Telstra a case study in the stock-picking income trap

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Income strategy managers and research houses have run their rulers over Telstra as a dividend producer for investors. It’s halo is severely tarnished. It has been, and is now evident as, either a ‘trap’ or a ‘honeypot’, they say. Whatever the vernacular, the stock is to be treated with caution in future.

The darling of retirees for years is following the banks into relative disrepute for anticipated dividends, for different reasons. There appears to be no problem with Telstra’s governance but there are several to do with its business model and likely dividend-producing capacity in the future.

Last week, Lonsec Research used Telstra to explain why investors should “beware the dividend honeypot” and income-oriented fund manager Plato Investment Management went through the nuts and bolts of income investing at a media briefing, with Telstra as the prime example of a dividend “trap”.

Lonsec’s note to financial planners and other clients said: “Shareholders burnt by Telstra’s dividend cut and spiralling share price should be wary of high-yield shares with attractive dividends but shaky fundamentals. Telstra sparked an exodus of investors after announcing a cut in its dividend from 15.5c per share to 11c, with the challenges facing Australia’s major telco suddenly made palpable to mum-and-dad investors.

“The lesson of Telstra is that investors should not invest purely for income or tax advantages (i.e. franking credits) at the expense of sound fundamentals. Despite being stuck in a downward trend since mid-2015, investors tolerated the stock’s poor performance so long as it maintained its attractive fully franked dividend.

“The problem is that by the time a company is forced to cut its dividend, fundamentals have already deteriorated. In other words, investors waiting for the dividend cut as a signal to bail were already too late. While Telstra has confirmed a semi-annual dividend of 11c, FY19 guidance is vague, stating it will pay a dividend in the range of 70-90 per cent of underlying earnings.”

Don Hamson, the founder and managing director of Plato Investment Management, said that Telstra, which had been a “great income stock” has seen its price fall by about 50 per cent in 18 months. The four banks, also income stalwarts, have fallen about 18 per cent in 18 months, while the Australian sharemarket as a whole has risen 9 per cent. “And you still get some income from the rest of the market,” he says.

Plato believes that Telstra will cut its dividend by up to a further 50 per cent in the next year or so. The fundamentals driving the woes mainly revolve around increasing competition due to the NBN and forced sale of Telstra’s monopoly ownership of the “copper wires” which are still the mainstay of telecommunications and new mobile reseller entrants. Hamson said the telco was now “just another reseller”.

In terms of active management of income-producing portfolios, he said: “You don’t have to own a stock for 12 months for a dividend. You only need to own it for two days for the dividend and 45 days for the franking credits… The easiest way to get a high yield [for a stock]is for its price to collapse. That’s the dividend trap.”

While its five products or strategies are all long-only, Plato’s process includes making forecasts about companies which are likely to “make up” their dividend, either through the use of reserves or asset sales, and then avoids those stocks “We try to pick the losers, too,” Hamson said.

Plato, which started in 2006 and is an affiliate of Pinnacle Investment Management – the majority of its shares being owned by staff – has three Australian equities funds, one global equities fund and one LIC. Funds under management total about $4.5 billion.

“We tend to have a mid-cap bias,” Hamson said. “We built the process to pick the huge names as well as those that a lot of people would never have heard of.

Lonsec says: “Since the end of its final privatisation, Telstra was the darling of mum and dad investors, who saw Telstra as a ‘national champion’ that could provide sustainable income over a long period of time. Telstra’s fundamentals came under threat in the form of competition from the NBN and other players like TPG, diminishing fixed-line revenue, and a crippling bureaucracy.

“Telstra’s new strategy, named ‘Telstra 2022’, splits out the telco’s infrastructure into a separate business and aims at reducing costs and improving customer service. Whether investors consider re-entering Telstra should depend on whether this strategy can improve the telco’s long-term prospects, rather than the success of short-term measures to boost profit and distributions.”

Australia is the highest dividend producing market in the world, averaging about 6 per cent yield including the value of franking credits. It’s the franking credits which prompt companies to maintain a high dividend, and therefore their share price, when good sense may suggest otherwise. The MSCI World ex-Australia average is 2 per cent.

Nevertheless, Plato is a supporter of the franking system and has, in fact, launched a petition to oppose Labor’s promise to abolish or dilute the system if elected. You can join the petition on the Plato website: www.plato.com.au

– G.B.

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