Dividends and accepting stock market risk
Will Baylis is a Portfolio Manager at Martin Currie, a specialist investment manager within the Franklin Templeton Group. He is lead Portfolio Manager for the Equity Income and Sustainable Equity strategies and Co-Portfolio Manager for multi-asset portfolios.
GH: Martin Currie in Australia recently wrote to the chair of every major company in your income portfolios with the message, ‘If your company has reasonable cashflows and a sound financial position, dividends should be paid.’ What have the reactions been?
WB: We've had remarkably positive responses. And in many cases, the chair has taken the time to write a detailed reply rather than just an acknowledgement. One chair of a large company said he had been writing about the importance of dividends since the 1990s. Companies receive up to 20% of their dividends back in reinvestment plans, and if they're worried about cash flow, dividend reinvestment can be underwritten for a small fee.
GH: And franking credits are of no value on the company balance sheet.
WB: Yes, they’re unique to Australia and they belong to shareholders. This chair has always advocated that where companies have the means and reasonable capitalisation, they should pay dividends, but that doesn't mean dividends need to go up every year.
GH: Any other feedback?
WB: Another company, a large utility, attached our letter to the board papers. They've just announced that because they have a high free cash flow, they will pay special dividends next year. So, we are pleased with the letter and they said it was very timely.
GH: Last week, we saw ANZ pay a dividend, although reduced, while Westpac suspended theirs. What’s the difference between these banks?
WB: Well, ANZ has a high level of capital and they acknowledged that they want to pay dividends, they have different types of shareholders and many rely on the dividends and have done since the GFC when interest rates have fallen from being quite meaningful to zero. Westpac has poorer trends with their bad and doubtful debts and made a balanced decision to hold back the dividend this time.
GH: Were you surprised that a company like BHP, which has had the benefit of strong iron ore prices, reduced its dividend a little?
WB: We hold BHP and we’re happy that they paid a meaningful dividend. Whether it was 10% below or above consensus is not our point. BHP has enjoyed strong iron ore prices, they've got strong free cash flow and they paid what we call a meaningful dividend.
GH: Do you think a board should maintain a steady stream of dividends and in good years hold some back in expectation that future years might be a bit leaner?
WB: A board should be aware of their capex requirements for maintenance and growth and their operational costs, etc. If they retain more capital than they need, it has to be put to work. They will be measured against their weighted average cost of capital. If there is a poor marginal use of that capital by retaining it, it makes more sense to pay it to the shareholders. Retaining dividends should be linked to a greater or different purpose for that capital.
GH: In your income funds, what are you expecting on the income for FY2021 compared with FY2020?
WB: At this stage, we're expecting income on our Equity Income Fund to fall about 20% to 30 June this year. That said, the market's income is expected to fall between 30 to 40%. So we've tried to hold companies that have a higher probability of paying dividends with quality characteristics of free cash flow and strong capital positions.
GH: And how do you balance capital preservation with generating income?
WB: When you manage a strategy for income, you have two main objectives. One is to give dollar income to your investors from dividends and deliver a yield which is higher than the broader market. Our strategy is expected to deliver about 6% including the value of franking credits. So, if we can deliver that, we feel we've done a good job in minimising what we call a drawdown on income.
GH: Right, that’s the income point of view. Is the capital outcome too difficult to predict in this market?
WB: We believe if we have a high-quality portfolio, with companies that have high barriers to entry, high levels of free cash flow, etc, over time it should give a lower level of capital volatility than the broader market. The Equity Income strategy has a beta since inception in 2010 of around 0.9. That is, slightly less volatility than the broader market. Rather than focusing on the total return, which is capital plus income, we find companies with a lower level of income drawdown because we feel we have more control.
GH: Given the pandemic has delivered winners and losers, with names like Kogan and Afterpay doing well and Flight Centre and Qantas struggling, have you made changes in the last three to six months?
WB: The interesting thing about owning companies in Australia with reliable dividends relative to the market is we tend not to own the Kogans and Afterpays of the world, and even CSL because it has a dividend yield of less than 1%. But we have made changes to reduce the income drawdown. We reduced exposure to energy, because we're worried about the oil price, and we exited Sydney Airport due to the closure of international borders, which we think will be a much more prolonged event than the closure of domestic borders. We’ve invested in some companies that have benefitted from COVID like JB Hi Fi, Coles, Woolworths and Harvey Norman. The government support and stimulus has helped some companies.
Another thing we did back in March was go through the entire universe to check which companies will have solvency issues and which will have a significant fall in revenue, because we don't want to own those companies in an income portfolio.
GH: What have your investors been doing in the last three to six months?
WB: The funds under management have been steady, we haven't seen outflows but we haven't seen significant inflows either. CBA recently reported a $15 billion increase in their term deposits in six months. That tells you that a lot of people are accepting 1% or below. Banks are now funded substantially by their own term deposits and people are holding a lot more cash.
GH: Although the equity market has done surprisingly well since March.
WB: Yes, but a lot of the big rises have been in a few technology or health names, whereas the companies that we own in our Equity Income portfolio have not done as well because of the level of uncertainty around the outlook.
GH: There are many different ways that people manage income funds. Do you use derivatives?
WB: Not at all. If you start using call or put option strategies to either boost income, which is basically close to dividend stripping, or alternately trying to protect capital, there's a cost to that. It's like an insurance premium, which has to be paid from the client's return. We focus more on the sustainable dividend with franking credits of each company over time.
GH: You recently wrote an article for Firstlinks on looking through the pandemic for quality companies even if you recognise they might have some short-term problems. How does that work?
WB: Look at the example of Transurban. Before COVID, Transurban had a history of growing its distributions by 9% to 10% per annum, but recently, it has reduced dividends markedly because the volume of traffic on its toll roads has collapsed. But we see Transurban as a really high-quality company, the dominant owner of toll roads and exceedingly well run. So we were tolerant in knowing Transurban would reduce its distributions while we are holding it.
GH: What about the Australian banks which many people have relied on for income?
WB: Well, three of the four banks are still paying a dividend, they all have high capital buffers, we know the banks are vital to the safety and security of the Australian financial system, so again, we hold all four banks in the Equity Income strategy. We're not at index weight and we knew dividends would fall but we’re happy to hold them through the crisis.
GH: Transurban is an example I often use in presentations. When Sydney’s Eastern Distributor opened, the toll was $3.50 and now it’s $8. That’s a lot of money for some people but that’s pricing power for an asset drivers want to use.
WB: That’s true, but to their credit, they’ve set up a division which focuses on customer hardship. It's a genuine attempt to provide relief for customers who can't afford the tolls.
GH: Final question. What do you say to a retiree who wants the income from shares but is worried about capital preservation - the risk/return trade off?
WB: I would suggest to your readers that they contrast the risk/return around term deposits with the risk/return of owning a diversified equity portfolio. On term deposits, the capital risk and income return are both close to zero. That will be the case for the next few years but most retirees can’t live on a 1% return. Contrast this with say 6% including franking on equity income with a historical volatility of about 11% on the capital. That doesn’t mean that every year, investors should net off the 6% yield against an 11% decline in capital. It simply means that over time, the capital value of the portfolio is likely to move up and down by 11% a year on average.
But for investors who can accept the 11% volatility, they still receive the 6% income. So they don't need to drawdown on capital if they have sufficient income and they don’t need to worry as much about the implied capital volatility of the portfolio. The income comes in every quarter through the unit trust structure. For many, a 1% return is intolerable and a 6% return with volatility of 11% should be tolerable if they can rely on the income. Investors should think long term and hope to live to a very fine age.
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