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BHP dividend cut heralds the death of the yield play

"We now have to recognise we're in a new era, a new world," said Andrew Mackenzie this week, as he explained why BHP Billiton would be cutting dividends by 74 per cent.

The cut came as no surprise to institutional investors, many of whom had been urging BHP and its old rival Rio Tinto to rethink the size of their dividends.

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BHP release dire first-half results

BHP Billiton's interim results for the half year ended December 31, 2015.

That didn't prevent a good old-fashioned shareprice rout when the bad news finally landed; BHP shares fell 11 per cent in three days as yield-focused investors accepted that one of Australia's biggest companies was no longer satisfying their lust for yield.

BHP and Rio Tinto's lead was followed by embattled retailer Woolworths on Friday, and ANZ has indicated that it could be next to trim dividends.

While the hunt for yield remains a powerful force in the Australian market, there are signs that companies are starting to rein back their generosity.

Profits outgrow dividends

BHP chief Andrew Mackenzie launched a calm and determined defence of his company on Tuesday.

BHP chief Andrew Mackenzie launched a calm and determined defence of his company on Tuesday. Photo: Pat Scala

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Estimates calculated by Goldman Sachs suggest that the 2016 financial year will see earnings per share across the biggest 200 stocks on the ASX grow faster than dividends per share.

That has not been the case since 2009, when corporates were battening down the hatches in a bid to survive the global financial crisis.

The February reporting season has thus far indicated that earnings per share will contract by, on average, 4 per cent below 2015 levels, while dividends per share have contracted by 6.5 per cent.

The result looms as a stark contrast to the previous five years, when earnings were flat and dividends per share grew by 18 per cent.

"I'm not trying to sound bearish, but there isn't really much more room for the market as a whole to lift dividends faster than earnings as a whole," said Goldman's Matthew Ross.

So is the yield trend no longer the friend of the retail investor?

No one is buying commodity stocks for yield... if they have been they are crazy.

Morningstar's Peter Warnes

A fad's passing

Fund manager Roger Montgomery.

Fund manager Roger Montgomery. Photo: Michel OSullivan

"Investors will always get burned chasing fads, and the yield play was a fad," said fund manager Roger Montgomery this week.

Montgomery runs an eponymous investment business, and has been one of the biggest critics of the yield game, which has arguably been the dominant trade in Australian markets over recent years.

"We get these situations where a fad forms and everyone jumps on it and nobody thinks beyond the immediate share price rise to say 'what is the ultimate result? The result is a divergence between price and growth and then no growth from the companies," he said.

The chase for dividends was a product of quantitative easing and historically low interest rates in many of the world's advanced economies.

With term deposits now offering tiny returns, investors moved up the risk spectrum into shares.

The play was particularly common among retiring baby boomers, who saw franked dividends as a reliable way to earn tax free income without selling down their positions.

Initial success

Telstra chairman Catherine Livingstone's greatest skill, stemming from her natural curiosity about technology, is an ability to look over the horizon.

Telstra chairman Catherine Livingstone's greatest skill, stemming from her natural curiosity about technology, is an ability to look over the horizon. Photo: Nic Walker

Initially, the plan worked a treat; companies like Telstra (Australia's most traded stock by volume in each of the past six years) and the big four banks continued to boost dividends while the popularity of the trade saw their share prices swell

Investors got reliable annual income and capital growth.through rising stock prices.

But Montgomery says the hunt for yield was such a dominant theme in markets, that companies started neglecting long term growth.

"From a company perspective, boards acquiesced to shareholder demands for more income, increased their payout ratio which left them with less profits to retain for growth," he said.

"They have an attractive yield but they start to behave more like a bond than an equity, and people are paying exorbitant equity-like prices for what is in effect a bond."

Miners faring worst

Many commodities have become over-supplied.

Many commodities have become over-supplied.

The sacrificing of long term growth to pay dividends was particularly severe within Australia's two biggest miners BHP and Rio Tinto.

Like sharks; mining companies die if they stop moving forward.

Their assets are depleted with each dig of the shovel, meaning producers of natural resources must constantly find new mineral deposits.

Between 2012 and 2016, BHP and Rio slashed the amount they spent on exploring for, and developing those new assets.

With many commodities becoming over-supplied, the big miners saw little incentive to find new deposits, and plenty of incentive to reduce their spending.

But while spending was reduced on almost all items, there was one item where spending increased; dividends.

As the commodities downturn gathered pace, the big miners started ramping-up dividends.

BHP was most generous

Australia loves dividends.

The 2015 financial year was arguably the peak of the big miner's generosity; BHP's statutory profits fell by more than 86 per cent yet its dividends (which are paid in US dollars) rose by 2.5 per cent.

Rio's dividends per share rose 12 per cent in a year when earnings per share slid 9 per cent lower.

In January 2016, before BHP confirmed it would cut its dividend, the company's share price was so low, and its dividend so high, that one share purchased would be entirely repaid by dividends within eight and a half years.

The situation was described as "the dividend yield of a lifetime" by Shaw and Partners analyst Peter O'Connor.

Nobody was surprised when one month later, it turned out to be too good to be true.

"We are seeing a lot of companies in the resources space change their dividend policies because they were unsustainable," Mr Montgomery said.

"Unless companies can grow profits they are not going to be able to sustain growing dividends, and if investors want to preserve their purchasing power, they need to grow their income".

Risks with yield strategy

Financial advisers are moving clients out of Australian dividend stocks and into US stocks.

Financial advisers are moving clients out of Australian dividend stocks and into US stocks. Photo: Karl Hilzinger

Lonsec investment consultant Eleanor Menniti​ believes that such cuts to dividends are reminding yield hunters that their strategy is vulnerable.

"It is now being hammered home to investors that these dividend strategies are not risk free. Dividends can be cut, and they can be cut without warning," she said.

"Long term growth in some of these dividend stocks is not guaranteed either. Investors need to be balancing long term growth with yield, and its dangerous to focus too much on one or the other.

"If markets continue to be volatile, this will become a more pressing issue, particularly for those looking to use yield to maintain a lifestyle."

Some financial advisers are moving clients out of Australian dividend stocks and into US stocks, in the hope that a strengthening US dollar will deliver yield growth for Australian shareholders even if those US companies are paying out only modest dividends.

"Some people will be tempted into higher risk things like hybrids, and overseas markets are going to look more and more attractive. Australian investors have always had that home bias and that will remain the case to a certain extent. But I think there has recently been a realisation that there is a lot of growth offshore and people are more interested now in some of those offshore stocks," said Ms Menniti.

The large established tech stocks in the US like Facebook and Google, have attracted attention, but have also encountered selling the early months of 2016.

Property trusts have also been viewed as an alternative. But not everyone believes it is time for a new game plan.

'Crazy' to buy miners for yield

Morningstar's Peter Warnes concedes some investors started to question the yield strategy.

Morningstar's Peter Warnes concedes some investors started to question the yield strategy. Photo: Simon Alekna

Morningstar's Peter Warnes said cuts to mining dividends should not be seen as proof that the other dividend stocks on the ASX will follow suit.

"No one is buying commodity stocks for yield, whether they are alleged blue chips or whatever. If they have been they are crazy," he said this week.

"In the yield play you have to buy sustainable companies."

He said the big four banks, Telstra and to an extent Wesfarmers have been the true focus of the yield play over recent years.

Warnes concedes that some investors have started to question the longevity of the yield strategy, particularly amid growing debate over the banks' future.

"Certainly the enthusiasm that has been pushing that trade over the past three years has waned, and it has probably waned because interest rates have stopped going down," he said.

"But I do think that now because the alternatives, such as bond yields, are not that appealing, that once this reporting season is over (which has generally better than the market was looking for) the defensive yield plays will still be there paying out."

Banks split investors

The big banks' exposure to resources as a percentage of total loans.

The big banks' exposure to resources as a percentage of total loans. Photo: Deutsche Bank

The big banks recent share price falls have split opinions over their ability to continue shelling shareholders with dividends.

Facing requirements to hold more capital and expectations that their exposure to bad debts will rise, many believe bank profits are on the way down and will inevitably drag bank dividends lower too.

Shares in the big four banks have fallen by between 26 per cent and 39 per cent since they peaked 11 months ago.

Commonwealth Bank, which in 2015 broke BHP's reign as Australia's most traded stock by value, has been the most resilient, while ANZ has suffered most.

In a bearish note published before Christmas, Citi predicted the big banks' dividend payout ratios were headed toward 80 per cent, and needed to be reduced to between 60 per cent and 70 per cent.

"On a 3-year view, we expect all the major banks to cut dividends," the note said.

ANZ is focus

ANZ chief executive Shayne Elliott says the objective in Asia is driving value.

ANZ chief executive Shayne Elliott says the objective in Asia is driving value. Photo: Chris Hopkins

ANZ's new boss Shayne Elliott indicated that the company's dividend was one of several things that might need to be cut in the future.

But Warnes said the share price declines witnessed over the past 11 months had made banks' dividend yields – which compare the dividend per share with the price of each share– even more attractive than they were when Commonwealth Bank was fetching more than $95 per share.

"The fact is the yield trade is probably fundamentally stronger now than it was when the bank shares started to come off," he said, adding that it was particularly the case for Westpac, NAB and Commonwealth Banks.

"The bank dividends (excluding ANZ) aren't coming down we don't believe...going forward we believe the dividend per share and earnings per share will be more in unison and the earnings per share will start moving higher than it has because that dilution from the capital raisings has worked its way through.

"If the Reserve Bank want the dollar down they may have to cut rates again. It wouldn't surprise me if they cut rates by 25 points in March and if that happens then the yield trade is on again in earnest."

Philip Capital's Michael Heffernan thinks ANZ, Westpac and NAB could all reveal "slight" dividend cuts when they publish their half year earnings in May.

But he said CBA and Telstra's dividends look solid, and the sharp falls in all bank shares mean dividend ratios will remain attractive, even if there are dividend cuts.

"I don't think it is over, the dividend yield is still highly attractive particularly in a low inflation environment, so i think the demand for good dividend stocks is still there," he said.

Look further afield

While dividend growth is slower than at any time in the past five years, the yield game is here to stay.

While dividend growth is slower than at any time in the past five years, the yield game is here to stay.

Heffernan said investors hoping to stay in the yield play may want to look beyond the battered blue chips to companies like Transurban, Sydney Airport, Flight Centre and the ASX itself.

"People could look beyond the banks, Telstra and Wesfarmers for stocks that pay good dividends now and there are a few mid-caps who have delivered reports that look okay," he said.

While dividend growth is slower than at any time in the past five years, Ms Menniti thinks the yield game is here to stay.

"In an low interest rate environment for the forseeable future and with bond yields at all time lows, the chase for dividends and yield will remain a factor in the market to some extent," she said.

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