Time to get real on growth

Photo of John Addis By John Addis

min read

The Global Financial Crisis was a big kick in the head to investor sentiment, although it wasn’t that crash hot before it. The ASX 2014 Australian Share Ownership Study reveals that direct share ownership peaked at 44 per cent in 2004 and has been declining. Last year, 31 per cent of the population had a direct interest in shares.

The mood has certainly changed. After dealing with the GFC, an interminably long European debt crisis and the end of the mining boom, investors are cautious. Dividend yield is the only game in town. Investors know it, company boards know it, and central bankers are worried about it.

Why? Because the expectations currently built into the returns most investors are banking on are probably too high.

Before explaining the cause, a dollop of finance theory.  You can get to the total return expected from an investment by adding the income it delivers (the dividend yield in the case of equities) to the rate at which you expect that income to grow over the long term, which should approximate the rate of earnings growth for equities.

The idea is that by adding these two things together you get to a return you are happy with. This in turn should depend on the returns you can make elsewhere, and the starting point for this is the yield on government bonds – sometimes known as the “risk-free rate”.

Now, no investment meets that criteria but government bonds get pretty close, at least if you plan on holding until they are redeemed (it helps that governments can print money). You would clearly never accept less than this from a share, otherwise why take the risk? In fact, you would demand a bit more. How much more is a matter for personal taste and we’ll leave that to another day.

The key point for present purposes is that return expectations should go up and down with government bond yields – and over the past few years they have been heading down. Since the GFC, the yield on 10-year Australian Government bonds has more than halved from above 6 per cent to below 3 per cent (see chart below) and US Treasuries have done something similar.

The reason is that very little growth is expected around the world, so it is unlikely that central banks will get the chance to raise interest rates by very much.

Source: RBA

The response of sharemarkets has been reasonably rational on the face of it, with the so-called “rush to yield” driving the dividend yield on the S&P/ASX 200 Index down from above 5 per cent in 2012 to below 4 per cent in recent months. Naturally, no one is complaining about the surge in share prices this has delivered. The trouble is that these returns may be hiding a more worrisome problem.

Source: Intelligent Investor

Going back to the theory, one less percentage point of dividend yield is one more percentage point of growth that will be needed to meet the same return expectations. Yet the lower bond yield is predicated on lower growth in years to come.

How investors respond to lower return
There are two ways investors can respond. The first is to smash the share prices of companies not delivering the desired, and unrealistic, expectations of growth, to the point that their future expected returns rise to the desired level. The second is to pare back those expectations. The evidence from the recent reporting season is that the first approach appears to be winning.

The trouble is, this feeds into the expectations of corporate decision-makers. RBA research recently revealed that 90 per cent of Australian businesses will not invest in a new project unless they anticipate a return of more than 10 per cent.

Computershare Chief Financial Officer, Mark Davis, told the Australian Financial Review that the company typically targets a 15 per cent post-tax return on capital before it undertakes an acquisition or new project. Woodside Petroleum aims for 12 to 15 per cent, and property group Abacus has a hurdle rate of 25 per cent.

With such high return expectations it is little wonder that insufficient investment is taking place to get the economy growing again. Reserve Bank governor Glenn Stevens’ frustration with investment-shy business and political leaders is palpable. A recent RBA report noted that “firms are using hurdle rates that have not changed in a long time, set at a time when nominal long-term interest rates were far higher than they are today”.
In what might be called a real-life version of “pushing on a string” theory, the report tells of the many company executives that said “low interest rates do not directly encourage investment”. Sure enough, capital expenditure is down 10.5 per cent compared with last year and it is not just the mining sector that’s cutting back. In the March quarter, non-mining capital expenditure fell 4.8 per cent.

In an interview with AFR Weekend, Seek’s Andrew Bassat, bemoaning how few local companies were pushing into Asia, said: “I don’t know who is to blame; whether I blame the CEOs for being gutless, or whether I blame investors for making the CEOs gutless.”

It might make sense for individual investors to demand a dividend and for particular companies to succumb to that demand and reduce investment. But when everyone follows the same path it becomes a systemic problem. There is a strong relationship between business investment and economic growth, which is why Stevens desperately wants companies to stop paying out spare cash as dividends, lower their hurdle rates and start investing.

Single-digit returns more likely
The bond market understands the problem. Equity investors are the ones missing the point. If future economic growth is lower because of lack of investment, it is unreasonable to expect double-digit returns from one’s investments. Mid-to-high single digits is more likely.

Back in the real world, steady earners such as Computershare and Woolworths are struggling to grow. Even the banks are facing the prospect of lower returns. A recent Morgan Stanley research note forecast Commonwealth Bank’s return on equity slipping from above 18 per cent to 16 per cent, Westpac’s 16 per cent to 14 per cent, ANZ’s 14 per cent to 12 per cent, and NAB’s stuck at 13 per cent.

Assuming economic conditions worsen and impairments rise to their average historical levels, would knock another 2 to 3 per cent from these figures.

Compared with a 10-year bond yield below 3 per cent, though, returns of 10 to 13 per cent are nothing short of extravagant. So much so, that the banks should be investing more at this rate and paying out less in dividends. This emphasises the point. If the best businesses in the land are struggling to grow, how is everyone else going to fare?

Investors need to recognise that the next few years of earnings are largely irrelevant to a company’s underlying value. What matters is what they are doing to build their competitive advantages and increase the value they provide to customers.

If they do these things, they will create long-term value. But if we want them to do the right thing, we need to get away from focusing on near-term earnings and judge them on the investments they are making for the long term.

Ironically, if we pare back our expectations of growth, it might just get things growing again.

About the author

John Addis is an analyst with Intelligent Investor Publishing. This article contains general investment advice only (under AFSL 282288). Authorised by Alastair Davidson. To unlock Intelligent Investor's stock research and buy recommendations, take out a 15-day free membership.

Disclosure: The author owns shares in Computershare.

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