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The premature death of the dividend yield

This is the number one question asked at CMC investment seminars. It has various forms:

“Should I sell my bank shares”

“Should I buy more banks?”

“Are banks good value?”

All are alluding to the same question – where are bank share prices headed, and what should I do about it?

The answers are partly a function of market outlook, and partly a function of an individual investor’s circumstances. A person’s investing aims, market experience, risk appetite, available funds and existing portfolio are just some of the factors that must be considered in answering the questions above.  Naturally, investors without the experience or skills to deal with these issues may be best served by seeking expert advice.

A very significant driver of bank share buying over the last four years was the attractive dividend yields. Some are concerned this dynamic is now played out. However, the notion that the ‘dividend yield play is dead’ seems as premature as the early forecasts of Mark Twain’s demise. While eventually it will diminish in investment importance, streams of income well above current interest rates still have a place in most portfolios.

Dividend yields – some risks

Dividend yields are expressed as a percentage. The comparison with deposit rates is natural, but investors must be aware of the higher risk nature of dividend yields. Perhaps the most important risk is that share prices can fluctuate. This can be positive or negative risk, as share prices can rise as well as fall. However, investors with shorter or fixed time horizons must be aware that their own circumstances could force them to sell at the wrong time.

Earnings can fluctuate, and so can pay-out ratios – the proportion of profit given to shareholders as dividends. When analysts talk about dividend yields they are estimating future dividends. These estimates are usually based on immediately past dividends, adjusted for the company’s earnings outlook.

The most commonly highlighted risk to bank earnings is the potential for a housing market downturn. Other potential culprits include increased funding costs due to regulatory or ratings changes, or a deterioration of other credit exposures. However, it’s my view none of these are as large a risk as many pundits would have you believe.

Looking at the big four banks specifically, a crowded trade can turn ugly very quickly if there is a stampede for the exit. If everyone decides to sell out at once, share prices can drop well below any notion of fair value. Once again, investors must consider their ability to ride out any downturns in share price.

With these and other risks in mind, consider the table of dividend yields above, calculated at Monday’s closing prices. The dividends in black are the actual previous dividends. The crimson numbers are estimates for the two immediately upcoming dividends. ANZ is estimated to cut dividends, the rest are held steady. This could be considered cautious given the long record of dividend increases in the banking sector.

Telstra, another noted dividend paying stock, is included for comparison purposes. For Australian investors, the most important column is on the far right, where dividend yields including franking are estimated.

The objection to buying banks based on their dividend yields might be considered emotional rather than numeric. The question “what happens if dividends fall” is easily answered:

A 10-20% fall in dividends would still generate a dividend yield significantly above current term deposit or savings account rates. Theoretically, dividends could be slashed to zero, and this scenario should be part of any risk analysis. Practically, a 50% cut would be very dramatic. Yet even at a 50% cut to dividends, the estimated dividend yields are still superior to a cash rate of 1.5%.

The purpose of “doing the numbers” is to help remove emotional components of investing. Emotionally charged investors are subject to whip-sawing with the market, selling when prices are down and buying when prices are up. This is rarely a route to investment success. Individual investor circumstances vary, and this is not a blanket, “buy banks” call. However, the numbers above show that the dividend yield play is far from dead.

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