The hunt for red herring

A “red herring” is known as something that distracts from a more important area of focus. There are numerous different attributions to the etymology of this saying. From 17^thcentury fox hunters deceiving dogs with herring; to 19^thcentury bandits using herring to throw bloodhounds off their scent; to early New England settlers leaving bits of red herring along their trail to confuse the wolves that were following. In equities today, perhaps “income yield” is the red herring – throwing investors off the scent of “total returns”.

Does the following investment proposition sound appealing to you? A note which guarantees five per cent yield on your principal for a minimum of twenty years. If you answered yes, read on.

Anyone could sell you such a note, simply by taking your principal of, say $100, and handing back $5 per year for the subsequent twenty years. Of course, under this example, there is nothing left of the principal after twenty years – your $100 was literally just handed back to you over a long period of time which, of course, achieves nothing.

The point of this simplistic example is to illustrate how a focus on yield alone is meaningless. And yet, many investors let yield determine which equities and funds to own.

In 2015, the stock price of the Commonwealth Bank of Australia (ASX:CBA) was around $90 per share and the dividend yield at the time was around five per cent. At a conference with a large number of CBA shareholders – most of whom were retirees, your author was struck to learn that the primary reason for owning CBA was the five per cent dividend yield. Today, four years later, CBA’s stock price has fallen to around $75 per share. An investor over this period would have received their roughly five per cent dividend each year – but the capital value of said investment has reduced by approximately the same amount. Said another way, the investor’s total return over these four years has been roughly zero. This is not unlike our hypothetical investment proposition above that simply takes your money and hands it back to you over time. (Meanwhile, a diversified global equities portfolio over this period would have resulted in a total return in the order of 50 per cent).

Back to the conference with CBA shareholders: when pushed with this thought experiment, the answer was that the dividends are fully-franked and, therefore, many of the retirees could benefit in the form of tax refunds from the government – in addition to the five percent dividend yield. This is true (for now) but is this not a red herring as well? Sure, CBA’s effective dividend yield for these investor-types might be closer to seven per cent, not five per cent, but when the capital value of one’s investment is falling at around 4.5 per cent per year, even a seven per cent yield results in only a 2.5 per cent annual return, little more than the rate of a term deposit.

The point is that franking credits appear to have created an unhealthy overemphasis on the importance of income yield in the consideration of equity investments made by many Australian investors. Solving for higher total returns must be a superior strategy to one that solves only for high income yields – even in a world of franking credits. And for those who need the income to live on, sell down some assets over time. Don’t be thrown off the scent of total returns by the red herring of income yield.