Historically, the search for yield has often led to a compromise in the risk/reward proposition, introducing ‘unintended risk’ which has, on occasions, led to the gradual erosion of wealth over time or capital losses over shorter periods.
Two notable examples are the rout of Australian government bonds in the 1970s (thanks to the gradual erosion of wealth due to stagflation) and the sharp correction in listed property trusts in the last decade.
The latter revealed payout ratios had been inflated by gearing for several years prior, which proved to be unsustainable.
Often, elements of yield are overvalued or receive too much focus at the expense of other important fundamentals that should be given greater consideration.
There is no doubting the benefits of regular cash flow from investment securities. However, these should be considered in the context of the overall risk/reward proposition and appropriate asset allocation.
Strong focus on yield is distorting asset prices
The reticence of Australian investors to deploy capital globally has been discussed extensively over the last couple of years.
Recent studies show that Australians have very low capital allocations to offshore assets.
While the natural ‘home-market’ bias is clearly at play, there is no doubting the generous dividend policy of many Australian companies, and relatively higher term deposit rates (until recently) have been key drivers.
There are two key perspectives that should be added to this discussion – franking credit value and aspects of behavioural finance.
Firstly, when franking credits were initially introduced, the market did not recognise their value for many years and consequently were undervalued for a period of time.
As their value has been recognised, we believe that in many cases investors are now paying a premium.
Secondly, earnings growth is required to support sustainable growth in dividends. This seems obvious, yet is often ignored by investors at their peril.
‘Heuristic simplification’ is the assumption that current circumstances will continue into the future.
This phenomenon has become a powerful force due to the strength of the Australian economy and resilience of Australian investment markets over the last 10-15 years.
While current fundamentals (slowing in demand for natural resources, subdued consumer sentiment, etc) point to a changing backdrop for Australian corporate earnings, dividend policy has broadly remained unchanged, driven by many companies’ desire to pacify yield-hungry investors, inflating payout ratios beyond perhaps what they would be under other circumstances.
Compelling opportunities offshore
Many Australian investors are aware that Australian shares have provided better returns than US shares over the last 10 to 15 years.
However, many would not be aware that the US S&P500 has outperformed the Australian All Ordinaries by seven per cent per annum over the last five years (to January 2014).
The fundamentals have broadly been ignored as conservatism biases extrapolate [the notion] that US shares are a ‘bad investment’ based on the last 10-15 years.
While the returns from the S&P500 in recent times have been impressive, we can also see that they have been delivered against the backdrop of improving balance sheets and fundamentals relative to Australia.
We expect this to continue over the medium term.
Even without consideration for the concentrated nature of the Australian share market, we believe that on a fundamental basis, there are clear diversification benefits and compelling valuation opportunities available offshore for Australian investors.
There may also be an opportunity to minimise the risk of another yield trap – time will tell!
While yield has its place, a myopic focus on yield can lead to poor investment outcomes if other factors are not considered.
It is important to look beyond any cognitive bias and remain focused on the fundamentals of the risk/reward proposition.
Rob Thompson is head of distribution at PM Capital.
