The shares of bricks and mortar retailers Speciality Fashion and Kathmandu have climbed 60 per cent and 43 per cent in the past three months. Who wants a 7 per cent dividend yield from a bank when this type of return is on offer?
Both these stocks delivered earnings surprises indicating there is still a lot of life in their clothing franchises.
But even after the rises, these stocks remain good value. Specialty Fashion for example, trades on an operational earnings multiple of about 3.5 times, compared with the Small Cap market average of 8 times.
This is in stark contrast to the expensive Big Cap stocks, which have delivered big returns because of their high dividend yields. As interest rates go lower, investors are dumping their term deposits and purchasing the banks and Telstra which have dividend yields of about 7 per cent, including tax credits.
Whether investors in the big banks and Telstra know it or not, they are in a high risk category, due to the high concentration of the Australian market.
There are 2188 companies listed on the ASX. The biggest 300 by market capitalisation are in the ASX 300 Index. The top 10 in this index represent 54 per cent of the total market cap!
Over half of the index’s return last year came from three of the four banks, Telstra and the pharmaceutical company CSL, as investors hunted for the perceived safety of dividends.
But because these dividend spewing giants are trading at record levels, they are as vulnerable as ever to a sell-off in the event of a hiccup.
On average the big four Australian banks, CBA, ANZ, Westpac and NAB, are trading on just under 2 times their book value. Elsewhere in the world banks are trading at a discount to their book value. Telstra is trading on a PE of about 15 times, compared to its rating of 11 times less than 12 months ago.
Moreover, these companies have very little, if any, forecast earnings growth.
It is always important to remember that it is the movement of share prices, not the dividends paid, which dictates the returns investors make, over any period of time.
From 2000 to 2012, the return from Telstra’s dividends was 73 per cent, but its price return was -47 per cent. It delivered a measly total return of 26 per cent over this whole period.
Companies only grow when profits are reinvested, and when a company’s sole objective is to maintain a high dividend yield, it doesn’t augur well for long-term value.
Compare Telstra’s return with the gold producer, Newcrest Mining. The miner delivered an average annual dividend yield of 0.78 per cent between 2000 and 2012 with the annual dividend increasing from 5 cents in 2000 to 35 cents in 2012.
An investor that bought Newcrest in 2000 would have achieved a total return of 406 per cent in 2012, comprising a 363 per cent price return and a 43 per cent dividend return.
Let’s put the banks under the microscope.
It is common knowledge that credit growth for housing is very low as people concentrate on reducing their debt, and increasing their savings in the wake of the financial crisis.
At the corporate end this is also occurring and companies are not only paying off their debt but they are cutting spending. For example, mining companies are pulling big projects.
The banks are getting less profitable for a number of reasons. Prior to the financial crisis the Commonwealth Bank’s return on equity was 21 per cent, whereas today it is 19 per cent.
In the competition for funds, banks are increasing their rates for term deposits, eroding their margins. More important is the increasing liquid or readily sold capital, like cash, that banks have to own just to stay in business.
Because of more stringent regulations, banks are now required to hold 10 per cent of Tier 1 capital. When you subtract a bank’s liabilities (the amount it owes) from its assets, Tier 1 capital is the amount of residual core equity that can deal with adverse scenarios, like a run of loan defaults.
Doing this makes banks much stronger, but it also makes it harder for them to grow. These days all their excess capital is going to pay investors’ dividends in order to prop up their share prices.
The banks and Telstra might keep chugging along, but Radar knows that they won’t deliver the kinds of returns that can pay the big bills in the future. It’s the small caps of this world like Specialty Fashion and Kathmandu that will do that.