The ASX's growth problem
Australian companies are on an investment strike that is already making the ASX one of the lowest earnings-growth share markets in the world and threatens to damage long term returns for Australian shareholders.
Rising dividends & falling investment
Instead of using their spare cash to invest in future growth, launch new products or expand into new markets, top ASX companies are now passively handing 63c in every dollar earned back to shareholders. That’s up from around 40c a decade ago.*
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In fact, the ASX companies hand back a higher share of their profits to shareholders than most other peer indices. For example, the top companies on the London stock exchange pay out just 50c in every dollar, while American companies listed on the NYSE give back just 29 cents.
The high dividends of Australian companies reflect a lack of growth ambition.* They don't believe they have strong enough investment opportunities to warrant holding onto shareholder funds.
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The low-growth doom loop
Australian companies are in danger of falling into a self-fulfilling doom loop. Weak investment is leading to low growth which further discourages investment. The earnings growth outlook for our major companies – as measured by broker forecasts – is lower than at any time since the GFC.
Earnings growth in Australia’s top companies is forecast at just 6.6% over the next five years - that's the same level of growth as anemic Japan and much lower than top companies in the UK and USA.
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Why are share prices rising if earnings are falling?
But if Australia’s earnings growth outlook is so dire, why are stock prices on the ASX soaring?
Over the last five years, the ASX200 generated a healthy 63% total return for shareholders. But what has generated these strong returns? More than half (32%) has come from dividend payouts, another half (30%) has come increases in the price-earnings ratio. Earnings growth expectations has, on average, contributed nothing to ASX shareholders.*
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Rising Price-Earnings ratios reflect share price appreciation above earnings growth.
The price-earnings ratio is proportional to the inverse of the discount rate minus the expected growth rate of companies' earnings; so as long as the discount rate is falling faster than the growth rate, the price-earnings ratio will rise. That is exactly what is happening on the ASX: the growth outlook for our economy has dropped, but interest rates have dropped even further which means that PE ratios are going up, and share prices are able to rise without any earnings growth.
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Short term gain, long term pain ...
While higher dividends and lower interest rates can boost the sharemarket in the short run, they are not long-term drivers of strong returns for investors. That’s the problem for the ASX today. The chart below shows that companies can deliver mediocre performance through steady cash return, but top quartile performance tends to be powered by earnings growth.
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The problem for the ASX is that higher dividends mean lower investment and, ultimately, lower long-term earnings growth. Falling interest rates raise the value of shares through Price-Earnings ratios, but this is a one-off effect, not a sustainable source of growth.
If Aussie companies don’t start investing, our index will become a global backwater - a dividend cash cow for domestic super funds rather than an attractive destination for global capital.
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Business & governments both have to act ...
In the next decade, Australian companies will find growth harder to come by. We will need both policymakers and businesses to work together.
Governments will need to forge ahead with structural reform to lift barriers to investment, including through tax policy, trade policy and regulatory reform. They also need to lead the way with smart investments in infrastructure and sensible industry policy to boost our non-resources sectors.
But whether policymakers show leadership or not, there are three priorities for Australian businesses. First, they should examine their investment decision-making processes to ascertain whether a “bias against risk” is preventing them from pursuing attractive opportunities. Whilst capital costs have fallen, many companies retain overly high hurdle rates for investment. Second, as the mining boom comes off, Australian businesses need to think creatively to gain exposure to new sources of growth, especially in the non-resource industries that will benefit from the lower dollar, lower interest rates and technological advances. Finally, Australians should be looking abroad to gain exposure to fast-growing markets. In particular, there is a huge opportunity for Australian companies to deploy their commercial skills in the rapidly developing South East Asian economies.
Read this article in today's Australian Financial Review
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