Why You’ve Got to Look Beyond Bank Stocks in the Chase for Dividends

With ANZ [ASX:ANZ] delivering a surprise increase in its provisions for bad debts last week, the share price instantly took a tumble. It dropped by over 5% in just one day.

ANZ, like the other banks (and most of the market), got hammered in the January sell-off. Having briefly fallen through $22, it enjoyed a bounce off its recent lows in March. The share price clawed its way back up over $26, before the recent update saw ANZ quickly back below the $24 mark again.

The news from ANZ put the spotlight on the other major banks. Westpac [ASX:WBC] responded quickly with their own increase in bad debt provisions. Now, the market is anticipating a similar announcement from the other two — National Australia Bank [ASX:NAB] and Commonwealth Bank [ASX:CBA].

The big banks have enjoyed near two decades of growth, accompanied by a matching rise in profits. Of course, the banks have also had their fair share of scrapes along the way. However, long term shareholders have benefitted from a string of growing, fully franked dividends.

With interest rates in freefall ever since the financial crisis, the banks have also been buoyed by investors’ hunt for yield. Many forget that the official cash rate was 7.25% until August 2008, before being quickly and dramatically lowered by the RBA as panic began to take hold.

In October 2008, the RBA dropped rates by a full 1% in one hit, and an additional 2.75% by the following February. As interest rates continued to head lower, investors relying on term deposits and other cash investments were hit particularly hard.

Investors looking for yield were forced to continually funnel money into the stock market as interest rates remained stuck at historical lows. Even as of today, $100,000 in a term deposit with one of the big four is only going to generate $2,450 in returns. And that’s over a whole year!

The dilemma for investors, though, is the capital risk they have to take on to generate higher returns in the market. For example, Westpac is trading on a current yield of 6.1%. That’s a whole lot higher than the 2.45% per annum on the term deposit example above.

However, if you bought shares in Westpac last year for the yield — let’s say closer to the $39-plus high — you would now be sitting on a considerable capital loss. With Westpac’s shares now closer to $31, that’s a hit of around 20%. It’s going to take quite a few dividends to make up for that loss of capital.

The real issue now facing shareholders is whether the banks can maintain their level of dividends. First, off a higher number of shares — APRA forced the banks to issue additional equity to meet international standards. And second, from any increase in the size of the banks’ bad debts.

Bad debts for the banks aren’t just about mortgage stress. It’s also about the massive amounts of money they’ve lent to the resources sector. And if one has a problem in this area, it’s likely that the other big banks will too.

The fall in the banks’ share prices over the last 12 months reflects the growing concern the market had with the banks’ ability to meet these challenges. What it also shows, though, is that focusing purely on yield can quickly lead to a loss of capital if anything fundamental changes in the market’s perception of the underlying share.

Like what we’ve seen in the banks.

Another issue facing income focused investors is that they’re also likely to have a big chunk of their money tied up in just one section of the market — financial services. Financial services make up something like 40% of the market weighting in the ASX 200, with around 30% of the entire market in the major bank stocks.

By any gauge, that’s a pretty high concentration. This level of concentration is also apparent when you consider the popular index hugging funds. Investors buy into these with the aim of diversifying their portfolio away from holding just a handful of shares.

If you’re new to these, these funds replicate the index as far as practicable. To do this, they hold each share as per their weighting in the index. But, again, you can see the limitation. An exchange traded fund (ETF) that matches the ASX 200 index is still going to have 40% of its capital tied up in financial services.

One way to help overcome these limitations is by investing in ETFs that specialise in purely chasing income and other areas outside the main index.

For income hungry investors, there are actively managed ETFs that focus solely on chasing yield. The fund buys into companies with upcoming dividend payments. After qualifying to receive the dividends, they then replace the stocks with the next batch. It’s a type of ‘dividend harvesting’ strategy.

There are also listed investment companies (LICs) that chase both capital gains and income by trading in some of the medium sized industrial companies on the ASX. Specifically, they don’t typically invest in ASX 20 companies, so it can help diversify your portfolio away from the usual income stocks, like the banks and Telstra [ASX:TLS] — common holdings in a typical income based portfolio.

And just because they invest in mid-size companies, it doesn’t follow that their dividends will be smaller. Some of these LICs have consistently generated 7% fully franked yields without ever touching a bank share!

For those chasing yield, it’s worthwhile checking out these ETFs and LICs. Particularly with the bank stocks under pressure. There are over a 100 of them listed on the ASX, with a whole lot more set to launch this year.

It’s unlikely that interest rates are going to return to 7% anytime soon. It’s also going to be difficult for the bank stocks to replicate the massive growth they’ve enjoyed over the last 20 years. If you’re in the chase for yield, you need to open your sights further. Taking the time to work your way through a list of the ETFs and LICs on the market could get you ahead of the curve.


Money Morning Australia