Interest rate tailwind

Canny investors need to balance optimism with risk awareness

STORY GREG HOFFMAN

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THE TOUGH ECONOMIC conditions aren’t necessarily bad news for sharemarket investors. That was a key theme from 2012 and one I expect to continue in 2013. A basic formula will help us explore this contradictory-sounding phenomenon.

Generally, share prices are the result of multiplying the amount of profit (or earnings) per share of a company by the multiple investors are willing to pay for those earnings (known as the price-to-earnings ratio, or PE ratio or P/E).

Most commentary you see relates to factors impacting only the first part of that equation – the earnings of a company. These include currencies, the political situation in Europe, the economies in Japan, the US and China and other intellectually stimulating material.

Such big-picture factors, along with company-specific considerations, influence profits. And there’s plenty of cause for concern on this front.

Australian property prices have stumbled and competition is intensifying in sectors such as retail and stockbroking. Other industries, such as newspapers and television broadcasters, are facing technological threats that mean their profits are never likely to attain the heights reached a decade ago.

Our strong dollar continues to strangle many exporters and a marked slowdown in credit growth is crimping profits for the banks – the Australian sharemarket’s second largest sector. This is not an environment where company profits look set to soar.

That’s enough to turn many people off shares. They’ll wait for clear, positive signs, mistakenly believing the relationship between profits and share prices is a direct one.

It’s an easy error to make when company profits make all the headlines. You know the ones: “BHP profit down by more than a third” or “CBA posts record $7.1bn profit”.

Yet in the face of patchy profit growth, the Australian sharemarket managed to return 19% (including dividends) during 2012 (measured by the S&P/ASX 200). That was in a year when there was plenty to worry about. Indeed, one prominent commentator told his readers at the end of 2011 that he was significantly reducing his “already reduced exposure to equities, possibly to zero” because of the high risk of “another major panic selloff on the market”.

There was plenty to worry about 12 months ago and there’s plenty to worry about now. So how does a stodgy blue-chip share such as Commonwealth Bank soar more than 24%?

The answer is in the second part of our equation: the multiple that investors pay for company profits. It’s an increase in the multiple (the PE ratio) that drove returns in 2012 and, I believe, will play a major role in 2013.

It’s easier to think about this in terms of what investing great Benjamin Graham called the “earnings yield” – the profit per share divided by the price. If you’re mathematically inclined, it’s the inverse of the PE ratio.

Note that this “earnings yield” is not cash you will necessarily receive in your bank account. Most companies hold on to a proportion of their profits to reinvest in the business. But assuming those profits are real (they’re sometimes not, but that’s a story for another day), then they’ll either be paid out to you as dividends or be working in the business on your behalf.

If a company makes $1 a share in profits, an investor paying a multiple of 10, or $10 per share, is receiving a 10% “earnings yield” ($1 in “earnings per share” divided by the $10 share price paid). An investor paying a multiple of 20, or $20 per share, for those same profits is making an “earnings yield” of just 5%.

You can see from those numbers that money can be made when nothing changes but the multiple that others are prepared to pay for your company’s profits. And, counter-intuitively, share prices can appreciate due to this increase in the multiple even as profits are under pressure.

Retirees face a quandary

Particularly in the second half of 2012, investors were prepared to accept a lower earnings yield (and therefore pay a higher PE ratio). As interest rates fell, stocks offering relatively safe dividend yields became more attractive.

This trend has continued into 2013 and here’s why: with interest rates around 6% a few years ago, a retiree wanting $40,000 in annual investment income without taking any risks with their nest egg (that is, they wanted to keep it in government-guaranteed deposit accounts) required $666,000. Today, with lower interest rates, they need more than $1.1 million.

Today’s retirees must choose between three difficult options: make substantial downward lifestyle adjustments, cut deeply into their capital each year (effectively betting against their own longevity) or increase the amount of risk they’re prepared to accept for the chance of generating higher returns.

Taking into account the benefits of franking credits, the dividend return on Woolworths is more than 6%. For Westpac it’s closer to 9%. Many income-hungry retirees are being enticed away from the safety of cash and into such shares. For the early movers, it’s been a great ride so far.

This trend is likely to run further in 2013. While profits may struggle to show much growth, demand for quality shares will probably continue to be high – in particular, those offering reliable dividend returns exceeding 6%.

A further 10-15% rise in the market is quite possible. It could be even more if we get any positive profit surprises toward the end of the year, such as surging demand from Japan due to a devalued yen (they’re working on it).

If the market does rise by this magnitude, many income-hungry investors will be placed in a quandary, having swapped the safety of cash for shares, which will have provided income and capital gains. If those gains haven’t been enough to bridge the funding gap between their lifestyle needs and returns from safer investments, they may be stuck with a permanently higher-risk investment portfolio. So let’s canvass some of those risks.

How to protect yourself

Among the panoply of unpredictable but consequential things that might occur are an international banking crisis, terrorism, pandemics, war and severe natural disasters. For share investors, such events are terrible to consider but dangerous to ignore.

The best way to approach 2013, I believe, is with some optimism that falling interest rates provide a strong prevailing wind for quality stocks. Temper that optimism with a healthy degree of risk awareness and I think you’ll have the right combination.

A diversified portfolio of quality stocks should offer some protection against sector-specific disasters. Looking for particular names? Woolworths, a big bank or two (I prefer the strategies of Commonwealth or Westpac) and sharemarket operator ASX all offer juicy dividends and are worthy of consideration.

Finally, I’d like to share an observation made by billionaire investor Kerr Neilson (of Platinum Asset Management) at an Intelligent Investor conference in November: “The stockmarket owes you nothing. You think the stockmarket is there to make you rich? It most certainly is not. It is there to deprive you of wealth. But if you are cunning and if you are of independent mind, it need not.”

So I hope that you manage to stay independent and cunning and that 2013 proves a rewarding one for you, your family and your portfolio.

Disclosure: Portfolios managed by Greg Hoffman own shares in Woolworths and ASX. He is an independent financial educator, commentator and investor and a director of the Intelligent Investor group of companies. See www.greghoffman.com.au.

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