Pinned straw:
Firstlinks: Looking beyond banks for dividend income
James Gruber, 20 November 2024
The Big Four banks have had a stellar run over the past 12 months. For instance, Commonwealth Bank (ASX: CBA) is up 56% during the period, and 43% year-to-date. It’s a head spinning move for the ASX’s largest stock with a market capitalization of $260 billion.
Source: Morningstar
Is CBA a $115 billion better business (the equivalent of Westpac's current market capitalisation) than a year ago? Not if you go by earnings, which were down 2% in the last financial year. The prospects for future earnings aren’t impressive either, with most analysts looking for mid-single digit growth over the next three years. And these analysts assume provisions for bad debts remain near all-time lows – a big assumption.
What explains the rampant run-up in bank share prices? ‘Fundamentals’ as we like to call them in the finance industry don’t explain the moves. More likely, it’s liquidity. Mining stocks have been in the doldrums and large fund managers and super funds have essentially been forced to buy the banks to get returns. Passive ETFs have amplified the price rises.
Gone are the good old days
Once upon a time, the banks offered high starting yields (due to lower prices), with steady, growing dividend streams, but that’s now a distant memory. For instance, CBA grew dividends by a compound annual growth rate (CAGR) of 9.2% in the decade to 2003, by 8.9% in the decade to 2013, but by just 1.74% in the decade to 2023. Similarly, Westpac increased dividends by 9% CAGR in the ten years to 2003, by 9.5% in the following ten years, yet dividends declined by 3.1% per annum in the decade to 2023.
The slowing dividend growth is the result of slowing earnings growth, due to a host of reasons. Increased competition for deposits and loans, greater capital requirements, slowing credit and economic growth, and other factors have played a part.
Future earnings growth also looks tepid at best, and consequently so does dividend growth. Even with franking credits, the picture doesn’t appear anywhere near as positive as it did over much of the past 40 years.
Yet, the current share prices don’t reflect this. CBA is sporting a price-to-earnings ratio (PER) of 27.7x, making it the most expensive bank in the developed world, and by a distance. The PERs of the other banks are cheaper, though far from cheap: Westpac (ASX: WBC) at 17.4x, NAB (ASX: NAB) at 17.5x, and ANZ (ASX: ANZ) at 15x.
These high prices have left dividend yields at the lower end of history, with CBA’s yield at 3%, Westpac’s 4.5% NAB’s 4.3%, and ANZ’s at 5.1%.
Looking beyond banks
Banks have been the go-to source of dividend income for investors for years, yet they don’t offer the same prospects for high, growing income that they once did. What should investors do?
The yields on banks aren’t disastrous, so I’m not suggesting that it’s time to cut and run from them. However, it does seem an opportune time to look beyond the banks for better dividend prospects.
Here are some ideas:
Steady compounders. These are potential bank alternatives, offering steady, growing income. I like medical insurers such as Medibank Private (ASX: MPL) and NIB (ASX: NHF), with dividend yields of 4.4% and 5% respectively. Yes, there are risks around hospital cost negotiations, yet these seem to be at least partially priced in. While pricing is set by government, growing demand for private healthcare should ensure increasing earnings and dividends for many years.
Origin Energy (ASX: ORG) is another one in this category. It’s the country’s electricity and gas supplier and its attractive prospects have made it the subject of takeover bids. With a 5.1% yield and reasonable valuations, it deserves a place in income portfolios.
Dividend growers. This group of companies comprises great businesses with relatively low dividend yields but with opportunities to grow those dividends at a brisk clip. Brambles (ASX: BXB) is one, offering a yield of 2.6%, albeit only partly franked. Resmed (ASX: RMD) is another, with a paltry yield of 0.8%, but with a great track record of increasing dividends (more than 7% CAGR over the past ten years). And a personal favourite is Washington H. Soul Pattison (ASX: SOL). It has raised dividends in each of the past 24 years, by 10% per annum. It’s a phenomenal track record that’s unlikely to be repeated. However, the future still appears bright for the conglomerate. Soul Patts offers a 2.7% current dividend yield.
Comeback stories, returning cash. Here are stocks where there is real value and the potential for business turnarounds and for cash to be returned to shareholders. Ramsay Health Care (ASX: RHC) offers a possible opportunity. Better returns should come from an increased focus on its Australian assets. Also, negotiations with insurance funds over costs could prove a catalyst for the stock.
Perpetual (ASX: PPT) is another one. Everyone hates the company given its history. Yet, it’s inexpensive and if a proposed demerger goes ahead, that should result in about a billion dollars finding its way back to shareholders.
What didn’t make the list
There are notable absentees from the stock ideas above. First, there are no miners. I just don’t think miners deserve a large spot in portfolio given their volatile earnings and dividends. Second, the supermarkets are excluded too. Despite recent issues, the shares still seem on the expensive side and dividends aren’t compelling. Government pressure is effectively capping pricing, and they’re still dealing with cost issues.
What about dividend ETFs?
Given ETFs are all the rage, the inevitable question is whether there are ETFs that can provide investors with decent dividend income. My issue with a lot of the dividend ETFs is that they’re loaded with banks and materials companies. For example, the largest dividend ETF, Vanguard’s Australian Shares High Yield ETF (ASX: VHY) has 66% exposure to financials and materials, in line with its benchmark. It’s fine if that’s what you’re looking for. However, if you want to diversify away from banks and miners for yield, then please carefully read the fine print of dividend ETFs.
Are international shares an option?
International shares are an option for those seeking income. However, these shares don’t have the franking credits that are on offer in Australia. For this reason, I’ve always looking for yield in Australia and growth outside of it. It’s a strategy that may not suit everyone and depends on your circumstances.
James Gruber is editor of Firstlinks and Morningstar.
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Source: https://www.firstlinks.com.au/looking-beyond-banks-dividend-income
Disclosure: I do not hold CBA or any bank.
According to Commsec CBA is currently very expensive at 3.58 x book value - possibly the most expensive bank of scale in the world.
The decision to sell if you've held CBA for years is more complex because of things like CGT considerations, and the dividend yield based on your buy price being OK, rather than the current dividend yield now based on where they are trading today - which is low. However, in terms of CBA being a "Buy" up here... Yeah, Nah! Not even close.
When overseas money and then passive funds flow back out of our large banks, there will be significant downside - because there's so far to fall back to book value and also down to an above-market dividend yield.
And with the likely market volatility alongside possible economic risks we're likely to experience in 2025 - including the risk of the A$ falling further against the US$ - our big banks are not going to be as "safe as houses" in my opinion.
Further to what is making CBA (and the other big three to a lesser extent) run so hard: I watched an interview by Rask with Nathan Bell (of Intelligent Investor, manages the IIFs) and Nathan was bemoaning how he couldn't bring himself (via his income fund) to hold the banks earlier in the year and so has underperformed significantly, purely because of that.
Because of that, he went looking for data on who was buying our Big 4 Bank shares (Cumulative Net Purchases). His data (below) came either from Shaw and Partners or Macquarie (I can't remember but it was one or the other) and it tracks three groups - Australian retail investors, Australian institutions and International institutions - buying the banks back to 2001.
Nathan's explanation for the increased buying from Australian institutions was that they're being drawn into it because of fund managers having to cover their returns against benchmark and also ETF managers having to continually buy.
His explanation for the increased buying from International Institutions was that a lot of money has been and still is fleeing China, and needs somewhere "safe" to go, and at least for the short term, the international fund managers involved are not so much concerned with returns as with financial stability = safety and capital preservation.
For that, CBA and our big banks are viewed (rightly or wrongly) as the perfect place to park the funds while they find some better-returning but safe place to put them or wait out the current global issues.
I found the explanation interesting and have to wonder what it means for this crazy bank rally when those international fund managers do find viable investments with better returns and reallocate their funds.
I do think the limited supply is one significant driver. I've held CBA in my SMSF for yonks, and now the SMSF is in pension mode and 0% tax, I've been selling off in tranches. First tranche went at $140 - actually sold at $143 once the order went through! Second tranche I had planned to execute at $144 - by the time I returned from OS (only away for 2 weeks), it went for $158! Waiting to see where it goes before I pull the lever for the third and last tranche. Doing much the same for the other three big banks as well. BUT according to my financial advisor, I'm in the minority. He had two separate clients in the last week who, when he gently suggested selling CBA would be a good idea because they needed the cash and are also in the 0% tax situation, both swore they were dying with those shares. Why??? But there you are. Boomers who bought at the float seem determined to cling to those shares forever. Well...I have to admit I'll still be holding some, but a much much smaller number.
Discl: All 4 big banks still held IRL - but only in SMSF for for the dividend
One theory I have a bit of trouble getting on board with is that passive money alone is driving the CBA share price to ATHs. If that were the case, why isn't CSL, BHP, etc., in fact, all of the ASX200, which all get passive flows at ATH? IMO, the issue is with the supply side, not the demand side. Im a holder of CBA, have been for decades, which means a big CGT liability on sale. CBA has a high retail skew, as opposed to other large-cap stocks, in this case, it restricts supply. to be clear, i would sell the lot if the tax bill was lower, so now i dribble them out. i suspect many are in the same place, or the usual retail strategy, its going up hold on. those of us who believe valuations win in the end (although that may be a long road in some cases), wouldn't go near it. there are a few others for different reasons as well. perversely bad news could have a bigger counter impact.
held --maybe i can do a synthetic that locks in today's price and sells some every year so it spreads the tax over many years.