I believe to write accurate investment strategy you have to forecast where capital will flow. I know that sounds an obvious statement, but too often in the professional investment world investors/analysts/strategists over complicate and over analyse very simple themes.
For the last nine months we have forecast that falling local and global cash rates would force savers out of cash and lead to sustainable dividend yields being bid down in the equity market. We believed all those who relied on investment income to live would be forced up the risk curve.
Australia has been late to this equity yield compression party because we previously offered acceptable returns in cash to savers who wanted to preserve capital. Yet, with the RBA crushing cash rates to 3.00% and banks lowering their margin on term deposits from a peak of 2.00% over swap to 1.20% over swap, post tax returns on unfranked term deposits are collapsing bringing an end to the “do nothing” investment strategy.
I believe you can sense a change in the RBA’s rhetoric where they are starting to follow the FED. The RBAhave basically told investors that they are going to have to acceptable higher risk to generate the returns they require. Whether that involves buying a rental property, equity dividend yield or corporate debt, I believe you can see the RBA is moving to force savers out of cash and into productive assets. As those asset prices rise it should in turn generate a rise in consumer and business confidence.
30% of Australian super funds are now self-managed. Data suggests around 30% of SMSF assets are currently held in cash or cash equivalents. 90% of all Australian bank term deposits are of 1yr year duration or less. Our strategic view is that wall of increasingly low return cash is going to move to higher income stream assets over the years ahead.
On that basis our research department, led by retail investment strategist Peter Quinton, ran a model comparing the after-tax returns from bank term deposit rates vs. other higher risk bank products. This is a really good piece of work.
In the table below we are comparing the return if you were to invest $100,000 in a: 12-month term deposit, a subordinated debt issue (sub—debt), a hybrid issue (hybrid), and the grossed-up fully franked dividend yield from the bank equity (shares). The table below compares the return based on 7/12/2012 the top marginal tax rate for individuals of 46.5%, the tax rate paid by Superannuation Funds (15%) and the tax rate paid by Superannuation Funds in pension mode (0%).
In this example we have assumed the interest on the term deposit will be paid at maturity and the rates are from Monday 26th of November. The equity yield is the estimated yield for fy13 based on Bell Potter research notes. The sub-debt referred to is subordinated debt; ANZHA, CBAHA, NABHA, WBCHA. The hybrids referred to are the mandatory convertible preference shares; ANZPC, CBAPC and WBCPC.
What I want to focus you on today is the differentiated after-tax returns between term deposits and bank equity dividend yield at the two superannuation tax rates. While the sub-debt and hybrid analysis is interesting, I want to focus on the equity vs. TD returns inside a super fund structure.
For example, a NAB TD inside a 15% tax rate paying super fund returns 3.74% after tax vs. NAB equity dividend yield @9.52% after tax. Further, a NAB TD inside a super fund in pension mode paying 0% tax returns 4.40% after tax while NAB equity dividend yield returns 11.2% after tax.
Now, looking at the lowest dividend yield bank, CBA. A CBA TD inside a 15% tax rate paying super fund returns 3.40% after tax vs. CBA equity dividend yield @7.65% after tax. Further, a CBA TD inside a super fund in pension mode paying 0% tax returns 4.00% after tax vs. CBA equity dividend yield @9.00% after tax.
Six months ago we recommend investors get out of bank term deposits and into bank equity dividend yield. Of course at the time that call was criticised by the financial press who said we weren’t comparing apples with apples because there always should be an equity risk premium paid to investors in equity to compensate for volatility and risk. We completely agree, but as after tax returns get crushed in unfranked cash products we
believe the equity risk premium in terms of after-tax return premium offered by bank equity dividend yield is compelling, in fact, the equity risk premium is too high and likely to be bid down in the years ahead.
In the average 15% tax paying super fund the after tax return in pure income terms from NAB shares is 2.54x higher than currently offered by NAB TDs (9.52% vs. 3.74%). For those super funds in pension mode the after tax return in pure income terms from NAB shares is also 2.54x higher than currently offered by NAB TD’s (11.2% vs. 4.40%). In our lowest risk bank, CBA the after tax return in pure income terms inside a 15% tax paying super fund is 2.25x higher in CBA shares over CBA TD’s (7.65% vs. 3.40%). In a super fund in pension mode the after tax return in pure income terms is also 2.25x higher in CBA shares of CBA TD’s (9.00% vs. 4.00%). In other words, you are being paid a huge after tax equity risk premium (in income terms) to move from TD’s to bank equity.
It’s also worth remembering that this analysis is based off current TD rates. In the macro strategy we believe in we see the RBA taking the cash rate to 2.50% and banks offering around 120bp over swap for 1yr term deposits. That equates to 1yr TD rates of 3.70% at some stage next year. When TD’s have a “3 handle” the switch to equity dividend yield will accelerate.
The analysis above also reminds you of the after tax return power of franking credits inside a superfund structure, particularly one in pension mode. You can see why I see a wall of money moving into high, sustainable fully franked equity dividend streams ahead as Australian superannuants move from capital protection mode to retirement income protection mode.
Unfranked cash is no longer king; fully franked sustainable dividend yields are now king.
We continue to have all 4 major banks, Suncorp and Telstra in our high conviction buy list on this theme and remind you of our share price targets on those stocks based of dividend yields being bid down to 6.00% in fy14. I am actually starting to think those yield based targets will prove conservative if TD’s have a 3 handle.
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Charlie Aitken - Bell Potter (reproduced with Charlie's permission)
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