Equity markets year-to-date have been characterised by elevated volatility. This has been caused by a combination of global factors driving uncertainty, including a rapid acceleration of inflation as global economies begin to reopen following prolonged COVID-19 lockdowns, growing expectations for monetary policy tightening over the short-medium term, and heightened geopolitical tensions following Russia’s invasion of Ukraine.
In Australia, the impacts have been amplified by elevated valuation metrics across certain segments of the equity market, most notably in technology and other growth-style exposures, which had been clear winners through prolonged COVID-19 lockdowns. These stocks have now seen quite severe price reversion as the economic reopening gathers momentum.
With uncertainty across markets expected to persist, retirees and investors in need of an income streammust be cognisant of controlling capital risk while generating low volatility income growth to offset the impact of inflation and longevity risk. In this regard, not all equities are created equal.
Six reasons why a different approach is attractive in this environment
The MCA Equity Income strategy has been specifically designed to provide exposure to an attractive and growing income stream, with lower volatility than the broader Australian equity market. We like to call this a ‘sufficient income for life’.
The way we think about providing a ‘sufficient income for life’ for our clients means that our MCA Equity Income portfolio looks very different to both traditional benchmark-aware equities and other lower capital risk income-focused approaches. Our starting point is income needs and income risk, not an arbitrary benchmark.
These differences are key to why the strategy offers a compelling opportunity for income-focussed investors, especially as higher volatility, inflationary pressures, and valuation dispersions remain prevalent in the Australian market.
We describe the six ways the MCA Equity Income portfolio can provide greater certainty in this environment in detail below:
1. Protection against inflation / rising cost of living
By design, the MCA Equity Income strategy invests in domestic companies that offer strong protection against rising inflation and cost of living increases. This is a key consideration for investors given the rapid acceleration in inflationary measures in Australia.
For the right type of company, higher inflation can lead to increased revenues, but it is vital that they are able to pass on the higher costs associated with inflation to protect or grow their margins, and ultimately grow their dividends. We therefore focus on companies that possess meaningful pricing power in their markets.
The economic sectors that the strategy invests in exhibit these positive inflation trends:
- Financials companies, such as banks and insurers, can pass through costs via rate increases.
- Real Assets such as toll roads, shopping centres and utilities will typically have inflation pass-through mechanisms.
- Industrials benefit from dominant market positioning and gross margin protection.
- Resources companies will benefit from increasing commodity prices.
This inflation dynamic is a clear income growth opportunity for equity investors, which critically is not a feature of fixed income or term deposits.1
Telstra management have noted that the company will look to pass through any cost inflation to the customer through price. The company do not consider mobile connectivity to be a discretionary item, so this provides protection for the service to remain within the household budget. Experience in recent years demonstrates that customers value network quality over price and are therefore willing to pay for a superior product, so shifting to lower-priced plans with competitors doesn’t widely occur. These factors demonstrate Telstra’s strong market positioning, and meaningful pricing power in an inflationary environment.
The MCA Equity Income strategy has been specifically designed to provide exposure to an attractive and growing income stream, with lower volatility than the broader Australian equity market.
2. A core focus on Sustainable Dividends
Breakdown of cumulative franked returns2
Our portfolio construction process places great importance on a stock’s long-term Sustainable Dividend, rather than a current or consensus dividend. This refers to a company’s ability to maintain payments to shareholders through all different stages of the cash flow cycle and considers the risk of the ‘worst case scenario’.
By investing in the most attractive stocks on this measure, the income component of a stock’s total return, and the total portfolio, will be more stable, thus providing lower income volatility and therefore greater certainty of the dollar income amount from an investment going forward, regardless of the capital gains or losses on any individual stock. As the chart below highlights, the income component of the strategy’s returns has been stable and growing overtime, despite any ups and downs in capital returns.
For example, National Australia Bank is a key portfolio holding due to its Sustainable Dividend. We expect that the bank will grow its dividend-per-share faster than earnings over the next year, supported by the lifting of APRA constraints and the ongoing economic recovery from COVID. The company is showing a clear path to reducing costs in a reasonable loan growth environment and is leveraged to the Australian economy outperforming on recovery.
3. High quality companies have lower income volatility
High Quality companies will typically have strong pricing power and high free cash flows, which in turn allows them to generate more attractive Sustainable Dividends.
Rather than just focussing on payout ratios or yields, we have found that screening out stocks with lower Quality and skewing toward higher Quality stocks results in a portfolio that has naturally less income volatility than the broader market, meaning that there will be lower income risk where a dividend that cannot be sustained ends up being cut.
As COVID restrictions have eased, Scentre Group has seen foot traffic and tenant sales recover quickly. Strong tenant demand/occupancy trends are translating to the power to push up retail rents as tenant sales grow. We consider Scentre to be a highly rated Quality company that presents a compelling income opportunity with a strong liquidity and covenant position. Post-COVID, we believe that Scentre can maintain cash flows and win market share in a retail sector under pressure.
Portfolio quality distribution (%)3
4. Franking credits offer investors a free kick
We extract the full benefit of franking credits in order to maximise after-tax income for 0% taxpayers such as retirees.
We incorporate the value of franking credits directly into our investment process. Our investment process formally values franking credits and penalises unfranked dividends.
The high franking component of our portfolio is another aspect of the income stability we seek from companies with Sustainable Dividends. This means we have been able to consistently provide a franked yield premium to the broader equity market. Relative to the broader equity market, the forecast yield premium for the MCA Equity Income strategy remains near a record high.
It should be noted that fixed income and term deposits pay no franking credits, while global equities incur withholding taxes and thus miss out entirely on the benefit of franking credits.
Components of Next twelve-month (NTM) expected returns4
Fixed income and term deposits pay no franking credits, while global equities incur withholding taxes and thus miss out entirely on the benefit of franking credits.
5. Avoiding over-concentration mitigates income risk
When you look at portfolio construction through an income lens, minimising any income shocks is more important than tracking a highly concentrated market benchmark such as the S&P/ASX 200.
We use a benchmark-unaware portfolio construction approach to limit individual securities to a maximum 6% and sectors to 22% to avoid any concentration risk. We believe that this helps to ensure a more stable income stream while mitigating the impact of income shocks caused by any individual stock. In practice, this approach means that we are structurally underweight the largest ASX listed companies given the weight of stocks such as BHP Group, CSL and the big-4 banks.
CSL is one of the largest companies listed on the Australian stock exchange, currently ranked behind only BHP Group and Commonwealth Bank of Australia by weight in the S&P/ASX200 Index. While CSL has a strong track record of earnings and dividend growth over time, a low payout ratio means that the dividend yield of the stock is very low (i.e., investors are paying more for a dollar of earnings than they would for other companies), and additionally CSL do not pay franking credits.
Benchmark-relative strategies would necessitate holding CSL to manage stock-specific underweight limits, however, our benchmark-unaware process means that the MCA Equity Income strategy is able to avoid such an allocation, which would clearly be inefficient from an income perspective.
Diversified Sector exposures5
Due to the highly concentrated nature of the Australian equity market, Australian indices also typically do not provide good insight into the effect that Australian inflation has on long-term income requirements. The MCA Equity Income strategy is structured to provide better diversification across the domestic economy while mitigating the impact of external factors, which better aligns the portfolio’s income growth with an investor’s domestically-focussed income needs and local inflationary forces.
6. Avoiding impairments to protect the capital base
In an uncertain market environment, an important way to maintain capital growth, and future income generating ability, is not to take unnecessary risks that might impair capital.
- Strategies that use derivatives to provide income enhancements or capital protection are in fact potentially detrimental to capital growth, and thus income growth, as the cost is borne by the capital base.
- Strategies that automatically sell stocks because of an income shock, such as rules-based high-yield ETFs, can result in impaired capital value despite maintaining a steady headline yield.
- High turnover strategies are also more likely to impair capital due to excessive trading as they are turning capital to income by constantly moving to the next dividend-paying stock.
The MCA Equity Income strategy does not use derivatives, is fully active in investment decisions, and is designed to be low turnover thus reducing drag from the cost of trading.
The Martin Currie Australia Equity Income strategy
Volatility is likely to be a feature of equity markets in the near- to medium-term as global economies continue to reopen, while grappling with accelerating inflation and the normalisation of extreme monetary policy settings.
In this environment of heightened uncertainty, it is imperative for investors to seek risk-controlled income generation, particularly given the impact that higher inflation will have on real returns across traditionally ‘safe’ fixed interest exposures.
The MCA Equity Income strategy is designed to provide a solution to the uncertainty, offering exposure to a diversified portfolio of high-quality securities that pay higher income, provide inflation protection, and have lower volatility than the broader share market.
Click to display all sources >>
The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the security transactions discussed here were, or will prove to be, profitable.
1 Past performance is not a guide to future returns.
The investment vehicles shown may have different risk profiles and a direct comparison may not be appropriate.
2Source: Martin Currie Australia, FactSet; as of 28 February 2022. Data calculated for a representative Martin Currie Australia Equity Income account in A$ gross of management fee. Assumes zero percent tax rate and full franking benefits realised in tax return. Inception date: 31 May 2010.
3Source: Martin Currie Australia, FactSet; as of 28 February 2022. Data calculated for a representative Martin Currie Australia Equity Income account This strategy is not constrained by a benchmark, however for comparison purposes it is shown against the S&P/ASX 200 Accumulation Index. *Top 200 consists of Australian equities covered by MCA research analysts, assumed equal weight in each stock.
4Source: Martin Currie Australia, FactSet, RBA; as of 28 February 2022. Data calculated for a representative Martin Currie Australia Equity Income account in A$ gross of management fee. The Next 12 Months (NTM) Income yield is calculated using the weighted average of broker consensus forecasts of each portfolio holding – because of this, the returns quoted are estimated figures and are therefore not guaranteed. Assumes zero percent tax rate and full franking benefits realised in tax return. Term deposit based on average 'special' rate (all terms).
5Source: Martin Currie Australia; as of 28 February 2022. Data calculated for the representative Martin Currie Australia Equity Income account. This strategy is not constrained by a benchmark, however for comparison purposes it is shown against the S&P/ASX 200 Accumulation Index.
Regulatory information and risk warnings
This information is issued and approved by Martin Currie Investment Management Limited (‘MCIM’), authorised and regulated by the Financial Conduct Authority. It does not constitute investment advice. Market and currency movements may cause the capital value of shares, and the income from them, to fall as well as rise and you may get back less than you invested.
The information contained in this document has been compiled with considerable care to ensure its accuracy. However, no representation or warranty, express or implied, is made to its accuracy or completeness. Martin Currie has procured any research or analysis contained in this document for its own use. It is provided to you only incidentally and any opinions expressed are subject to change without notice.
The document does not form the basis of, nor should it be relied upon in connection with, any subsequent contract or agreement. It does not constitute, and may not be used for the purpose of, an offer or invitation to subscribe for or otherwise acquire shares in any of the products mentioned.
Past performance is not a guide to future returns.
The views expressed are opinions of the portfolio managers as of the date of this document and are subject to change based on market and other conditions and may differ from other portfolio managers or of the firm as a whole. These opinions are not intended to be a forecast of future events, research, a guarantee of future results or investment advice.
Some of the information provided in this document has been compiled using data from a representative account. This account has been chosen on the basis it is an existing account managed by Martin Currie, within the strategy referred to in this document. Representative accounts for each strategy have been chosen on the basis that they are the longest running account for the strategy. This data has been provided as an illustration only, the figures should not be relied upon as an indication of future performance. The data provided for this account may be different to other accounts following the same strategy. The information should not be considered as comprehensive and additional information and disclosure should be sought.
The information provided should not be considered a recommendation to purchase or sell any particular strategy / fund / security. It should not be assumed that any of the security transactions discussed here were or will prove to be profitable.
Risk warnings – Investors should also be aware of the following risk factors which may be applicable to the strategy shown in this document.
- Investing in foreign markets introduces a risk where adverse movements in currency exchange rates could result in a decrease in the value of your investment.
- This strategy may hold a limited number of investments. If one of these investments falls in value this can have a greater impact on the strategy’s value than if it held a larger number of investments.
- Smaller companies may be riskier and their shares may be less liquid than larger companies, meaning that their share price may be more volatile.
- The strategy may invest in derivatives (index futures) to obtain, increase or reduce exposure to underlying assets. The use of derivatives may restrict potential gains and may result in greater fluctuations of returns for the portfolio. Certain types of derivatives may become difficult to purchase or sell in such market conditions.
- Income strategy charges are deducted from capital. Because of this, the level of income may be higher but the growth potential of the capital value of the investment may be reduced.