Saturday, 5 October 2013

Give Me the Dividends Mr CEO (Valuing the Australian Stock Market)

As a stock market investor there are only 2 ways for your wealth will grow – share price appreciation and the reinvestment of dividends which are also hopefully appreciating on a per share basis.  How do CEO’s achieve this share and dividend per share appreciation for us?  I see two distinct methods.  The first is what I like to see and includes:

  • funding of focused and targeted R&D to generate new products with unique selling points when compared to the competition allowing market share gain;
  • looking for new white spaces in the global market where products can be sold; and
  • tirelessly working to find operational efficiencies which increase profitability for a given amount of earnings, to name but three.

The second method I'm not so keen on and includes:

  • the merger and acquisition (M&A) of companies that supposedly have “synergies”.  Sure, some acquisitions work resulting in 1+1=3 but “study after study” also “puts the failure rate of mergers and acquisitions somewhere between 70% and 90%”.
  • share buy backs.  Maybe I'm being cynical here but why do I believe CEO’s undertake share buy backs?  I believe it’s to boost Earnings per Share and the Share Price.  Now why would they want to boost those?  A lot of Executive bonuses are based improving metrics such as these including straight up cash incentives but more stealthily through incentives like share options.

What would I prefer to see from CEO’s?  If they are out of ideas on how to grow the top and bottom lines organically then give the profits back to me in the form of dividends.  Unlike the CEO I can then reinvest those dividends across the whole market if trackers are my thing or a completely different sector if I think that one is overvalued in any world location.  This gives me an advantage over the CEO who only has his/her own company or “synergistic” companies to choose from.

Give Me the Dividends Mr CEO

It’s not a perfect science, because issues like company and shareholder taxation get in the way which/do cause forced behaviours/distortions, but if we look at the ratio of dividend yield to earnings yield we might be able to get some idea of which countries CEO’s are trusting the shareholder and which are having delusions of grandeur and trying to line their own pockets.  Today the S&P500 has a dividend yield of 2.0% and an earnings yield of 5.7% for a ratio of 0.35 meaning US CEO’s are only giving the owners of their company’s 35% of company earnings.  In contrast the FTSE100 is offering a dividend yield of 3.6% (80% more than the US) and an earnings yield of 6.7% for a ratio of 0.54.  So FTSE100 CEO’s are giving back 54% of earnings.  Now let’s jump to another developed country with a relatively small population – Australia.  The ASX200 today has a dividend yield of 4.3% (19% more than the UK and 115% more than the US) and an earnings yield of 5.6% (pretty much identical to the US) for a ratio of 0.77 or 77% of earnings being returned to shareholders.  A visual representation of this can be seen in the chart below.

Chart of S&P500, ASX200 and FTSE100 Dividend and Earnings Yields
Click to enlarge

This method doesn’t claim to be perfect and I could write a page of caveats as to why but it does give some food for thought and further analysis.  One of which is that the reason the return to shareholders is so large in Australia is because Earnings are falling while CEO’s naively maintain (or increase) dividend payments.  Let’s therefore step away from the method and analyse whether the Australian Share Market is good value.

ASX200 Pricing

The ASX200 Price at market close on Friday was 5,208 which is down 0.2% from last month’s Price of 5,219 and up 15.3% year on year.  An historical view of ASX200 Prices is shown in the chart below.

Chart of the Monthly ASX200 Price
Click to enlarge

While this is the type of chart you will typically find in the mainstream media I’m not a fan because I find it sensationalist.  Why? It doesn’t account for the devaluation of the Australian Dollar through inflation.  Additionally, it should also be on a logarithmic scale which allows percentage changes in pricing across history to move by comparable amounts.  Let’s therefore correct the chart for both of these issues.

Chart of the Monthly Real ASX200 Price
Click to enlarge

This shows the ASX200 is below its trend line and is running at pricing levels seen in 2008 while we were within the midst of the Global Financial Crisis.

ASX200 Earnings

The Earnings of the ASX200 which has been calculated using the MSCI Australia P/E Ratio and ASX 200 Price (rationale for this assumption) is currently 292.  That’s 4% lower than this time last year.  Of course inflation flatters this result.  After inflation year on year Earnings growth is actually down 6%.   This all gives an Earnings Yield as mentioned above of 5.6%.

Chart of Real ASX200 Earnings
Click to enlarge

Chart of ASX200 Earnings Yield
Click to enlarge

ASX200 Dividends

MSCI Australia annual Dividends, which I accept as an ASX200 proxy per the rationale above, are today running at 222.  Nominally that’s 5% higher (4% inflation adjusted) than this time last year implying some of the falling Earnings rising Dividend risk mentioned above.  Dividing the Price by the Dividend gives the Dividend Yield mentioned above of 4.3%.

Chart of Real ASX200 Dividends
Click to enlarge

Chart of ASX200 Dividend Yield
Click to enlarge

Valuing the ASX200 – The ASX200 Price/Earnings Ratio (ASX200 P/E or PE) and the ASX200 Cyclically Adjusted Price/Earnings Ratio (aka ASX200 PE10 or CAPE)

A popular valuation metric is the PE ratio which is the Market Price divided by Earnings.  The MSCI Australia PE Ratio is currently 17.7 compared with my dataset (since December 1982) average PE of 18.2.  Could this imply the market is 3% undervalued?

Personally, the valuation metric I prefer is the ASX 200 PE10 (effectively an ASX 200 cyclically adjusted PE or ASX 200 CAPE for short).  The method is based on that made famous by Professor Robert Shiller and in this instance it is simply the ratio of Inflation Adjusted Monthly ASX 200 Monthly Prices to 10 Year Inflation Adjusted Average Earnings.  This is currently 16.2 compared with a dataset average of 21.8. If this average was “fair value” then it indicates that today the ASX200 is 26% undervalued.  I’m not convinced of this though and think it is a result of a relatively short dataset.  For my own investments I therefore “correct” for this by making quite a large assumption, which is that there is a high correlation between the performance of Australian Equities and International Equities.  With this assumption I then look at my mature S&P 500 dataset ( ) which tells me that since 1881 the average PE10 has been 16.5 and from 1993 it has averaged 26.3.  Taking a ratio of these two PE10’s and multiplying by the current ASX200 Average PE10 I arrive at a “pseudo long run” Average PE10 of 13.6.  Comparing that with today’s PE10 of 16.2 suggests the market is now 19% over valued and it is that data that I am making my own personal investment decisions from.  Personally, this doesn’t mean I’m not holding any ASX200 tracker funds.  It simply means that instead of targeting a holding of 19% of total wealth in Australian shares I’m targeting a holding of 17.5%.

If you’re interested in getting some exposure to the Australian market how might you go about it?  The method which I believe will maximise your wealth creation is to simply buy index tracker funds for the lowest possible cost.  Global or Asia Pacific funds available in your local country will usually include some exposure.  If you’re looking to be more targeted and UK based then the UK variant of iShares has the iShares MSCI Australia UCITS ETF (SAUS) with a TER of 0.5%.  You could pop that into a TD Direct Investing ISA paying £12.50 for the purchase with no ongoing annual expenses provided you have an ISA balance of at least £5,100.

If you’re reading this from Australia then you have two fund types to choose from.  The first is a mutual fund like the Vanguard Index Australian Shares Fund which can be bought directly from Vanguard.  Expenses via this route are quite high early on with management costs of 0.75% on the first $50,000 worth of investments.  Alternatively, the Australian variant of iShares has the iShares MSCI Australia 200 ETF (IOZ) with management costs of only 0.19%.  You could buy that via an online share trading site like E*Trade for either $19.95, $24.95, $29.95 or 0.11% depending on the value of the purchase with no ongoing annual expenses.

Does your current wealth contain any Australian Equities?

As always DYOR.

Assumptions include:

  • All historic figures are taken from official data from the Reserve Bank of Australia.
  • Latest P/E ratio is calculated using the 04 October 2013 Price and the July 2013 Earnings which is extrapolated from the RBA’s published P/E.
  • October 2013 Price is the 04 October 2013 market close.
  • October 2013 Earnings and Dividends are assumed to be the same as the September 2013 numbers.
  • Inflation data for July to October 2013 are extrapolated.


  1. Hi RIT,

    A common belief here in Australia is that the two main reasons for the high dividend payout ratios of Australian companies are:
    1) favourable tax treatment of dividends compared to other countries; and
    2) a small domestic market means that growing companies reach market saturation relatively quickly and then have to chose between attempting to expand into foreign markets, which is risky, or accepting that the business is now mature and raising the dividend payout ratio.
    Three is not a very big sample size, but your comparison of the dividend payout ratios in the US, UK, and Australia does suggest a possible correlation between population (and, therefore, size of domestic market) and payout ratio.


    1. Hi Dave

      Thanks for jumping in with "the local thoughts on the street".

      Let me give my thoughts from somebody sitting on the other side of the world:
      1) I agree that the Australian Dividend Imputation system does indeed provide for favourable tax treatment. I'm not familiar with US tax treatment but I can say that in the UK if you are careful it too is very favourable. ISA's allow 20%, 40% and 50% tax payers to pay no tax on dividends. Outside of the ISA environment 20% tax payers (the majority of the employed tax paying population) also effectively pay no dividend tax. So if I compare to the UK I can't see that being a strong reason. Maybe compared to some other countries though...
      2) The analysis above used the ASX200 for Australia. I believe that company 200 is Boart Longyear (BLY) which had revenues of USD2.01B last year. Here in the UK I know of companies that are an order of magnitude smaller who are trading in 10's of foreign markets successfully. I'm therefore struggling with that hypothesis also. Could it be something to do with the geographically being so isolated from "a lot of the world"? To answer my own question I also struggle with that given Australia is one of the closest developed countries to China.


    2. Hi RIT,

      Paying no tax on dividends is okay, but not really what I would call favourable. Favourable tax treatment is a $70 dividend attracting a tax refund of $30. It sounds unbelievable, but it is true. An Australian resident with a marginal tax rate of less than 30% gets a refund of the company tax already paid on their dividends. If the marginal tax rate is 0% (for example, for a superannuation fund in drawdown) then company tax is refunded in full, which means a $70 dividend is topped up to $100 by the government. That makes pensioners very keen on dividends.

      Regarding the effect of a small domestic market on payout ratios, it is not really about whether smaller businesses can expand into other countries successfully. It is about what happens to those that don't, either because they try and fail (which is more common than the success stories might suggest) or because they don't try. In a small market a growing business quickly reaches the point where it dominates its market and can't grow any further. That can happen in as little as ten years in Australia. There are plenty of stories in Australian investing circles of investors being burned because they bought into a business with a great growth story just as the growth came to an end. The ASX200 does include some successful international businesses, but dominant local businesses with little or no presence in foreign markets are more common. When the opportunities and/or plans for growth disappear, so does the need to retain earnings to fund growth, and up goes the payout ratio. I am sure that this is not the only reason for the higher payout ratios, but I suspect that it is part of the explanation.


  2. Hi RIT,
    I think one of the aspects to look at is the relative size (market cap.) Aus is only around 3% of world market compared to the massive US of around 46% and UK around 9%.

    Yes, the yield may be higher, but I would suggest this is because there is more risk in buying into a smaller market.

    I have some exposure to Aus via my Far East focussed investment trusts but as part of my total holdings, I would not think it comes to more than 2% or 3%. As a UK based investor, I would feel uncomfortable with the levels you have (not a criticism) and the associated risks. Having said that, I am probably too focussed on the UK market!

    1. Hi John

      I'm not sure if you are aware of how I ended up with my Australian allocation. It was covered in a number of early posts but let me detail again briefly.

      When I first built my strategy I thought that my working life would be in the UK/Europe but I was seriously thinking of Australia as my Early Retirement home. I was therefore actually trying to reduce my risks by splitting my "local" equities allocation equally between the UK and Australia. The strategy then has me reducing this allocation by 1% (0.5% UK and 0.5% Aus) annually to reduce risk. That reduction is reallocated to lower risk investments, namely Index Linked Gilts of NS&I ILSC's (when available).

      Fast forward to today. Having spent some time in Aus it is no longer a target retirement country but I'm still following the same strategy for 2 reasons:
      - it seems to be working
      - I don't want to continually tinker with my strategy as my life develops and transitions.

      That said now that Australia is no longer on the table I am considering shifting the risk reduction 1% to be just Aus equities. I haven't made the change yet as I can't help but think in a globalised world such as we live today that Aus could be on the table again at some time in the future..


  3. Your complaint is a special case of the proposition that CEOs and their cronies are given to rape and pillage of the shareholders, and that a remedy needs to be found in changes to corporate governance laws.

    At least I hope a remedy is to be found there; otherwise we'll have to encourager les autres by hanging the occasional one.

    1. Hi dearieme

      "Your complaint is a special case of the proposition that CEOs and their cronies are given to rape and pillage of the shareholders". I couldn't agree more. But given that hanging is no longer allowed how does one start to change it?


    2. Not the foggiest, old bean; not my field. But a change is clearly needed. Perhaps the best hope is to find a poacher prepared to turn gamekeeper and suggest some changes designed with inside knowledge.

  4. The problem with releasing dividends is that most companies have an alternate method of using cash that you didn't address - paying off debt. It generates higher returns than us investors can get on average in the market, whilst decreasing our (ie, the company's) risk.

    If a company has debt at something even as low as 5-6%, I would still much rather them guarantee me those returns than give me the cash. And most companies' debt is more in the region of 8-9% or higher! If you know somewhere where I can generate those kind of returns, let me know :D!

    It becomes an even better proposition because it allows the companies to have access to more credit in the future when they do identify tangible, high return 'white spaces'/R&D opportunities etc. as you highlighted.

    1. Also, FYI I am an Australian and recently the local 'investment gurus' in the popular media have been hyping up dividend-paying stocks. Companies like Telstra/the Big Four Banks have sen huge capital growth as people have been buying up these high-yielding companies - which has obviously now depressed their yields.

      It seems to be the 'in' thing to invest in at the moment :/!

      And companies have responded by issuing special dividends and increasing their payout ratios (See, eg, Westpac and Woodside). In my, very cynical, view the management are just doing this to ride the current wave of excitement, bolster the shareprice and cash in on performance bonuses as you alluded to re: buybacks!

      For an example of the opposite, see QBE who lowered the payout ratio in order to retain capital for their consolidation/cost-cutting after a huge period of M&A - market punished them even though most people would agree it's pretty good management!

    2. Eg:

  5. Also check out the ETF that trades under the ticker STW. State Street ASX200 fund. Nice low MER.