Dividend Yields: NZX against US Markets

I think that dividend yield is one of the most important numbers to know when it comes to shares. The whole point of investing from my perspective is to get a piece of the action. The more money that comes to shareholders as opposed to executives, the better in my opinion.

The dividend yield is calculated by dividing the share price by dividend per share. Just like the price/earnings ratio, we need to be careful about making investing decisions on the basis of one ratio however.

If there’s one big difference between the NZ sharemarket and the US sharemarket (NASDAQ, NYSE…) it is the different attitudes towards dividends. New Zealand companies have very high dividend payouts relative to US companies.

What’s the reasoning behind this? I think it has a lot to do with how dividends are taxed. In New Zealand, there is an imputation credit system where dividends can be paid with imputation credits attached.In effect, this means you only need to pay extra tax on the dividend you receive if you are in the highest income tax bracket.

The story in the United States is very different. There, the company pays tax on its profits and the shareholder has to stump up again when the dividend lands in their account. This is called “double taxation”, and as a result, some companies are reluctant to pay dividends instead preferring to invest in growth or executive compensation.

An interesting exercise is to visit the great website Top Yields. Look at the NZX50 top yields and the sorts of companies appearing. Then look at the NASDAQ and NYSE top yields and the sorts of companies appearing.

In New Zealand, pretty solid performers like our banks (which despite all of their faults have been fantastic for shareholders the past decades) and retailers. In the United States, most of the top yields come from companies best described as “second tier”.

There are several theories as to why this is. For one thing, New Zealanders have more on term deposit than they do invested in shares. Since the 1987 sharemarket crash a lot of people have avoided shares and instead focused on non-productive housing investments.

There is a cultural reluctance to admit that poorly developed local capital markets mean raising finance offshore is the only way for many domestic companies to get the capital they need. In effect, our aversion to shares is making covered bond issues in Europe and dual listings on the Australian Stock Exchange far more palatable than domestic issues.

The stalling of partial asset sales, which would provide some solid new issues for the NZX, will only make the problem worse. Substantial inflows from Kiwisaver haven’t really happened. Some analysts think that all Kiwisaver has done is change where household saving is done as opposed to the actual level of household savings.

All of this is in stark contrast to the US markets. Despite the rise of high frequency trading and quantitative easing disproportionately benefiting the holders of financial assets, they have far more domestic participation in their capital markets.

That means that even when dividends are paid in the billions, the market capitalisations they are paid out against mean really low dividend yields like 2% or even less are standard.

Many US corporations are also sitting on massive cash balances offshore or domestically, not investing it in their business or returning it to shareholders. This of course makes NZ dividend yields look substantially higher than US markets.

I believe that the only reason to own shares is to get the dividends. Capital growth is a lottery and there are no guarantees that paying a premium for average businesses will be rewarded by long term growth in earnings and dividends.

For that reason, despite the almost hegemonic influence of US corporations, their policy against paying dividends and sitting on massive cash piles makes them less attractive as options.

For Kiwi investors, the Foreign Investment Funds tax regime is another tick against participating in the US markets. You could end up with a tax bill and no cash to pay it with, forcing an early sale.

Very high dividend yields can obviously be a sign that something is wrong. A company could be in the middle of a debt crisis or PR crisis. The underlying business could be uncompetitive or struggling. But for the present time, in light of NZX performance over the last year, the dividend yields in the New Zealand sharemarket are bloody good.

A lot of the risks – political, currency, volatility, adverse external shocks – are unlikely to destroy the ability of some high dividend payers to pay their dividends. For example, if the economy continues to meander through Great Depression 2.0 the profits The Warehouse Group (Dividend Yield of 9.49%) will earn are unlikely to come to an end anytime soon.

Why Price / Earnings Ratios Matter For Investors

The price/earnings ratio is one of the most important financial ratios we can calculate for a company that’s traded on the share market. It is calculated by dividing the share price by earnings per share.

For example, Chorus Ltd, currently trades at $2.94 per share. It has earnings per share of $0.265. 2.94/0.265=11.09. This is different than the figure shown below because I used the current price rather than the opening price.

Selection_066Source: NZX

In effect, if you buy 1 share of Chorus for $2.94 (excluding brokerage), you are purchasing underlying earnings of $0.265. You won’t necessarily get all of this as a dividend, but the 11.09 ratio allows you to compare different companies share price in relation to their earnings per share.

The P/E ratio can indicate whether a share is undervalued or overvalued. That doesn’t mean its share price will have anything to do with its valuation, but can help identify speculative bubbles.

In order for a high P/E ratio to be justified, a lot of earnings growth must be anticipated. If that growth in earnings per share doesn’t eventuate, a bubble stock can quickly collapse.

Because of the incentives faced by executives of publicly traded companies, increasing earnings per share each quarter is very important. The long term profitability of their business can take a sideline to making sure they “hit the numbers” that research analysts forecast for the company.

In the Dotcom bubble of the late 1990’s and early 2000’s, some companies achieved very high share prices without any underlying earnings growth. Their P/E multiples were very high – some companies were even making losses and burning through shareholder wealth at a rate of knots.

We have to remember that calculating ratios like these and making investment decisions based on them is risky business. Because of the casino nature of the financial markets these days, the most useful thing a P/E ratio can do is help us avoid piling into a bubble stock.

It can also help us avoid buying a dog on the cheap, because we think it is “under valued”. While the efficient markets hypothesis is academic fantasy, a lot of information is contained in the price of a share. If it’s going cheap, there’s probably a solid reason behind it.

Take for example Telecom – which of course used to have Chorus before regulatory action forced structural separation in the New Zealand telecommunications market.

Selection_067Source: NZX

We take the current price of $2.275 and divide that by earnings per share of $0.536 which gives us a price/earnings ratio of 4.24. This is much lower than Chorus’ p/e ratio of 11.09.

What does this actually mean? Well, traditional finance thinking would say that Telecom is undervalued because the price/earnings ratio is so low. Robert Shiller, in his book Irrational Exuberance, posits a long term average P/E ratio of 15 for US stocks.

While it’s hard to apply US data to a New Zealand market, on a global scale, both P/E ratios are low. That’s because New Zealand is not the United States. There are many risks that lower the premium investors will pay for New Zealand earnings.

  • New Zealand has currency risk, because investments are denominated in NZD.
  • New Zealand has political risk, because the telecommunications sector has been heavily regulated over the past decade.
  • New Zealand has volatility risk, because we’re like a lifeboat in the South Pacific – movements in overseas markets can very much influence our markets.

A value investor, someone who thinks share prices will move towards their actual value as opposed to the market price, would prefer Telecom to Chorus because of the lower P/E ratio.

A trader, someone who thinks the market price is all that matters, might think Chorus is preferable to Telecom because the higher P/E ratio means more people think that way and it’s still not “overvalued” so there’s potential upside.

Price / earnings ratios matter because they can influence the decisions of a lot of people. Some superannuation funds might have rules that stop them from paying a premium for underlying earnings growth. Executives at the firm might even engage in accounting games to show steady EPS growth.

When it comes to making investment decisions, how you view the results from calculating things like the price/earnings ratio will inform your eventual decision. But we shouldn’t forget that there are lots of factors outside the model that affect ratios like this.

These include regular buying from institutional investors that must own the share to track the index their performance is benched to. It also includes the company itself engaging in Treasury buybacks where it purchases and cancels its own shares to increase earnings per share.

Fairfax Selling TradeMe Is No Surprise

The news that Fairfax are selling their stake in TradeMe is no surprise. This is because Fairfax has made a string of poor decisions over the past decade.

They failed to aggressively expand in online media, benefiting primarily through the acquisition of TradeMe. They loaded up on debt and TradeMe was a key contributor to maintaining Fairfax’s debt servicing ability over the past few years.

The reduction in Fairfax’s debt will give them a lot of breathing room. But it will basically take them back to the position they were in pre-TradeMe. That’s a poor online strategy.

It is a fascinating insight into how executives are not very good stewards of shareholder wealth, if you subscribe to that theory. It’s also an interesting insight into how supposedly smart people can make really dumb decisions.

If we look at Fairfax’s most recent investor presentation, we see Fairfax are trading away a business with a margin of 75% (TradeMe) and EBITDA growth of 11.2% for a core group of businesses with margins between 5% and 28%.

The Fairfax executives are basically betting that their transformation strategy will deliver more cost reductions and revenue growth than using TradeMe as a cash cow to pay down their other groups debt.

Their arrogance is amazing. From their own financials, only their internal whole of group restructuring (HR, IT, operations) is delivering higher returns than TradeMe!

One of the biggest contributors to their cash flow – enabling them to stay alive – was the proceeds from the TradeMe IPO!

But we have to remember that the major Fairfax loss is a non-cash impairment as a result of their ~$2.8 billion writedown in masthead value and goodwill.

They have to write down the value of their print assets, yet somehow think selling off TradeMe is a good strategy.

This action reminds me of something Bob Jones wrote in one of his books – whatever AMP is doing, do the opposite.

Corporate executives have a track record of poor decisions. Fairfax loaded up on debt during the boom and delayed aggressive cost reduction until it was too late.

Now they’re letting go of a franchise business with massive margins that can fend off any¬†competition for the foreseeable future.

This whole debacle is another reason why excessive executive compensation is so wrong.

You can make completely stupid decisions that put a company on a trajectory to insolvency but there is no likelihood of Fairfax executives having to repay their “make hay while the sun shines” compensation.

If I was a major institutional investor in Fairfax I’d be extremely annoyed to the point of spending the rest of my career aggressively shorting companies with executives responsible for this at the helm.

“Go short the idiots who think selling TradeMe is a good idea” could be a rewarding hedge fund strategy over the next decade or so!