Dividend ramping makes small caps a compelling buy
One of Australia's biggest fund managers has done research that indicates that dividend ramping is common in big cap stocks like Telstra and the banks.
This outcome is because everyday investors have been chasing dividends, in many cases paying too much for the tax credits associated with them, leaving them vulnerable to the slowdowns in so-called "defensive" sectors.
Telstra is a case in point. On 17 August it closed at $3.90, then when investors lost the rights attached to the 14¢ fully franked dividend, the next trading day, 20 August, it fell 20¢ to $3.70. The franking credits were only worth 6¢ if you got the money on that day. Taking the time value of money into account they were worth much less. Telstra currently trades at $3.81.
The fund manager, who declined to be named, points out that the heavy weighting of retail investors, to Telstra and the banks, is the reason why these stocks are being bid up, and are susceptible to a big selloff.
Problems for Telstra and the banks
In 2012 total telecommunications growth fell for the first time, driven by a slowdown in mobile phone revenues. Telstra is covering its dividend for now, but its margins will be cut when it reverts to being a reseller of the national broadband network (NBN). There is no doubt that its board will be looking for growth avenues to exploit using the $11 billion or so in its coffers as a result of its fixed network sale, rather than paying out extra dividends. Big companies don't like getting smaller.
Telstra trades on a price/earnings ratio of 13 times which is slightly above the industrial market, and on a dividend yield of just over 7 per cent - also above the average of about 5.5 per cent.
The banks' metrics look similar to Telstra, but in many ways investors should be even more wary. People forget how leveraged these beasts are to the economic cycle. They are vulnerable to bad debts in an environment where there is zero lending, or credit growth.
Banks take money and lend out seven or eight times more than that. If there is a hiccup in their debt collection, their profits will fall and shareholders will feel the pain. And as the economy gets tougher and more businesses fall over, there is a greater risk of this happening.
They are also under a tougher regulatory environment, which means they are being forced to raise capital to maintain their increasing capital adequacy ratios (the amount of funds a bank holds in deposits and the like to offset its loans). A bank lends $12 for every $1 of its capital.
Invest in small caps to make "many times your money"
Companies that are considered to be in industries where their earnings growth is protected from a severe downturn are trading on the kinds of P/E multiples that suggest Armageddon is coming our way.
Classic defensives like pharmaceutical services providers CSL, Cochlear and ResMed are all on 20 times. Private hospital operator Ramsay Health Care is up 33 per cent in the past six months and trades on a PE of more than 18 times and a dividend yield of 2.5 per cent.
Andy Gracey runs money for Australian Ethical Investments in both big and small caps. He says that these types of companies face a big risk if sentiment improves: “Ramsay has been run extremely well, but can it go up another 50 per cent? I think not.”
Value now exists in the smaller end of the spectrum, he says: “This is the end of the market where you can get value for money now. Sure there is risk, but you're buying on low P/E multiples and you often get a yield.
“If you can find a nice small cap with a thematic growth engine it's looking to tap into and you're not paying a big multiple, you can make many times your money.”
Under the Radar couldn't have put it any better ourselves.
Click here to access the fortnightly newsletter Under the Radar Report: Small Caps, edited by Richard Hemming.