Counting on cash

Regular income isn't the only thing that matters when comparing investments - but it's not a bad place to start, writes BRENT SHEATHER.

When it comes to valuing investments, financial analysts use a host of measuring sticks.

But while strange-sounding measures such as PE, PEG or EV/EBIT may be important to the analysts, many investors find them complicated and confusing.

Inevitably, when it comes to comparing alternative investments, many people fall back on a simple, easy to understand measure of value; the return on your money, otherwise known as the income yield.

This may be simplistic, but focusing on the dividend or cash income actually distributed by an investment has much to commend it. For one thing, it allows investors to compare different asset classes with that standard benchmark - what the banks offer.

Dividend devotees would have neatly side-stepped the mania for technology shares, although they may also have missed out on much of the share boom of the last decade, given that dividend yields overseas average only around 2 per cent.

In New Zealand, if you want a high yield the property market is usually the first stop.

Yields of 8 to 12 per cent are available on listed property companies and by investing directly in flats, shops, petrol stations and the like.

At first glance these rates sound pretty good, but one needs to be careful.

Firstly, with most bonds or bank deposits, after you have invested your money for the agreed term you get your capital back. However, with property the asset may have appreciated or depreciated. The higher the yield the more likely it is that the asset will be worth less at the end of the investment term. Secondly, the yields from property companies and most direct property investments are before any allowance for depreciation, whereas listed-company dividends are usually after depreciation.

For example, if a building has a 25 year economic life with minimal value at the end of that time, we should really be reducing the stated yield by around 4 per cent a year to make it more comparable with fixed-interest investments.

The third caveat to high property yields is the risk that you will lose your tenant and suffer a loss in income while you find another one.

Lastly, high yields from property investments can simply imply either that the building is over-rented - meaning that eventually the rent will fall - or that expected rental growth is minimal.

Earlier this year the media was full of stories detailing how investors had come unstuck while chasing high yields offered by lending their money to various unlisted property companies.

Warning signs were there, however: one of the oldest investment rules is the one that says beware of high yields.

Why? Because company treasurers don't pay high interest rates because they're nice people or want to make lots of friends.

They pay high rates because the market demands it, because the company is risky or has poor growth prospects, or a combination of both.

Metropolis bonds yielded 14 per cent because they were risky.

Conversely, central business district office buildings in Manhattan yield only 6 per cent.

When talking to people about investing in international shares one question comes up again and again: why should I accept a yield of 2 per cent on international shares when I can get 5 or 6 per cent in the bank?

Fair question. The answer, of course, is because shares offer growth, in particular growth in income.

Since 1926, the dividends paid by US shares have risen by an average of 4.5 per cent a year. This is less than the rate of profit growth because companies have retained more and more earnings.

An increase of 4.5 per cent a year doesn't sound much until you consider that $1000 in dividends from US shares in 1926 would have bought goods and services worth $2640 in 1998.

For bonds the real value of $1000 would have shrunk to $101 in 1998.

Even the New Zealand sharemarket has averaged dividend growth of 3.5 per cent a year since 1928.

So, when looking at shares as an investment option, the way economists tell us to calculate the return is as follows: return = dividend yield plus the profit growth rate. In the last 40 years US profits have grown 7 per cent a year on average, so the expected return with the current dividend of 2 per cent is 9 per cent.

One of the most commonly used measures to value shares is the dividend discount model. Among other things this model says that the appropriate dividend yield of an asset is inversely proportional to its growth prospects.

Complicating things further is a recent blurring of investment classes. Back in the 70s we were taught that shares were riskier than bonds, but nowadays some investments marketed as bonds are actually more risky than some shares.

In New Zealand the investment waters have been muddied by the tendency for companies - most famously Skellerup - which need finance but find it expensive to raise money on the sharemarket to issue capital notes instead.

Typically shares are more risky than debt because in the event of a company getting into trouble the interest bills are paid before dividends. What the advent of capital notes did was create a new higher risk hybrid instrument which was subordinate to the firm's bank borrowings but ranked in front of the ordinary shareholders.

And if the company which issued capital notes already had plenty of bank borrowings, that made the notes quite risky.

Corporate treasurers thought these capital notes were great because they viewed them as cheap equity, retail investors thought they were great because they looked like high-yielding bonds, stockbrokers and financial advisers didn't take much convincing because these bonds paid commissions normally associated with shares.

Fortunately, except for Skellerup, capital notes haven't provided any nasty surprises for investors thus far. Nevertheless, selling equity masquerading as bonds to novice investors except as part of a diversified high-yield portfolio is asking for trouble.

High yield bond funds have been all the rage in the US and to a limited extent in Europe in the last 12 months but their potential in NZ is limited because the market is not large enough to permit the construction of a properly diversified portfolio of 50 or so issuers.

Yield junkies also need to be aware that investments which promise a high interest rate can act quite differently in times of market stress.

In late 1998 many investors were worried that the Asian crash could lead to a substantial period of deflation where prices fell due to falling demand, putting pressure on profits.

At this time the yields on lower risk government bonds fell, but the yields on higher-risk bonds rose.

The market's logic for this difference was that the return demanded from government-guaranteed debt should fall as inflation fell, but in the same tough deflationary environment many companies would find the going tough, thus a higher return was required from corporates which did not have the luxury of being able to print money.

Given that bonds are included in many portfolios because they provide a high degree of income and protect capital in bad times, higher-risk bonds can be something like an umbrella which works only when it is not raining.

It seems then that analysis of the income yield is but one tool which we have to compare investments, and focusing on it exclusively can lead to bad decisions; we can end up with too much in depreciating assets (high-yield property), too much in high-risk products (junk bonds) and not enough in higher-growth sectors (shares).

At times financial markets favour income assets, other times growth is the name of the game. As ever, some sort of balance between the two will be right for most investors.

Looking at income yield doesn't answer all the questions, nevertheless, it is a vast improvement on hit and miss methods.

An understanding of why different products have different yields can make your investment decision process safer.

* Brent Sheather is a Whakatane sharebroker and investment adviser.