I’ve attempted in these notes to present the case for diversification, via geography, sector and stock, as a way of both reducing risk and increasing returns. FY20 was a classic example of why diversification really matters.
Australian equities had a poor FY20, returning -11% at the ASX200 level. This was the worst return since 2016, with many of the worst annual stock specific returns coming from “high dividend yield” stocks who couldn’t sustain their dividends as COVID-19 hit.
As the warning label says on all financial products “historic performance is not a guide to future performance”. More specifically to Australian equities, it should read “historic dividends are NOT a guide to future dividends”.
In an environment of ultra-low cash rates and yield curve control, it is highly, highly unlikely any equity truly yields above 5%. Investors need to stop falling for the honeytrap of high dividend yields based off historic and unsustainable dividends and paid from unsustainable payout ratios.
I realise savers are being punished for a crime they never committed and are reaching further and further up the risk curve to find income streams. This has been the case for a decade but has been exacerbated further in the last quarter as central banks took cash deposit rates to zero and negative in real terms.
However, if you reach too far up the risk curve and buy unsustainably high dividend yields your punishment will be permanent capital loss. This is a far worse outcome than simply accepting we are going to be in an ultra-low interest rate environment for a VERY long time and there very rarely is a true sustainable HIGH dividend yield in that scenario.
My friend Richard Coppleson from Bell Potter did some good work on just how large in dollar terms the dividend reductions in Australian equities have been. His research is quoted below:
“We have seen -$13b less divs from March to July vs last year…and it is because of:
- Dividends Cancelled =$578m
- Dividends Deferred =$534m
- Bank Divs reductions =$6.385b
- Bank Divs Cancelled =$2.1b
- Last years “Special Divs” not paid this year =$3.69b
Total from these = -$13.28b less”
So that explains the -$13b less we are seeing in the last 5 months to now…
That’s a whopping $13b less in dividend income to Australian investors and before you consider the value of franking credits. Capital losses in stocks that cut or cancelled dividends have been universal and significant.
This does beg the question are too many Australian SMSF investors approaching equities completely the wrong way? By that I mean, are they looking for dividend yield over capital growth?
I think the answer is yes and I believe if you want to generate the best return from equities you need to focus on sustainable capital growth and the compounding effect it drives. Dividends I see as a bonus as such, with the best businesses in the world able to generate better internal rates of return via reinvesting their profits back into themselves and therefore almost guaranteeing future growth. Amazon is a great example of a company that has NEVER paid a dividend and is just about the best performing equity on the planet.
On the other hand, companies that have paid out unsustainably high dividend payout ratios, such as Australian banks, come cap in hand asking for capital whenever there is an economic or regulatory speed bump. This leads to dilution and permanently lower returns.
There is no “free yield lunch” when cash rates are zero. If it looks too good to be true, it is.
This is why I believe portfolio construction and diversification is so important in this environment. You can always generate income by selling a small portion of your capital gains. Perhaps this is the better approach in a world of zero interest rates. Aim for sustainable capital growth and harvest some portion of that capital growth as income when required. Yes, it’s not as tax efficient but investing for tax driven reasons is flawed and is also the reason why so few Australian’s have exposure to the structural growth sectors of the equity world, such as US technology companies.
The Australian addiction to yield and franking credits has led to an overall asset allocation mistake. Australian’s have simply too much exposure to lower quality domestic cyclical companies with unsustainable dividend yields.
Even my own fund, via owning the world’s best businesses in global currency generated a return +21% better than the ASX200 in FY20. We simply own great global businesses that have fortress balance sheets and low dividend payout ratios.
Forgetting me, the question all investors need to ask themselves is if their asset allocation reflects the past, or the future?
As we enter a new financial year, I remain constructive on equities as an asset class.
I always try to look forward and assess macroeconomic settings and how consumers and businesses will respond to those macroeconomic settings.
In my entire career I have never seen a more supportive set of monetary and fiscal policy settings, ones that could well lead to FY21 surprising everyone…wait for it, to the upside.
In simple terms, the amount of liquidity being pumped by central banks and governments is unprecedented and, in my opinion, will find a home in risk assets.
The old adage is “Don’t fight the Fed”, but in this case you’re fighting every central bank acting in a coordinated fashion using tools they didn’t even use in the GFC.
You’re also fighting every government in the world acting in a coordinated fashion, with announced government stimulus of around $8trillion and counting. That equates to around 21% of world GDP, and truly unprecedented global fiscal spending stimulus.
You’re also fighting every medical research facility of any note globally working on a vaccine for COVID-19.
Unprecedented monetary policy, unprecedented fiscal policy and an unprecedented medical research response are the three key macroeconomic forces of FY21. I wouldn’t recommending fighting them and I remain strongly of the opinion that cash will be the worst returning asset class in both nominal and real terms.
However, as we sit here today cash and money market holdings have never been higher. Investors ran for the “safety of cash” in March and April. They remain parked there to this day, with cash holdings moving even high in June to around $5 trillion globally as investors continued to sell into the equity market recovery.
I absolutely do not believe cash returning zero real is the place to invest.
In an Australian context I like the investment case for names like Seven Group Holdings, Wesfarmers, Boral, Lend Lease and JB Hi-Fi to name a few as we come out of recession.
In a global context I remain a firm believer and invested in US technology such as Microsoft, Amazon, Netflix, Salesforce and Alphabet. I’m also backing Warren Buffet at Berkshire Hathaway whose stock looks seriously undervalued.
One of the keys to investing is to learn from your mistakes and don’t repeat them. My own advice as we enter a new financial year is to stop falling for yield traps and own more high-quality growth stock exposure.
I wish you and your families good health and prosperity in FY21.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.
