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.
19-June-2022: CBA is Australia's second largest company (behind BHP) and is currently rated #283 here on Strawman.com (as I type this), having moved up the rankings a fair bit since their share price has reduced lately. It does say something about our primary focus here that a company like CBA rates so low in terms of people here who hold the company in their Strawman.com portfolio.
CBA is currently held here by only 4 Strawman Premium members. And I am not one of them. I have never held any of the big 4 banks in my SM portfolio.
Being the clear leader of the big 4 in terms of size and quality (and management also IMO), CBA is starting to look interesting from a price perspective:
$87.26 looks like a great price when you look at that, however when you zoom out and look at the 5-year chart...
...the pullback in 2022 hasn't been nearly so deep as the one in 2020, and I feel there is plenty of scope for that SP decline to continue further before they recover, purely based on sentiment around an impending Australian recession, and the rest of it. I think CBA is probably a decent BUY here, with a 5-year-plus view, but I think they're going lower and we'll be able to buy them even cheaper in the future, possibly the near future.
I found it interesting what FMG founder and major shareholder Andrew "Twiggy" Forrest said last week about the likelihood of a global recession this year - Andrew Forrest says no recession, but expects years of choppy markets (afr.com)
by Hans van Leeuwen, Europe correspondent
Last updated Jun 17, 2022 – 11.26am, first published at 10.36am
London: Fortescue Metals Group boss Andrew Forrest says there is “not a snowflake’s chance in hell” of a global recession this year, but warned that markets could be “choppy and uncertain” for up to three years.
Speaking to AFR Weekend during a visit to London, Australia’s richest man said Fortescue’s low cost base and its green energy plans left it well-placed to weather the storm of rising borrowing costs, soaring inflation and slower growth.
Andrew Forrest visited France this week to sign a deal for zero-emission trucks with manufacturer Liebherr.
He also shrugged off reports that China might create a centralised purchasing cartel to drive down iron ore prices, saying this was “a story which gets trotted out every three years”.
The Russia-Ukraine war has spurred sharp increases in energy and food prices. This has combined with rebounding post-pandemic labour markets and issues with supply chains and transport costs to fuel inflation.
“I don’t know of a better industry to be pivoting towards when fuel prices are going through the roof than an industry where you can make all your own fuel,” he said, referring to Fortescue’s ambitious plans to make hydrogen from renewable energy.
The prospect of rampant inflation has pushed central banks to start aggressively raising interest rates, sapping stock prices. Companies’ cost of capital may climb, deterring them from investing and expanding.
But Dr Forrest said Fortescue was relatively immune to these cyclical forces: it should still be able to raise capital, and could withstand any downturn in commodity prices.
“We smoke $3.5 billion worth of fossil fuel into the atmosphere every year. That is one hell of a pool of capital annually to invest into your own fuel production and green iron systems,” he said.
He also said there was still an abundance of capital looking for investible projects. “The largest part of that is for green projects, by a country mile. That’s not going to change.”
And even if the cost of capital rose or fell, “so does the commodity price”, giving him the revenue base he needs to push forward with his green transformation.
Fortescue plans to spend $800 million-plus to build an end-to-end supply chain for hydrogen and ammonia produced using only renewable energy, and is also investing in technology for hydrogen-powered or zero-emission ships, trucks and trains.
The biggest risk to Dr Forrest’s ambition would appear to be a drop in the price of iron ore, but he is not overly worried.
“Demand for our product has remained strong,” he said. “And if global demand for iron ore goes down, the last man standing will be the lowest cost producer. And that is Fortescue.”
‘Not a snowflake’s chance in hell’
Dr Forrest was not anticipating the kind of global recession that might sap demand for iron ore. He said there was “not a snowflake’s chance in hell” of that happening.
“From country to country, yes. But there’s pent-up demand from COVID and that’s now been exacerbated by the Russian invasion. And I think that demand is still going to be there,” he said.
“You are going to have a choppy two or three years; not recession, nothing hugely dramatic like a global recession. But markets are going to remain choppy and uncertain for two or three years.”
The other great uncertainty is geopolitical: the ever-lingering prospect of worsening relations between the US and China, with the potential for economic decoupling that might sweep up Australia even further.
Dr Forrest welcomed the Albanese government’s more temperate approach to relations with China as “a breath of fresh air”.
“I’ve really resented China being used in [Australian] politics,” he said.
He urged both Beijing and Canberra to “check their language” and make sure they were not creating an enmity by treating each other as enemies.
But his support for a détente with Beijing was based on “the public interest”, he said, as geopolitical tension was not a material concern for his business.
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So back to CBA. There will likely be further downside from here, but at some point they will become worthy of serious consideration as part of a diversified portfolio, particularly one like mine that currently has zero banking exposure.
The sell-down of the banks (including CBA) is not entirely unjustified. They WERE quite expensive, especially CBA, and the outlook is changing, however they are NOT going broke, they are very well managed, and at some point I will likely buy some if the price keeps falling.
Also, while the banking landscape will continue to evolve, I would back CBA to keep themselves at the cutting edge of banking here in Australia, as they have done so far.
Source: AFR Banking Summit | Deloitte Australia
