What Do Yields Tell You About an Investment?

We may have covered this subject before, so apologies in advance if we’re repeating ourselves.

However, it’s easier for us to just bang out 1,500 words than it is to trawl through the archive to check up what we’ve written about previously.

We did used to have a little spreadsheet where we would note the topic of each day’s article, just so we could rely on it for occasions such as this. Unfortunately, that stroke of genius only lasted about a week before we became bored with it!

Anyway, back to the point, what do yields tell you about an investment?

Well, in the good old days, the yield of a stock, bond or cash was a good indicator for investors about the relative risk of an investment.

That’s providing it was deemed to be an income producing investment. It works slightly differently for growth investments.

You could line up the yields of a few stocks, a government bond, a corporate bond and cash, and quickly see which was the safest and which was the least safe.

Of course, it wasn’t foolproof. But it was a useful guide. You could see that a dependable old utility company offered a decent dividend yield – but not much growth – but that it wasn’t as dependable as a government bond.

So the government bond would have a lower yield because it was seen as more secure. A corporate bond would yield something in between – all else being equal – the government bond and the share dividend yield.

It was riskier than the government bond, but less risky than the shares, because debt holders take precedent over share holders in the event of a company being wound up.

Then separate to that, you had companies that were priced for growth. That doesn’t mean to say they didn’t pay a dividend, but rather that the dividend was a bonus. Growth was the key.

Growth investments

Resources and technology companies are perfect examples of that.

But what determines the difference? At what point can you tell whether an investment is priced for growth and when it’s priced for income?

Well, it’s not as hard as it seems. Let’s get the simple one out of the way first. If the stock or investment doesn’t pay a dividend then it’s priced for growth. It’s as simple as that and therefore we can ignore it for the rest of this argument.

But what about investments that do pay a dividend? A good example to illustrate this is BHP Billiton Ltd [ASX: BHP]. The stock trades for around $41 and based on the last two dividend payments pays a yield of 2.8%.

So how do we know it’s priced for growth rather than income? The simple way of looking at it is to compare it to what they used to call the ‘risk free’ interest rate. In other words, the central bank rate.

The current Reserve Bank of Australia (RBA) cash rate is 3.75%. That’s the rate at which the banks can borrow money from the central bank overnight.

Then you can go one step further to look at government issued bonds for a one month maturity. The latest issue by the Australian Office of Financial Management (AOFM) for bonds that will mature on February 26 is for a yield of 3.864%.

And for a 10-year bond the recent tender produced a yield of 5.6316%.

For an investor you can make a good case to argue that’s the gross yield, and if we take into account costs, but ignore tax, then the net yield is roughly the same…

Look, I know it’s not the real net yield. The real net yield would factor in tax as well. But let’s keep this simple for now. You know your editor doesn’t like to over-complicate things!

Therefore, we can compare the yield on a government bond – 5.6316% – with the yield for BHP Billiton – 2.8% – and say that if an investor was interested in income then they would invest in the government bond because it pays a higher yield.

So, because BHP Billiton is a higher risk than the government, but it’s yield is lower, then BHP Billiton must be priced for growth.

In other words, if it was priced for income, the yield would have to be higher (and therefore the share price lower, if the dividend was unchanged) than the yield for a ‘risk free’ government bond.

Still with me?

The distortion of yields

However, the situation with another asset class is quite interesting. That asset class is housing. But I’ll get on to that in a moment, because first I want to look at the infrastructure funds that were devised under the so-called ‘Macquarie Model.’

Back when we started writing for our sibling publication The Daily Reckoning in 2005 we questioned the sanity of investment advisers and commentators who sang the praises of the Macquarie Model of infrastructure funds.

It just didn’t make sense to us that professional investment advisers were telling their clients they could get both growth and income from buying into toll roads and other infrastructure assets.

Furthermore, these investments were labelled as “reliable” and “secure” and “dependable”, ideal for a superannuation fund.

As investors bought in the share prices climbed higher. That you would think should cause the yield to fall. But it didn’t. First of all, it wasn’t called a dividend, because dividends are paid from profits. Many – but not all – of these investments didn’t have real profits so they had to be called distributions.

The distributions climbed because of a clever accounting trick. The funds could revalue the assets higher, book the revaluation as a profit and then pay out a bigger dividend, er, I mean distribution.

They were simply borrowing against future forecast cash flows in order to pay out an income stream today. That scam fell in a heap. Recent headlines in the press have highlighted how toll road investors have been stung with billions of dollars of losses – all from the same reliable, secure and dependable investments.

The point is, investors were fooled by the experts into believing that things were different and that a big dividend income and big capital growth were possible from the same investment.

I’m not saying that income and growth are mutually exclusive, but typically you won’t find huge capital gain potential plus a massive income stream from the same investment.

Which brings us back to property investing. We’ve noted in Money Morning on perhaps hundreds of occasions that the property market appears to be out of whack with reality.

In fact we’ll admit that we’re downright confused on most occasions. On the one hand we hear the property spruikers tell us that property doubles in value every 7-10 years. Such as according to spruikers the Investors Club:

“If property doubled every seven years our [hypothetical] investor would reach $17.2 million in just 43 years. What if you could find a property that doubled every five years? Do you get the picture? We’re talking serious money here – not petty cash like $7.5 million.”

All that’s possible – according to Investor’s Club – if you just start with $30,000 and a $300,000 property. Easy!

What is property priced for?

But then we hear from other property investors who tell us that we’re wrong to criticize the growth claims of property, because property investors aren’t stupid and they know property doesn’t double every 7-10 years.

Property investing is about the income, they claim. Not only that, but it’s the income aspect of property investing that will prevent the housing market from collapsing because investors will just put their rents up!

That’s where we get confused. Because there is absolutely no way on earth that property investing is priced for income. Not a chance.

Let’s use some data from our old pals at RP Data. We’ll forget about whether it’s based on median or hedonic or median hedonic because, well, we’re not even sure they know.

Anyway, their last much maligned – by us – press release suggests the “Quarter Yield Results” for Melbourne houses is 3.68%. And that’s the gross number.

In other words, a house that sells for $400,000 is yielding approximately $14,720 per annum in gross rental income. Gross rental income. Remember that, “GROSS.”

If we also consider the other mantra of property investing is debt and leverage then we can fairly assume that the $400,000 property isn’t paid for in cash. So we’ll be generous and say it’s covered by an 80% mortgage.

That results in a mortgage of $320,000 paying interest of $21,152. And that doesn’t include any repayment of principal – so add a few grand on top of that.

Now, remember we’re not factoring in tax deductibility here, but in simple terms an investment property is a cash negative investment. It produces a negative yield. Or as the spruikers like to term it ‘negative gearing.’

Somehow, in the mists of time, negative gearing has entered the investment psyche as a good thing to do. Even though a five year old can look at those numbers and tell you that a good investment isn’t one where it costs you to own it.

But let’s not forget something else either. Although we haven’t factored in the tax ‘benefit’ of negative gearing, we also haven’t factored in other ownership costs either such as real estate agent fees, maintenance costs, and periods when the property is vacant.

From a yield perspective, property investing is so far into the red it isn’t funny.

So, we can quickly conclude, that whatever our property spruiking friends tell us – the ones that try to play down their own doubling every 7-10 years rubbish – that property investing has nothing whatsoever to do with deriving an income from it.

Simply because it does not produce an income. It only produces an expense.

Therefore, we should be able to agree that property is not priced for income. That much is obvious.

If it was priced for income then having a negative yield would imply that a property investment is an infinitely safer investment than a government bond.

Governments riskier than tenants

It would imply that a tenant in a rental property is more likely to pay their rent on time, or indeed at all, than the government is to pay the coupon on a government bond.

Even your editor finds that argument hard to fathom. And we’re no fan of governments.

That means property can only be priced for growth. But even then we’re stuck. Because any growth asset still has to be priced on something.

It’s usually priced on its profitability. In the stock market you can work that out based on the company profits and comparing it to the share price. That’s the price to earnings or PE ratio.

But with property there is no income. It’s a negative income. And it can’t even be argued that we should use the gross yield as the income figure. Because the interest cost is a vital component. And it’s the interest cost that puts the yield into negative territory.

So, back to our original question, what does the yield tell you about an investment? In the case of property, a negative yield simply tells you that the price action is influenced by one thing and one thing alone…

And that is the belief among property investors that property prices will always go up.

We know that there is no income from buying property so investors don’t consider that when they buy – whatever the spruikers and one-eyed investors will try to tell you.

Their only rationale for buying is the belief that if they buy today they will be able to sell to someone else at a higher price in the future.

That is an irrefutable fact.

What is also irrefutable is that it’s the same thought process that hundreds, thousands and indeed millions of other investors have had throughout history – during every other asset bubble – the belief that regardless of the price they pay today that they’ll always be able to sell it to some other sucker for a higher price in the future.

Cheers.
Kris.

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