My Say No. 60 – Oh no, not again

It was disappointing to see, yet again, the use of a failed metric to distort the investment dialogue. Let me start this by reminding everyone of my preferred definition of investing; ‘the use of money productively to produce a regular income’. Contrast this with the definition of speculation; ‘buying and selling in an attempt to benefit from a fluctuation in the price’.

In general, the profit of a company is split broadly in two, 1. retained earnings for R&D, new technology etc and 2. the balance, or payout ratio, as a dividend. In mature, quality companies, earnings drive dividends and it is dividend growth, reflecting growing earnings that ultimately drives share price performance.

 

In an article by Elizabeth Knight, when talking about CSL, she writes:

“This is an old-fashioned growth stock – one that lifts profit every year – and ploughs much of it back into research and development and boosts its capital expenditure. It traditionally spends about 10 per cent of revenue on R&D and is currently working on, among other things, a $US550 million ($810 million) clinical trial to prevent secondary heart attacks. Investors have given CSL the mandate to invest rather than reward them with hefty dividends.”

So, CSL ploughs much of its earnings (10%) into R & D. This represents only 43% of net profit which is broadly in line with many companies. It then begs the question, what happens to the balance of the profit?

 

She then follows this with another burst:

The factor that sets CSL apart from its peers among the largest five Australian companies – BHP, the Commonwealth Bank, Rio Tinto and Westpac is that investors are not buying into it to chase dividend yield. CSL’s share price is driven by its earnings performance. The results it reported on Wednesday for 2019 sent the share price up more than 6 per cent – despite the fact it was in line with analyst expectations. While dividends increased to $2.68 in 2019, based on Wednesday’s share price of $233 – the yield is a relatively paltry 1.15 per cent.”

 

As an investor, I never chase yield, it is income I am after. It is here that the author fails as she uses the abstract metric called yield in an attempt to highlight the ‘paltry’ dividend. Yield is the abstract obtained by dividing two dollar values; dividend by share price. Thus, this abstract is hostage to movements in either one or both of these two numbers.

 

CSL, like a number of other very successful companies Cochlear, Credit Corp for example, are low yielding for the simple reason that as the profits grow, the dividends grow, and the share price goes up. Because of the phenomenal growth in dividends (a result of the phenomenal growth in profits) when you keep dividing a rising share price into rising dividends the yield never looks attractive.

 

Added to this, the success and strong dividends associated with all 3 of these companies ensures that the price is at a premium which naturally puts downward pressure on the abstract yield but, unlike our journalist, you must never assume that the low yield is an indication of low dividends.

The 3 shares I have mentioned, despite their low yields, have produced an extraordinary income stream.

 

Since purchasing Credit Corp (CCP) in 2000 we have invested a total of $137K.

Our CCP shareholding now, like CSL is worth $1.8 mill. It sits on a paltry yield of 2%. Why so low? Because the dividend has risen at the same stratospheric rate as the share price.

The good news for us is a current ‘yield’, (last dividend divided by amount invested), of 33% on our original investment! If that isn’t enough, total dividends paid now stand at $290K; a more than 200% return on our capital in income alone.

 

As previously mentioned, the current quoted spot yield for CSL is 1.15%; why so low? Refer paragraph above. The consolation for us misguided people ignoring yield and looking for income is the fact that our last dividend puts our original investment on a current yield of 14%, CSL being purchased some years after CCP.

Spot yield today    Current yield on the original investment:

Cochlear:                        1.5 %.                             12%

Event Hospitality            4.2%                              14%

 

I am grateful to a very patient Listed Investment Company CEO for providing the chart below showing the extraordinary growth in both share price and dividends that CSL has bestowed upon its shareholders

I could go on. The point is that a spot yield is indicative of nothing of value. It merely records an abstract numeric at a point in time. As an investor I am concerned with the growth in the income; not this abstract numeric which, by the way, I cannot spend in the supermarket.

The best example of this stupidity is the listed property trust sector, and I make no apologies for covering old ground. Refer to the chart below comparing the income from listed property trusts to the dividends from industrial shares. Clearly the shares produce a far superior income.

 

Now consider the chart below plotting the yield of these two sectors over the same period. There can be no doubt that property is a far superior investment for those seeking yield. Ever since I returned to Australia in 1988, I have had people, particularly retirees, telling me that property was a far better income investment than shares because of its superior yield, 30 years of this madness.

 

What makes this even worse was an article written in September 2010 by another (you guessed it) journalist.

Refer to chart one above and consider his following quote in September 2010.

“With a current average dividend yield of 5.7% property trusts have again become one of the most attractive sectors for income investors”.

 

The reason the yield is high is quite simple. Property trusts, as a result of their structure must distribute 100% of their income to avoid potential double taxation.
Therefore, the vertical income bars (pink) in chart 1 above represent a 100% payout ratio.

In contrast to this, the vertical yellow bars represent around 50% of the profits generated by industry. The corporate structure enables companies to retain profits without penalty for research and development, new technology etc as Elizabeth Knight highlighted in her article.

The trap is baited by the fact that the yield is an abstract numeric (income divided by index value) that basically tells you where the value line in chart 1 lies in relation to the top of the dividend bars. If dividends remain stable the simple numeric relationship means that if share prices fall the yields will rise; conversely, if share prices rise yields will fall.

It will be apparent from chart 1 that the high yield of property is simply a function of the fact that the capital value line is well below the top of the dividend bars. Similarly, the industrials are low yielding because the value line is much closer to the top of the dividend bars.

Now, try and imagine the yield on shares if all companies, like listed property trusts, retained no earnings and paid out 100% of profits every year! How the hell can someone get away with displaying this sophistry? Can anyone tell me what sane person would ever buy property trusts for income?

 

Sadly, time and time again the yield word is used to describe income whilst the reality is that the link between the two is uselessly abstract. If you are buying yield for income can I respectfully suggest that you die early to avoid the disappointment.

 

Experience has taught me that chasing the highest initial yield will almost certainly result in the worst possible income over the long term. Oh, and by the way, shares are not growth assets, they are income dynamos.

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