Investors of the bigger companies are not looking at the detail behind the profit numbers, they are looking at the dividend. Seriously, they should change the name of “earnings season” to “yield season”.

When the hunt for yield ends, or put another way, when interest rates start rising again, the returns from these dividends will be wiped out by capital losses. As one of Under the Radar’s investment columnists and portfolio manager Andrew Brown says: 

“If a company’s long term growth rate is below 5 per cent, unless you think there is a big cyclical upturn coming, it doesn’t make any sense to be paying a PE of 16 or more.”

In case you are wondering, he’s talking about the likes of Telstra, CBA, Coles supermarket owner Wesfarmers and Woolworths.

You should take note that in the current reporting season there have been signs that investors are getting nervous about the ability for companies to keep paying out big dividends. After all, many have payout ratios of 100 per cent. All their profits go into paying the dividend, and none into investing for the future, which is necessary if you want to grow any business.

A case in point is CBA, which met its numbers, delivering an 8 per cent rise in its cash profit, and increased its dividend, which impressed the analysts at the time. But since then its shares have come off a couple of per cent because of the realisation that its dividend growth has been in no small part fuelled by unsustainably low bad debts.

Small caps have largely been left alone amid this dividend addiction, but investors have proven willing to pay almost extortionate prices for what looks like certainty of earnings. This is at the very upper end of the sector, and it would be more accurate to call these companies “mid-caps”. These include realestate.com.au owner REA and Dominos Pizza, which have market caps of $3.1 billion and $6.5 billion respectively and have forecast PEs well in excess of 30 times.

When you are paying these prices for industrial companies like these, you are trading momentum. You have to be careful that it doesn’t disappoint, otherwise your investment will be shredded. Just this week the shares in the internet service provider iiNet plummeted 11 per cent in one day this month after it delivered a flat interim profit. Its shares are down almost 25 per cent in the past three months, but are still more than double their level three years ago. The point is to be careful paying up a stock which has massive expectations baked into its price.

For the record, the market is priced on a forward PE of about 14 times, which suggests growth in the region of 9 per cent. This isn’t as relevant as the forward dividend yield of 4.2 per cent, which is way above the current 10 year bond rate of 2.54 per cent, and even further above if you include franking credits. The real problem is that the payout ratio is about 71 per cent based on these figures, which is far too high to produce long-term profit growth.

Keys to lookout for this results season:

Be careful about the expectations

These are normally delivered in the outlook statement. It’s all about common sense. How is a company going to grow its profits 20 per cent if its sales line is growing 5 per cent? Analysts delivering their forecasts often get lost in their spreadsheets and make the numbers fit their pre-conceived beliefs. They forget the prevailing environment.

The currency & oil price effects

There has been big changes in the Australian dollar’s value vis a vis the US dollar; there has been a sharp movement down in energy prices. These will be two big earnings drivers for industrial and resources companies. The currency impact will have a much bigger impact than oil in the current reported numbers, but beware of the effects of the oil price on future earnings, which will be more relevant.

Write offs

This follows on from the point above. Write-downs of asset values, particularly goodwill, have been a feature of the oil and gas sector because valuations on balance sheets are based on much higher oil prices than exist. This shows that earnings are much lower from assets and the company may well have to raise equity capital to strengthen its balance sheet if there is too much debt.

Reinvestment or capital expenditure

Remember what we said about the danger of companies giving away 100 per cent of profits to investors in dividends. You need to ensure that the company is reinvesting in its business so that it can continue to grow earnings.