Paying out More Than Profits

Have we got it wrong?

About a crash, we mean.

Since the lows in February and April, the Aussie market has rebounded well. From the February low through to time of writing, the S&P/ASX 200 index is up 13.71%:

Source: Bloomberg

Click to enlarge

That’s a nice rebound. Furthermore, it means the Aussie market is now only down around 10% from the recent 2015 high.

So much for the idea of a sustained and catastrophic crash.

Does that mean we’re wrong about a crash, and that the past year has just been a blip in the ongoing rally that started in 2009?

We’re not ready to concede that yet. Ultimately, stock markets reflect the future earning power of companies. With interest rates at record lows, it indicates that economies worldwide are struggling for growth.

Certainly, a central bank doesn’t continue to cut interest rates if it believes the economy is doing just fine.

But, in the short term, investors don’t always see that picture. Right now, some investors, at least, are looking at stocks as a better alternative than cash.

If you like, the rally in Aussie stocks since February is comparable to the rally in Aussies stocks from mid-2012 onwards.

That was when the Reserve Bank of Australia (RBA) began cutting interest rates. Investors saw rates on savings accounts fall, and they saw big juicy dividends on blue-chip Aussie stocks.

For many investors, it was a no-brainer: get 3% on a term deposit, or get an 8% or 9% grossed up yield on Telstra Corporation Ltd [ASX:TLS] stock…plus the possibility of capital gains too.

As talk of an Aussie recession has increased, stocks have taken off. And if the RBA cuts rates further — as several analysts now predict — it’s not unreasonable to think that stocks could go even higher.

But before we let euphoria get the better of sanity, remember, the Australian economy today isn’t the same as the Australian economy of four years ago.

For a start, back then, Aussie banks were busy thumbing their nose at the dopes who suggested Aussie house prices would crash by 40%. [Editor’s voice: Who, me?]

Revenues and profits were climbing. Bad debt provisions were falling.

Aussie banks were, so it went, the safest and best in the world.

Furthermore, many Aussie companies discovered a clever ruse to attract investors and boost their stock prices — they increased the dividend payout ratio.

Companies that may have previously paid 60–70% of their profits in dividends decided to increase the payout ratio to 80–90%.

For investors desperate for yield, the thought of a big cash bonus from these bumper dividend payouts was too big a temptation to refuse.

That’s all well and good. But the more a company pays out in profits, the less it has to reinvest to grow the business. It’s good in the short term, and benefits shareholders in the short term, but it doesn’t necessarily benefit the company or the shareholders in the long term.

Because, once a company decides to ratchet up its payout ratio, few shareholders like it when the company turns more conservative.

Plus, if the economy remains soft, the company can’t increase its payout ratio much further once it hits that 90% level. Worryingly for the Aussie market as a whole, the payout ratio is well above the 90% level.

In fact, based on the numbers compiled by Bloomberg, the payout ratio (the percentage of profits paid as dividends) now exceeds 100%.

As the chart below shows, for every $100 of profit generated by Aussie companies, they pay out $118 in dividends:

Source: Bloomberg

Click to enlarge

You can see how this has increased gradually over the past few years. The market’s payout ratio for 2016 is the highest since 2008…and you know what happened in 2008, right?

Be clear: does this mean a crash will happen this week, this month, or this year? No. We’ve learnt enough over the years (often painfully) to know that events rarely happen exactly as we predict.

For instance, never for a minute did we actually think that the yields on two-year bonds on 15 of the 19 Eurozone economies would actually be negative.

And never did we actually believe that even sober mainstream analysts would predict that Australian interest rates could fall to 1% or less.

Those analysts are, if we may say, encroaching on our turf. It’s for us to sound the bearish alarm bells. Now, we have competition.

But the more who recognise and understand the warning signs, the better. We don’t mind folks stepping on our territory if it means they appreciate the scale of the problem.

In short, although the current rally may have the hallmarks and similarities of the 2012 rally, as investors scramble for yield, the reality is that Aussie companies have nowhere to go…without creating severe cash flow problems.

Is that something they could do? Could the market as a whole see the payout ratio increase to 140%, or 150%, or more? It’s possible. And not just because companies are paying out more dividends, but because profits fall further.

Remember, this is a ratio for the whole market. If total market profits fall further than dividend payouts, the ratio will increase. That’s part of what happened in 2008 and 2009.

We expect the same to happen again. Hats off to those investors who bought low in February. But we advise them to take a lesson from that unwritten book, Stock Market Investing 101 — Having bought low, sell high.

In February, the market was low. That was a good time to buy. Today the market appears to be high. And it appears to us that would make it a good time to sell.


Kris Sayce,
Publisher, Money Morning

Ed note: The above article is an edited extract from Port Phillip Insider.

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