The myth of yield finally revealed

EXPLODE the high-yield myth.

HOW often have you heard the following advice? "Bank stocks are selling on a dividend yield of 7 per cent and Australian bonds are offering 3 per cent, so bank stocks must be a good buy."

Let's explode this buying high-yield stocks myth once and for all and be wary for evermore about buying stocks on yield alone.

Suppose you purchased a "blue chip" (always zip up your wallet when someone trots out that phrase) portfolio of stocks on June 30, 2007, because you were advised of their relatively high dividend yield. Buying equal amounts of Telstra, NAB, Macquarie Group, Lend Lease and Leighton would have produced a blended yield of 4.2 per cent and higher with franking.

Despite the solid yields at the time, and their blue-chip status, the portfolio's dividends have been steady at best but mostly in decline over the past five years.

Not only that, but the five-stock portfolio would have recorded a 50 per cent decline in capital value over the same period and under-performed the ASX/S&P 300 index by 15 per cent.

Of course, the lower share prices today - Telstra has fallen 21 per cent since June 2007 - have resulted in dividend yields jumping from 4.2 to 6.0 per cent.

Importantly, the higher yields today combined with lower bond yields, means the portfolio now provides a "dividend yield to bond yield gap" of 3 per cent.

This "gap" is another tool used to get you interested in similar mediocre stocks. When the gap is wider, it's a good time to buy stocks, or so it seems. The gap simply measures the difference between dividend yields and bond yields, and when dividends yields are higher, you are supposed to be more attracted to stocks. The logic seems sensible. Bond yields of 3 per cent aren't high enough to beat inflation so you should move into stocks.

Leading academics Elroy Dimson, Paul Marsh and Mike Staunton, from the London Business School, recently analysed the financial market returns since 1900 of 19 countries. In Australia's case, inflation over the past 111 years has averaged close to 4 per cent. If you are buying a bond today yielding 3 per cent believing it is "safe", let me ask you; what is safe about being almost guaranteed to lose purchasing power over 10 years?

Health warning No 1: When long bonds are on a yield well below the long-term rate of inflation, they may not be safe.

Which is why it is no surprise that if bonds aren't safe, many investors look to the "gap" instead. Are they right? The dividend-yield-to-bond-yield gap varies greatly. In the US, for example, over the past 111 years, the gap has moved between negative 10 per cent (1981 saw dividend yields on 6 per cent and 10-year bond yields of 16 per cent) to positive 7 per cent (which occurred four times).

Health warning No 2: an apparently attractive "gap" today might be even more attractive tomorrow. And when that happens you will lose money.

Suppose, instead of buying stocks on high yields or trading the dividend yield to bond yield gap, you simply buy a portfolio of high-quality companies when they are very cheap?

If in June 2007 you purchased a portfolio of five stocks that included Seek, McMillan Shakespeare, Cochlear, Woolworths and CSL, your dividend yield would have been an unimpressive 2 per cent, or less than half the yield of the previously mentioned blue-chip portfolio.

Over the past five years, however, the dividends per share of every one of those five stocks has grown appreciably and, more impressively, the portfolio has delivered a capital return of 28 per cent, outperforming the ASX/S&P300 index by 63 per cent and outperforming the blue chip portfolio by an outstanding 78 per cent.

Roger Montgomery is the founder of Montgomery Investment Management and the author of Value.able: How to Value the Best Stocks and Buy Them for Less Than They're Worth, available at www.rogermontgomery.com."