensive” assets can become speculative investments, if you pay too much for them or they are encumbered with too much debt.

And a final point is that in business, periods of “consistency and predictability” are only temporary. There will be periods of low volatility where everything seems to be going right, but any investment which “promises” to insulate you from the vagaries of future disruption will come at a price. It will either be an illusion or produce a real rate of return after tax and inflation that approaches zero (e.g., cash in the bank).

Long-term investors need to accept that nobody knows the future, so the secret to successful investing cannot be to predict the future. The secret is to be prepared for the future by owning productive assets.

These will produce goods and services the economy needs and is prepared to pay for, today, tomorrow and for many years into the future, if not indefinitely. They will have little or no debt, and be sustained by innovation and investment.

If you are going to align your future (lifestyle and living standards) to Australia’s future, your investments should include a portfolio of Australia’s best businesses and real estate in the most liveable locations.

Cyclical businesses

Should investors own cyclical businesses for yield? Yes. They are just as critical to a modern economy as defensive businesses, and at the right price they make attractive long-term investments. Cyclical is not the same as speculative, but it does suggest a propensity to a boom-bust cycle that can lead to speculation.

There are many cyclical industries that actually provide goods and services the economy consumes every day. For example, minerals and metals.

There have been several boom-bust cycles over the past 100 years and there will undoubtedly be several more, but commodities are consumed every day for packaging, transportation, construction, manufacturing, medicine and much more.

The cycles are driven by periods of over and under investment, typically because the capital investment to bring on new supply is large and lumpy, and the underlying demand is a bit like the ocean with tides, waves and ripples.

The tides are, in effect, the rising global living standards; the waves are the economic and political cycles that finance and direct the infrastructure investment; and the ripples are the local residential construction and consumption cycles.

So, although there is definitely a longer-term trend to support multi-billion-dollar expansions, there is plenty of short-term volatility (periods less than 10 years) in demand.

The Rio Tinto experience

Rio Tinto is a very large, complex and diversified business, but if you consider the three largest operations that account for about 80 per cent of its assets, revenue, cash flow and earnings – iron ore, copper and aluminium – you have to conclude the company has some of the world’s best mining and refining assets.

They are mainly long life, low cost and well established, and are likely to remain at the bottom end of the production cost curve for decades to come.

Although I don’t know where commodity prices are going, I do know that for Rio Tinto to sustain its current productive capacity and provide incremental levels of additional supply, it will have to invest at least $2 billion a year. I also know that the global population is around 7 billion, of which only one third have a “middle-class income” or higher (at least $14,000 per annum).

So is the dividend sustainable, as the board of Rio Tinto boldly claims? I certainly believe it to be a commercially robust and reasonable claim when you consider the quality of the assets (cost structure, scale and remaining life); the current level of debt at around one to one and a half times its operational cash flow at current commodity prices and exchange rates; and the alternative supply sources of copper, aluminium and iron ore.

Commodity prices can go almost anywhere, but Rio Tinto has had to invest more than $80 billion to bring on and sustain some of the world’s best mining and refining assets, so a $4.5-billion dividend does not seem unreasonable.

About the author

Ken Howard is a stockbroker and financial planner. He has worked with RBS Morgans since 2001 and in the financial services industry since 1996. For more on the outlook for yield stocks, contact Ken Howard on 07-3334 4856 or email.

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