Generating Sustainable Income
If you were to look at the portfolio of just about any SMSF in retirement phase or indeed at the portfolio of any investor looking to generate a high level of incomes it’s likely you’d notice a few similarities. The big 4 banks of course would be a prominent feature, Wesfarmers and IAG would likely be blended in and Telstra would command a healthy allocation of the portfolio particularly now that it is trading on a grossed up yield of 9% even after its recent dividend cuts.
However just because the herd agrees that one stock or another is a good “income play” doesn’t necessarily mean that it's true. In the case of Telstra for example we’d argue that looking past the headline of a near double digit fully franked dividend yield reveals a stock that is ripe with risk and likely positioned for further losses.
Beyond selecting stocks that pay an attractive dividend we have 3 other criteria that we test stocks against before they make the cut for the HarbourSide Australian Income Strategy – The first of which is perhaps Telstra’s biggest flaw; momentum. Contrary to popular belief study upon study has shown that stocks that have exhibited strong recent performance are likely to continue to see strong gains whilst stocks that are falling are likely to continue heading south. Indeed a joint study of the ASX by researchers from the University of Technology Sydney and Waikato University found that on average the top performing 20% of stocks outperformed the bottom 20% of stocks in the next period by an average of 1.86% which supports the notion that previous price performance is related to future price performance at least in the short – medium term. In the context of an income portfolio though the key takeaway from this “momentum effect” is to steer clear from stocks that are tanking as poor performance is likely continue which means any income that you might have received could be gobbled up by capital losses. Just a brief look at Telstra’s 12 month price graph shows a fall from $4.82 to its current price of $3.36 which places it firmly into the category of a stock exhibiting poor performance thus making it a prime candidate to see continued poor price performance.
Clearly then Telstra fails our momentum test and thus poses too great a risk of further capital losses to warrant investing in.
However Telstra also fairs rather poorly against our second set of criteria which looks at t the quality of its business and the management team that operates it. Turning first to the quality of Telstra Corps management it takes only a very quick Google search to find a long list of very costly errors and poor executive decisions from the $500 million dollar write off of the companies Ooyala acquisition to ongoing woes with the NBN and increasingly frequent network outages. All these issues set against a backdrop of growing competition and structural change with the rollout of the NBN have left Telstra with a shrinking market share and EPS growth that has been going backwards since 2014. From an income investors perspective then investing in a stock that lacks an excellent management team particularly in an industry sector like telecommunications that is undergoing structural change and seeing competition increase could lead to a situation where earnings continue to fall thus requiring yet another dividend cut. With the loss of the monopoly Telstra had on the cooper network and the loss of the economic moat that monopoly brought the company we’d argue that investors really need to start rethinking Telstra’s business model and where its earnings are going to come from moving forward.
The third and final criteria that we use to evaluate income stocks is value. The markets aggressive sell off of Telstra in the last 12 months has meant that as a value proposition Telstra is actually quite well suited on a backward looking basis. Currently Telstra trades on a P/E ratio of 10.53 which is below the long term market average of 15 and in the range that would generally be considered “good value”. However when considering backward looking metrics like P/E ratio it’s important to remember that we are not buying Telstra’s past earnings stream but. It’s all good and well that Telstra has provided a certain level of earnings per share in the past however if it can produce at least those same returns moving forward then instead of scooping up a stock at a bargain price you’ve ended up overpaying for a diminishing stream of earnings. As we alluded to previously we take the view that Telstra’s woes are likely to continue with the prospects of a near term turnaround relatively small – As such we see the trend of declining earnings continuing which derails the case for Telstra as a “value stock”.
With Telstra failing at least two of our three key criteria we have looked past its big headline dividend yield and left it out of our Australian Income Portfolio. Instead we have filled the portfolio with stocks that not only offer attractive dividends but also check off all three of our key criteria for evaluating income stocks. This investment approach produced a growth return of 19.40% over the last 36 months outperforming Vanguards Australian Shares High Yield ETF by 5.77% over the same period of time. If you’d like some more information on the Australian Income Strategy then you can visit the fact sheet by clicking here or simply by contact us directly at firstname.lastname@example.org.
Sources – ASX, Stockopedia, Google Finance, Time-series and cross-sectional momentum strategies under alternative implementation strategies
HarbourSide Capital Pty Ltd (ACN: 166 765 537) an Authorised Representative (AR No. 448907) of HLK Group Pty Ltd (ACN: 161 284 500) which holds an Australian Financial Services Licence (AFSL no. 435746). Any information or advice contained on this marketing material is general in nature only and does not constitute personal or investment advice. All securities and financial products or instruments transactions involve risks.