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It is a crazy market when analysts maintain positive recommendations on stocks based on their dividend yield rather than their earnings outlook. That is yet another symptom of insane global interest rate policies that are forcing investors to buy riskier assets for income.

Never mind that negative earnings growth makes it harder for companies to maintain dividends, that some dividends are being funded by debt, and that mid-caps with higher return on equity are giving money back to shareholders when they should reinvest it for growth.

Or that some investors are treating equities like a surrogate bond and dividends like a coupon rate. Why put money in a bank term deposit and earn 3 per cent when the bank’s fully franked dividends pays 8 per cent, even though that return has much higher risk?

It is hard to see Australia’s dividend obsession – or the long-term damage it will do to corporates – ending anytime soon. More investment banks this week cut their target for the official cash rate to 1 per cent, which implies another three interest rate cuts from the current 1.75 per cent over the next 12 months. Some experts are even floating the idea of negative interest rates here.

Perversely, lower interest rates hurt bank margins but provide valuation support for bank stocks from yield-hungry investors. Macquarie Equities Research said as much this week in a note: “While banks’ current earnings growth profile appears increasingly uninspiring, we believe that healthy dividend yields should provide valuation support.”

In other words, hold your bank stocks because income investors will keep buying them for yield in this record-low interest rate environment. It’s a flimsy argument to buy such an important part of the market, but I begrudgingly agree with Macquarie’s view.

Australian banks have more headwinds that any time since the 2008-09 GFC. The current interest expectations profile suggests bank margins on their deposit books will be less profitable over the next few years, due to falling interest rates.

Macquarie ha downgraded earnings-per-share growth for the by up to 4 per cent in FY18. But it expects banks to maintain their elevated dividend payout ratios and deliver a “market leading” grossed-up cumulative dividend return of around 45 per cent over the next five years. That suggests the yield-trade in banks will be alive and well for some time.

The good news is that lower interest rates improve the debt-servicing ability of homeowners and take pressure off bad-debt impairments on bank balance sheets, at least in the medium term. In the longer term, record-low interest rates risk creating a housing bubble, if we are not already in one in parts of the property market, such as inner-city apartments. 

So should investors buy, sell or hold stocks given this challenging backdrop? It sounds like a cop-out to say it depends on your investment profile, needs and risk tolerance. But that advice is more applicable to the bank sector than any other right now.

Income investors must stick with bank stocks. For all the challenges, their valuations look more attractive than high-priced infrastructure plays, such as Sydney Airport, Transurban Group and Macquarie Atlas Roads, that I have favoured over the past few years. 

Banks’ dividend yields also appeal, provided payout ratios are maintained (which should be the case for the Commonwealth, Westpac and probably NAB). However, do not expect much dividend-per-share growth from the banks in the medium term.

As outlined in this column several times, I expected two interest rate cuts this year and have pencilled in a third for the first half of next year. A 1 per cent official cash rate is my base case for rates, but they could go lower still if inflation falls further. In that context, bank dividend yields will be increasingly attractive and, yes, provide valuation support for bank stocks.

I cannot see much capital growth for bank stocks in the next year or two. Most of their total return will come from dividends. Growth investors who are less interested in dividends should look elsewhere; the halcyon days of rising bank shares prices are over for now.

CBA remains the pick of the banks for long-term, conservative income investors. Although it has the highest valuation, lowest yield, and most to lose from lower interest rates, CBA is the best quality bank and the best placed to maintain its dividend. 

NAB is interesting. I became more optimistic on its prospects after it demerged its troubled United Kingdom banking operations, CYBG, earlier this year. NAB has had a solid rally since February and looks a reasonable medium-term investment, despite its earnings headwinds.

Chart 1: NAB

Source: The Bull

I outlined a positive view on CYBG for The Bull in April in ‘Clydesdale has the makings of a good demerger‘. I wrote: “CYBG is one to watch. It has some traits of high-performing demergers and the best spin-offs have handsomely rewarded shareholders over the years.” 

Chart 2: CYBG

Source: The Bull 

 

That view has been reinforced by CBYG’s release of its first-half FY16 profits this week. It has rallied from $3.94 to $5.30 since I last wrote about it for The Bull. CBYG’s cost savings have exceeded market expectations and the regional bank has plenty of opportunity in the relatively attractive United Kingdom banking market, notwithstanding the risk of the UK exiting the European Union and the disruption that would follow.

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Tony Featherstone is a former managing editor of BRW and Shares magazines. This column offers general commentary only. It does not take into account an individual’s financial needs or make stock recommendations. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis are at May 26, 2016.