Falling Share Price Impact On Dividends?

Hey All,

Having never invested in direct shares before, I've been watching the markets for the last few months, and decided to put some "play" money in an etrade account and wait and see if anything tempts me, in the full knowledge that I'm prepared to lose 100% of whatever I may take a punt on. I've been watching the banks take a beating, and picked up some SGB @ $24 today.

I'm curious as to what impact the falling share price may have on forecast dividends, because at my buy-in price, the forecast 2008 dividend is over 7.6% fully franked @ 30%. So basically, what needs to happen, or not happen, for the forecast dividend to be reduced or not paid?

As I said, at the moment I've only got disposable cash invested, but if these dividends are sustainable, I will certainly consider more serious investment to provide a relatively tax effective income stream.

I welcome your thoughts or opinions.

Cheers,

JustB

 

Bank dividends are very juicy at the moment, let's have a quick look at SGB at $24:

Earnings per share 2007 = 218c
Dividend per share 2007 = 168c
Payout ratio (div/earnings) = 77%
Price/earnings ratio current = 11x
Dividend yield 2007 = 7.0% FF

Earnings per share 2008 = 238c (estimated)
Dividend per share 2008 = 184c (estimated)
Payout ratio 2008 = 77% (estimated)
P/E forward 2008 = 10x (estimated)
Div yield forward 2008 = 7.7% FF

7.7% fully franked is 11.0% grossed-up.
Compared to term deposits at 7.5%, this is a 3.5% premium; I reckon that's a very tasty margin. At 31.5% tax rate, $100k in the bank would demand you pay $2362 in tax, but a $7700 FF dividend would see you pay $165 in tax.
In other words the after tax return of cash in the bank at 31.5% is 5.1%, whereas SGB dividend is 7.5%.

Let's consider that SGB fails to grow its earnings due to credit crunch issues (although they did just advise that EPS growth is on target), or that they reduce the payout ratio to 70% (more typical for banks).
This would mean that the 2008 forward yield would be more like 7.0% or 10.0% grossed-up.

Then you could go to MQ Prime and gear at 70% and the borrowed shares would be self-funding.
Borrow $70k at 9.45% fixed.
Provide $30k collateral.
Dividends $7000 pa
Franking credits $3000 pa
Interest $6615 pa
Tax deduction $2084 pa (at 31.5%)
Net position after tax at 31.5% = $2319 (ie cash back to you)

At 70% LVR, the shares could fall another 26% before you reach 95% gearing, which is the rate for the banks at MQ Prime.

What do you do with the $2319? You could put it back into the ML, then the LVR comes down from 70% to 68%, even if the shares don't move anywhere.
Or you could pay down non-deductible debt, or blow it on a 42 inch HD LCD.

But you can really think of it as the 'interest' you are receiving on you $30k invested. After tax, the $2319 is the same as a bank interest rate of 11.3% (11.3% of $30k = $3390, of which you keep 68.5% after tax)!

Let me summarise:

Invest $30k in the bank and you get 7.5% interest, or $2250, and then you pay tax, so you keep $1541 after tax (31.5% marginal tax rate).

or

Invest $30k in SGB through a ML with MQ Prime at 70% LVR, and you keep $2319 after tax. Meanwhile the dividends and franking credits pay the ML interest.
Any share price growth and future earnings growth are yours. Even if the share price collapses further, you can handle a 26% collapse before MQ Prime demand action.

Is there another 26% for SGB to fall? Well I reckon the calculations become more and more compelling, providing further support. Would the Australian investment community allow SGB to pay 10% fully franked yield???

And Tropo, yes I remember HIH. So I don't recommend you do this purely with SGB. Spread your company risk across ANZ, CBA, WBC, SGB and NAB. There is no way they will all do an HIH!

 

If 70% LVR freaks you out, consider 50%. At 50% LVR, the shares could fall another 47% before you reach 95% gearing.

Using the $30k collateral as per the previous example:
Borrow $30k at 9.45% fixed (50% LVR).
Provide $30k collateral.
Dividends $4200 pa
Franking credits $1800 pa
Interest $2835 pa
Tax deduction $893 pa (at 31.5%)
Net position after tax at 31.5% = $2168 (ie cash back to you)

With $2168, the after tax return to your pocket is still better than the $1541 you'd get in the bank.

Or just buy the shares with the $30k. But then the tax man is not paying you to own them!

 

If anyone's interested, I'm currently moving my portfolio across to MQ Prime, to free up cash and create collateral for buying big in the next few months. I'm starting with buying more bank shares. SGB is the only one of the five that I don't already own, so it's my first target.

The world is not coming to an end. The US may be heading for a grim recession, and there may well be many write-downs due to credit worries. But a $200m write-down by ANZ is not a horror result, but the market punished all the banks.

Even if each bank wrote off many billion dollars this year - that is all their profit then there would be a year of no earnings, no profit, no dividend. But then it would be back to normal! Sure a few heads would roll, but people still keep their money in the bank, still have home loans, still need to manage money. For me, Australian retail banking is the one sector that I feel has fundamental underpinnings.

Doom and gloom? Fortunes are made in times like these.

 

JustB, sorry for hijacking your thread, but I've been meaning to make a few comments lately, and your query about St George just got me started. Maybe I should start a blog somewhere.

 

Nice posts Rod, well thought out and well written.

I moved across to MQ Prime a few months ago now and its been a good move. Gives you alot more headroom for times like now and the GSLs are great (You get a fixed price stop loss which gives me alot of piece of mind). Also the IR is alot lower than other margin loans.

After much bitching and moaning they upped ARG, MLT to 82.5% and AFI to 90%!

Good stuff!

 

Thanks Frank. The interest rate is currently 9.45%, and moves with the RBA rate, so we can expect an increase in a few weeks. But they offer 9.45% fixed for 3 months, and then there will be a discounted rate pre-June 30 (they would not confirm anything concrete on the phone, but they did say there would be a 'significantly discounted rate'). So I intend to lock in 9.45% and then take the discounted rate.

(MQ Prime offer 0.25% enduring discount if you refinance a margin loan over $250k... I looked at setting up an interim ML elsewhere just to exploit this, but I want the transfer done as soon as possible so I can 'nab some NAB').

I don't like the practice of moving the goalposts with collateral rates on individual shares, but the rate for ASX20 companies has been constant at 5%. My portfolio is heavy in banks, BHP/RIO/WPL, WES, which are all at 5%. So I'm comfortable with ramping up my LVR to about 70% right now.

 

Funny - I nabed some NAB today. $28.89 - who would have thought?

They mostly only change small caps (which I couldn't care less about). As I'm pretty much LICs + Banks

 

Hi Rod,

Can you explain/link to the formula for this? I'd like to factor it in to my own calculations.

 

"And Tropo, yes I remember HIH.
So I don't recommend you do this purely with SGB.
Spread your company risk across ANZ, CBA, WBC, SGB and NAB. There is no way they will all do an HIH!"


I am glad that you remember HIH.
It seems that you forgot about Enron, Quintex, Bell Group etc...
ANZ,CBA,SGB,NAB may not repeat HIH story, but nothing is impossible in the market (at the moment ANZ,CBA, SGB, NAB charts represent another ‘View to a Kill’).
O yes...You suggest diversification.
Let me quote William O’Neil again:
‘Diversification is a hedge for the ignorant’.
If you can not get one stock right, how are you going to get a few stocks right?
Thanks for your recommendation but I stick to my own method which is more profitable than banks div.


"Or just buy the shares with the $30k.
But then the tax man is not paying you to own them!"


That would be my choice.
O yes - tax man...
Well....I would rather share say a $ 50 000 profit with the tax man than keep a half of it ($25 000) as a loss to myself.

 

The Grossed-up dividend is the amount you pay tax on, which is the dividend plus the franking credits.

Franking Credits = Dividend * 0.3 / 0.7 * F%

where F% is franking percentage

Grossed-up dividend = Dividend + Franking Credits
= Dividend * ( 1 + 0.3 / 0.7 * F% )

For 100% franked dividends, the
Grossed-up dividend = dividend / 0.7 = dividend * 1.43.

Note that the 0.3 and 0.7 represent the 30% company tax rate (and the 0.7 comes from 1 - 0.3).

You pay tax on the grossed-up dividend, but then you get the franking credits back as a tax rebate.

If you're on a 31.5% marginal tax rate, then fully franked dividends suffer very little tax in your hands. At 16.5%, 0% and 15% rates (low income earners and SMSFs) you actually get a cheque from the ATO on top of your dividend.

 

Thanks Rod for all the detailed information. It really is food for thought, and I am giving serious thought to altering my current strategy. I already have a substantial holding in several managed funds, and have been planning to double those holdings by dollar cost averaging into them over the next 12 months. I think a viable alternative is to put all or most of the remaining capital into bank shares at current attractive prices, as my gut feel is they won't remain so attractive for so long.....

Would the Australian investment community allow SGB to pay 10% fully franked yield???

This comment really struck a chord, as I can't fathom that happening. Again, gut feel is telling me the time to make a move is now, and better be quick about it, and may as well make it a big one.

Cheers and all the best,

JustB

 

It's not whether the Australian investment community would allow SGB to pay a 10% fully franked yield, it's whether they believe it will pay a 10% fully franked yield. In other words, this is all about future earnings, nothing more, nothing less. At current prices the market does not believe banks can sustain the level of future earnings analysts are/were expecting. Not just for 2008, but for future periods also. The market thinks, Rod, that that 7.7% f.f. yield you're referring to may well stabilise to normal levels in the medium term of around 4.5-5.5% eventually. Not because bank share prices will rise, if anything, the market is predicting they'll fall further in the short term, along with actual earnings and future earnings growth. If the goalposts have moved or are moving, then playing on the old field under the old rules is no longer valid and your 10% dividend is just not going to happen.

I know the banks say this whole mess won't impact them materially on earnings. But they also initially said it won't impact them at all. They have to say stuff like that. I work for one of the banks in Australia (not big 4), and the truth is, looking back at some of the accounting in hindsight, somebody had a fairly good idea how serious this would get since at least 1Q07. It has impacted us and will probably continue to impact our banks from an earnings perspective.

Having said all that, I'm with you on your investment plan. The best, safest business you could possibly own in Australia is a bank or five. The mistake many people make though is assume the banking industry is not cyclical in nature. This is not true. The banking business is cyclical, in particular the investment banking side of things, which can weigh on a bank's share price. In the long term, you'll definetely look back in 20-30 years and laugh at all this. Most of my portfolio is invested in banks also and in times like this, I just switch on my DRP's, if not already switched on, and continue to sleep soundly at night. However, as much money as we'll make in the very long term, you have to understand that this mess has the potential to set us back 2-3 years (or even more in a worst case scenario) in terms of investment opportunity costs. On the other hand we could have a very quick recovery. That's the point, nobody really knows for sure yet. All we know is that the money is currently on a few bad years.

 

Rod mate,

So you intend to spread your risk by buying into only 1 sector of the economy?
What sort of risk control is this?

Don't be fooled by the current returns, when company profits start to drop so will the dividents.
What's the point of getting a few $K in dividents when my MQ portfolio halves?

IMHO The financial sector is the one most likely to be hit by any further turmoil in the US.
I am no expert and I don't have a crystal ball either but from what I read the worst is not over yet.

Take care.

 

Yes, I own four banks. But they still only account for 25% of my ASX portfolio. BHP and RIO account for another 25%.

I'm still coming to terms with Tropo's comments on diversification: If you can not get one stock right, how are you going to get a few stocks right?
And now I'm being told that focusing in one sector is not a good idea?

At least I'm happy with my strategy.

 

i must say yes dividends are looking great... but look at CBA, its fallen a fair amount since ex dividend. Now is that because people are getting out so they can get into another bank for the dividend, or is it the over reaction that the banks are really gonna suffer.

Any yes i love mq prime, if only they'd offer those types of %s on managed funds... im really interested to see the type of discounting they do..

also they told me options will be available on the account later this year, so im looking forward to that...

 

Yep, I agree it's all about earnings.

If the yield is indeed expected to return to around 5% in the medium term, then we can throw the term 'earnings growth' in the bin, in fact we would be expecting the earnings to contract by 40%. But hang on, three months ago we had CBA at $62 etc, and the expectation was for EPS growth of 10% forward at least a couple of years. So has the Australian banking world changed from 21% two-year EPS growth to 40% EPS contraction in three months of credit woes?

The Aussie banks have a wonderful oligopoly that is capable of withstanding crunches, even though the current global credit crunch is a doozie. At the moment the focus is on margins as funding becomes more expensive and Australian interest rates rise. But the banks have shown that they can readily pass on increases in funding costs (despite the pathetic bleats of politicians) and interest rates might go up in the short term to fight local inflation but the medium term outlook is flat.

Australian retail banks have a very healthy deposit base, eg CBA funding is derived 55% from deposit accounts. So they are cushioned from funding costs to reasonable level. Yes, I know that they have exposure to Centro and others, that may not return better than 10c in the dollar. But like I said, we will have a purge of bad credit in the next 6 months, which will certainly impact earnings in the near term, which might affect earnings in the medium term, but will ultimately lead to better lending practices. But banks will work out ways to return value to shareholders, that's what they do better than any other industry.

I'm no economist, but I reckon the grim US outlook is being xeroxed onto the Australian market. But why then have the US cut federal rates by 1.75% in a couple of months, whilst we have expectations of a few more rises?

Earnings cyclical, yes. But I'm not looking at 3 months, 12 months or 3 years. I'm looking at 20 years. Right now I can buy ANZ under $22, NAB under $29, CBA under $43, WBC under $23. Wait 20 years and tell me what they'll be then. Opportunity costs in the meantime? Find me better value elsewhere (after all opportunity cost is only relevant if you take a different opportunity, and don't sit on your cash). Other than diversified resources (BHP, yes please, with a cherry on top), there are credit ghosts hiding in closets everywhere. Listed property? No thanks. Consumer discretionary? No thanks. Consumer staples? Interest rates rising, will tighten the weekly budget. Residential property? Maybe, but again interest rates are spooking many, and frankly, I don't want to buy more property.

To me this is not just about earnings, it's about market momentum, and at times underlying earnings and expectations are thrown out with the bathwater. Fund managers have to stay in the top half of the Morningstar tables, and must show returns above average in the quarter. So if shorting bank shares is a winner, then that's what they'll do. But I'm very willing to bet that momentum will swing. And even if it doesn't in the short term, the self-funding shares will sit nicely in my account. CBA just paid a nice FF dividend, and that $1000 EFT will be in my bank account soon - I look forward to it.

 

At the end of the day, that's what counts.

Cheers

 

I think Rod has provided some excellent analysis and reasoning, but for some counter arguments against investing in banks right now...

Inside Business - 24/02/2008: Troubled companies shake up ANZ's bad debt provisioning

Being a bull, I'm with Rod though. I reckon when in doubt, you're more often than not better off investing in Australia's greatest companies than not.

 

Here's an article from AFR. It applies to US banks, but the arguments are exactly the same:

An old bull finds value in financials
Barrie Dunstan/Smart Investor
AFR Feb 23-24 p41

Bill Miller, who runs Legg Mason's Value Trust, has about $US47 billion ($51 billion) invested in his fund by those who regard him as one of the greatest current investment managers.

They have good reason: his fund outperformed the S&P 500 Index for 15 years up to 2005 - a record that puts him up with legends such as Warren Buffett and Fidelity's Peter Lynch.

Mention a "value trust" and people tend to think of a portfolio of worthy names, with low price-earnings ratios and higher dividend yields. But the Legg Mason Value Trust tends to be concentrated in fewer stocks. Miller has also identified tech and internet winners: it is the second largest shareholder in Yahoo! (which is under a takeover bid from Microsoft) and it also bought about $US195 million of Google shares in its float in 2004 which, within a few years, had increased about five-fold.

Still the fund has run into headwinds recently and Miller admits frankly in his final Commentary for 2007, "we had a bad 2007 which followed a bad 2006". His fund underperformed the S&P by its worst margin since the last two years of sub-S&P performance in 1989 and 1990 and his frank analysis illustrates how a really smart investor thinks.

"About the only advantage of being old in this business is that you have seen a lot of markets and sometimes market patterns recur that you believe you have seen before," he says. It's not an accident that the past two years are like the 1989 and 1990 underperformance - and he thinks there's a reasonable probability the next few years will look like the subsequent 1990s recovery years.

In the 1990 period, there were eerie similarities, with housing in freefall, savings and loans groups going bankrupt, financial stocks collapsing and oil prices were soaring. Then, as now, Miller says, people also thought that it should be possible to read the economic data and then adjust their portfolios.

"But unfortunately, as I have often remarked, if it's in the newspapers then it's in the share price. The process works the other way: stocks are a leading indicator, so first they go down then the data comes in."

Miller is a value investor but he also is an unabashed optimist and brave enough to suggest the late-January fall in financial stocks might have been a bottom. Now the Federal Reserve Board and the US government have begun to move with some alacrity on monetary and fiscal stimulus.

"Will it be successful?" he asks, before answering with a positive "yes". If the measures already undertaken aren't enough to free up credit and stimulate spending, "then additional measures will be taken until that is accomplished," he forecasts.

"This does not mean that the recovery will be swift or seamless, or without additional trauma. But there will be a recovery and I think the market abounds with good value," he says. "Those values may get even better if the market gets more gloomy, but they are good enough now for us to be fully invested."

Miller says he thinks the market is in for a period of what the Greeks call enantiodromia - the tendency for things to swing to the other side. "This is not a forecast but rather a reflection on valuation," says the value investor who has seen it all before. He says the poorest performing parts of the market - housing, financials and consumer stocks (except for consumer staples) - are at valuation levels last seen in 1990 and early 1991 which, he says, was an extremely propitious time to buy.

But Miller thinks Treasury bonds, which have performed so well as a traditional haven in times of turmoil, are now very expensive. Applying price-earnings ratios to bonds, he says the two-year Treasury is at more than 50 times earnings (a yield of less than 2 per cent) and 10-year bonds are almost 30 times - compared with about 14 times for the S&P stock index. He says the valuation disparity between bonds and shares "is as great today in favour of stocks as it was in favour of Treasuries 20 years ago" before the 1987 crash.

Miller says the 10-year Treasury yield is down from 10 per cent in 1987 to only 3.6 per cent now - lower than the yield on the S&P stock index. So, he says, "you can get a greater yield in an index fund than you can in the two-year [bond] and a free, long term call option on growth."

These are the touchstones of a committed value investor. Miller explains to investors, who might be unhappy that the portfolio does not keep pace with the broader market, that the price of a publicly traded security is one thing and value is another.

"Price is a function of short-term supply and demand characteristics, which are heavily influenced by the most recent news and results. Value is the present value of the future cash flows of the business and that is what we focus on."

Miller is even prepared to chance his arm on financial stocks at a time when many equity investors are showing extreme risk aversion for the stocks. He says yields on financials are about double bonds and are trading at price-to-book value ratios seen at the last big bottom of financial stocks.

He thinks that enantiodromia has already begun. "What took us into this malaise will be what takes us out. Housing stocks peaked in the summer of 2005 and were the first group to start down. Now housing stocks are one of the few areas in the market that are going up."

As for the obsession about whether the US will go into recession, Miller brands this "a particularly pointless inquiry". Stocks that perform poorly in recessions are already trading at recession levels and, Miller adds, "if we go into recession we will come out of it."

In any case, he says the US has had only two recessions in the past 25 years that ran for a total of 17 months. "As long-term investors, we position portfolios for the 95 per cent of the time the economy is growing, not the unforecastable 5 per cent when it is not, " he says.

"Traders and those with short-term attention spans may still be fearful, but long-term investors should be well rewarded by taking advantage of the opportunities in today's stockmarket."