Abnormal returns

In year 427BC, the Greek philosopher Plato founded ‘The Academy’, which is considered the world’s first university. It is somewhat fitting then that half of Sydney-based fund manager, Plato Investment Management’s team have PhD’s.

With so much grey matter focused solely on generating equity income for their clients, it’s no surprise the results are impressive. Managing Director, Dr Don Hamson, shared in this interview that their investors will have received 16% gross yield after fees this financial year. That's about 10% above the gross yield of the index, though Don cautions that these were ‘abnormal returns’ supported by some political and corporate one-offs. 

So what is the outlook for dividends post-election? In our latest fund manager interview Don addresses this question, highlights one part of the market that remains under-appreciated for income and explains what he believes is the single most expensive asset in the market today. 

Topics discussed

• The outlook for equity income on the ASX.
• How lower rates are pushing up prices of riskier assets.
• Abnormal returns and what investors can expect in the year ahead.
• The single most expensive asset in the market today
• Overlooked opportunities on the ASX.
• Dividends staples: The outlook for bank stocks and Telstra.

If you just screen for the absolute highest yielding stocks you'll probably come up with a few traps. That means your capital is at risk and you may lose money on that.

Available to watch or listen

Watch the video below or access a podcast of the discussion on Soundcloud or on Apple Podcasts.

Transcript:

James Marlay: Can you give me some background on why you started Plato? And why the name Plato? What's the correlation to what you do?

Don Hamson: Well, I had worked for a number of institutions before then and the groups like, Westpac Investment Management and State Street. And had some issues about not having a lot of control and responsibility, et cetera. And the offer came up to start up my own boutique. And that's how Plato came about. Why the name Plato? Interesting name. I think a lot of fund managers called themselves after Greek gods or mythology or what have you. And I think we'd like to be the thinking man's fund manager. So Plato was the great philosopher, he's a bit of a dabbler in mathematics, mathematics as well, set up the academy, et cetera.

So we put a lot of research into a lot of work and a lot of thinking behind how we invest money. And so I think Plato is, represents that. And we're very happy with the way that it's branded and what it means to investors.

James Marlay: And you have a PhD.

Don Hamson: I do. In fact half of our team members have PhDs. So we're all very well educated. So you think back going into Plato's starting virtually the first university and or the academy. And well everybody's been to university in our team but say five have gone on to do PhDs. And another one's actually, of the 10 in the team, one's doing one now. So yeah, we're all pretty well educated.

James Marlay: What's your PhD?

Don Hamson: In finance. So we actually have three PhDs in finance. We've got a PhD in mathematics and one in astrophysics. So we call him the rocket scientist.

James Marlay: So you had the opportunity to start your own boutique. But your focus is specifically on equity income. Why particularly that niche or that specialty?

Don Hamson: Yeah, well it's something that I've had a fair bit of experience with. I mean 20 years ago I ran a somewhat similar fund at Westpac. The tax effective share funds. So, I mean it's actually around income and tax and other things. But I'm also, we saw a, I suppose a gap in the market. And a lot of people are still talking about it. We need to build strategies for retirement. And we built this income strategy from the perspective of a retiree. Because who needs income the most? Retirees, they want to live off the income from their investments. So we structured a fund, bottom-up from a retiree's perspective, from a retiree's tax perspective. But also the fact that they need income to live off.

And so if you can get a good consistent stream of income from a well-diversified portfolio. So it also marries in with some research that we'd done that there's some nice, not huge, but a bit, a little bit of outperformance in stocks around dividend ex-date. So, stocks tend to outperform for a couple of months before they go ex-dividend. Yeah, that's not massive, but it's a little bit. And you just need a bit of an edge in this game. So you marry that, these people want income, they get a bit of outperformance. It's quite tax effective for retirees, particularly people with superannuation funds. But also low-income retirees. Then it's a good product, and we actually won that five years ago our award, an award for our retirement product innovation. So we think it's a good product and thinks about what the end investor does.

I mean I think that the problem with a lot of fund managers is, I'm a value manager, I'm a growth manager. And what I really …

James Marlay: That's their style.

Don Hamson: Yeah, that's their style. But they don't really think: what does the investor want? Does the investor want something that works well for part of the cycle but not as well in other cycles? Do they want, what do they want? And retirees want income. So if we can give them consistent levels of high income, and a well-diversified portfolio. Sometimes we won't always outperform. But we've been pretty consistent in our performance. And these are retirees' money. They probably stopped work. They can't really go back and save money. So they've got to live off this investment.

So they want something that's also very well diversified. So we built a portfolio which is quite unusual these days. I mean everyone's got the 20-stock portfolio, the 20 best bets, et cetera. We have a very well-diversified portfolio of like a hundred stocks. But it's delivered consistency and has got consistent income. So it's what the end investor wants.

James Marlay: Out of interest, what do you benchmark your performance against? What's the, if it's an income strategy, what's the right … Is that the accumulation index? Or how do you measure yourself?

Don Hamson: Yeah. So, and I think that's important as well. We actually have two objectives. So they're both the same benchmark, which is the ASX 200. So, our first objective is to deliver income because it is an income strategy. So our aim is to deliver more income after fees than what the index delivers.

And we've ticked that box every year generally by around 3%. So, and that's after fees. But it's important that we also because a lot of investors get the franking, we compare ourselves to our tax-exempt version of that ASX 200 index, which includes franking credits. So the index has grossed up for franking and so is our performance. And that's the first part, people want the income. But it's also equity, it's equity income.

So the equity component, if you put your money in equities, well you want to beat the market. And active managers hopefully should beat the market more than they on average over time. So our, we also have a second objective, which is actually to outperform the ASX 200 Accumulation Index but including franking. So again, it's a tax-exempt accumulation index.

James Marlay: It's capital plus franking.

Don Hamson: Plus income. Yeah, that's right. I'm happy to say that we've done that since inception as well after fees. So we're ticking both boxes and I think that's what differentiates us from some of the other income strategies. Where it seems to be more about the income and less about the total return.

James Marlay: Yup. There's been a lot of change in the domestic landscape. We've had some uncertainty around what was going to happen with franking credits with the election. And we've also more recently had the Reserve Bank cutting rates. So some shifting dynamics that would have, I think an impact on the way that you were thinking about investing. Starting with the uncertainty around politics. There was discussion around companies wanting to release, built-up franking reserves. And I know there were companies, particularly the miners, paid out a lot of, there were some special dividends. Now that there is certainty around franking credits, what impact or what changes is that making for the companies where there are big reserves? Are you detecting any change in behaviour with how companies are planning on using any franking balances they might have?

Don Hamson: Well, I think what's going to happen is we're going to go back to a more normal period. So last year, last financial year, we've just gone through the financial year. Yeah, quite a few companies actually paid out extra-normal dividends, whether it was through buybacks or special dividends or what have you. And a number of them actually openly mentioned the franking credit issue and the potential that some clients, some investors, and it was only some, but some investors may miss out on that franking had they not paid it out. Now that we have an election result, and I think yeah, the franking issue's put to bed, and it will still be here for quite a while. I don't think politicians will want to be pushing that, flying that flag up the flagpole too quickly. Then I think companies will go back to a more normal situation.

Having said that, I think it was actually quite a good thing, some of these companies to flush out the franking. Because it's only any good for the investors when they get the tax back from the government. So if a company is sitting on one or two or $3 billion worth of franking credits, it's not worth anything in the company. But it is worth it if it pays it out to investors. So I think there was a bit of a realisation from companies that actually shareholders value those. We should pay them out and then maybe that might change.

Maybe companies might be a bit more upfront with their dividend policy. But I would expect companies to go back to a more normal level of dividends this financial year. And we haven't got, we also had an unusual situation where the likes of Rio, BHP and Woolworths sold big assets, and so had a flush full of cash and franking credits. And so it was a nice opportunity to do that capital management. And that's not going to happen every year.

James Marlay: So does that mean you're dialing back your expectations about how much income can be generated from the equity market over the 12 to 24 months ahead of us?

Don Hamson: Well, I think we're going back to a more normal year. I mean we've just finished the year. We just got the numbers through our fund. We'll distribute over financial year 2018-19 16% gross income after fees. Which is ridiculous. So it's gross, including franking when the index is getting about six. Now the index doesn't count the buybacks and actually doesn't count the specials. But it does count special franking credits but doesn't count a special as a dividend. But nevertheless the normal level of dividend in the market is about six, and we'd delivered 16, so that is silly. That's abnormal. We would expect to go back to about 9% this financial year we're just heading into.

We don't think companies are going to cut their dividends significantly. Although there's always going to be the odd one that has had tough times, et cetera. And we still see some very good dividends coming out of the resources sector. Particularly iron ore miners where despite all the economists and pundits saying iron ore prices can't keep going up, they have kept going up. And finished the financial year at a high. So BHP, Rio and Fortescue are going to be very profitable. And they're not investing a lot of money back into their business. So we expect them to pay record dividends again this year. Probably not the buybacks though.

James Marlay: So just in terms of the dividend landscape. The other part that I mentioned was the RBA cutting rates. Obviously when there's these high single and double digit yields available on the ASX, it makes it attractive. But if the Reserve Bank is cutting rates and they've done so twice, it suggests that everything is not looking all that rosy in the economy. From your analysis and looking at the companies that you're investing in, is there anything that gives you concern about the sustainability of those future earnings? A lot of the dividend yields that you can screen for are historic. And I understand looking in the rearview mirror is probably not the best thing to be doing when it comes to dividends. You want to be looking at the earnings going forward. So what are you seeing on that front given the context of those rate cuts from the RBA?

Don Hamson: Yeah. There's clearly some softness in the domestic economy and retail areas and those sorts of things. So yeah, we'll be vigilant for what we call the dividend traps. Because yeah, if just stocks trading on an incredibly high yield it could either mean two things, that they're incredibly profitable and that might keep going or it could also mean that their share price has fallen and it's a bit illusory and they're probably going to cut their dividend. So you need to be very cautious of that. So there is softness in a lot of domestic-focused industries. But as I mentioned before, I think the dividends coming out of the resources sector, particularly irn ore, will still be very, very strong. Banks, I think we'll probably maintain now that NAB has had its cut, will maintain reasonable yields. So I think the outlook's still pretty good. But you have to be cautious on some of those domestic stocks. Because yeah, you might, there are a few landmines out there where I think the earnings will disappoint and the dividends will probably be cut.

James Marlay: You're still taking equity market risk as an equity income manager. I had to look at PLA, it's an LIC, and I had to look at what was happening with the capital as well as the distributions with that fund. And then looked at an ETF that is purely looking to harvest income. And what you found was that there was a high yield, but over time there was quite a strong degradation of the capital value. What's the difference between what you're doing with your active fund and a dividend-harvesting ETF? And why are you able to maintain that capital value?

Don Hamson: Well I think you've alluded to it before, which is you shouldn't chase yield when you're looking in the rearview mirror. So the first rule is really not to use historic dividend yields as your selection criteria. I think a lot of the ETFs around there, basically say I want to buy the stock trading on the highest yield. And that's basically the historic yield. And as I said, there's two ways for a company to become high yield. The first one is that it's actually very profitable and paying out a lot of money, which is what some of the resource stocks are doing at the moment. But the more common way often is that a stock comes on hard times, the share price collapses. Because dividend yield is simply dividends paid out of the last 12 months divided by current price. If the current price is in a fall on 50 or 80% over the last 12 months, it's probably going t trade at a high yield if it paid a dividend the last 12 months.

And we try and avoid those, what we call dividend traps. Because if you just buy the absolute highest-yielding stock, you'll probably come up with a couple of traps. And that means your capital is still at risk. And so you may lose money on that. So we have two objectives. The first one is income, but the second one is total return. And so whenever we enter a stock, we look at both of those objectives. Yes, we want decent income, but we may often steer away from the highest historic yield stocks because we're not, we're all very concerned about the potential capital risk. And preservation of capital is important, particularly if you're managing money for retirees.

James Marlay: Do you think with the RBA lowering rates and forcing investors out of some of the more traditional income-generating assets, like term deposits, for example, has that elevated, has that created elevated risk in income-generating or dividend-paying stocks? Are you finding that as people get pushed out of things like bonds as they go hunting for yield, that it's skewing the valuations of stocks and puts that capital component at greater risk?

Don Hamson: It's certainly pushing up the prices of dividend-paying stocks, that's for sure. And the whole market for that matter. And we've seen a strong rally in the market in the first half. I mean including total return. The market is almost up 20% in the first half of this calendar year. Which is pretty huge, especially given we had three worries at the start of the year. Trade wars and a slowing economy, and both of those are still around. The only one that's really changed has been the interest rate outlook, which we are worried about rising rates last year, and now we're worrying about falling rates. So yeah, it has bid up the prices. Which does mean that in the very long term if you buy an asset expensive, then that's very important. We are value investors.

But I think when you look at it relative across all assets and that sort of thing is the expensive asset now is cash. I mean actually the numbers are very easy now that we have a 1% interest rate. And here in Australia as a cash rate, you think of, you don't normally think of PEs for debt instruments. But if you actually think about cash, if you're getting 1% on your overnight cash, you need to invest $100 to make one dollar. So your PE the price you pay to get $1 of earnings is a hundred. So what's the expensive asset? The expensive asset is cash and bonds. And this 10-year bond yield is not much better. So to me they're the very expensive assets. Equities actually haven't really fully factored in that. They've risen a bit because we've got a lower discount rate. But they haven't, I don't think, fully factored in those extremely low interest rates. Because I think that the market realises that rates will rise in the future.

So I don't think the equity market is that stretched. Given where interest rates are in a relative sense, I think equities are actually cheap relative to cash and fixed income.

James Marlay: You said you thought that markets could see rates rising in the future. It feels like something that's out for debate at the moment.

Don Hamson: Well, let's put it this way. It looks like a long way away before that that's likely to happen. I mean, given that we've only just started the first two rate cuts here normally have a cycle, and a cycle is usually longer than two. It's hard to see rates rising for a couple of years to be honest. So I think that worry is now a few years out. All I think is that equity markets have never really priced in the extremely low interest rates. Because they do realise that between central banks, whether it be quantitative easing at the long end or cutting rates at the short end, have actually set interest rates artificially low. Because they want to stimulate the economy. They want people to actually go out and buy equities. And they want people to invest in risky assets. And we suspect that investors will do that. There's still a lot of money, huge amount of money in term deposits, but it's not getting much. Not getting much income at the moment.

James Marlay: Just on that, going back to the idea of low interest rates pushing people into income-generating stocks. Are there any, you said as an asset class, you still think equities look pretty attractive. But within that, underneath that heading, are there parts of the market where you feel like yields have been compressed too far? Or anything that looks particularly risky to you at the moment?

Don Hamson: Well, I think the riskiest part of the market is actually the growth stocks. What do you call it the WAAX's here or what have you. But there are a lot of stocks that actually don't make any earnings or very little earnings, and don't pay dividends or very little dividends. And they've gone to, those growth stocks have gone to ridiculous prices. So I think that is the end of the market that I'd be particularly worried about. To me the banks look pretty cheap. Yeah, there's still a few risks around with them, et cetera. But I think by and large they look pretty attractive with price still.

James Marlay: Yup. Alrighty. I've asked you to bring along an idea or potentially an underappreciated income opportunity. Are you able to talk me through an example of a stock that you think is not well understood? Or that you think has a good earnings outlook and has that income component that you're able to share with us?

Don Hamson: Well, maybe it's starting to go through, and we've been saying this for a little while, but we still think the iron ore miners are actually, aren't fully appreciated as income stocks. I think if you ask the average person in the street: what's an income stock? They'd still probably say the banks and Telstra, what have you. And the yields that are coming off these guys this year. You are talking like eight to 10% I reckon. And it potentially can get better. So I think from medium term, I think they're actually pretty good income stocks. And I think typical income managers or income people looking for income haven't really looked at that area.

James Marlay: It sounds like a lot of the bad news is factored into the banks. And the miners, which we know a lot of BHP, Rio, are a really partly index, and haven't traditionally been income-paying stocks. It sounds like the opportunity to get some diversification from an income perspective is actually better than it may have been in the past.

Don Hamson: Yeah, I think so. Because yeah, if you look historically the banks and Telstra stood out as head and shoulders above the rest in terms of dividend yields. But now actually, you've got it in another area that's pretty similar and very well diversified. Benefiting from a lower Australian dollar. Iron ore prices in Australian dollar terms, they're getting back to the highs of six, seven years ago. So they're not quite there in terms of U.S. dollars, but in Australian dollars actually they're looking pretty solid. So, yeah, I think it's a good opportunity. But I would caution people that resources, it is a cycle. And these things can change quickly, so you need to be very aware of that. But for us, for the medium term, we're still pretty positive on those.

James Marlay: Yup. And Telstra is the other one that you named there. I know we spoke with one of your colleagues, Pete Gardner last year. It was one of the companies that he was concerned about the sustainability of the dividends there. Is that still the view? It seems to have come through a bit of a rough patch.

Don Hamson: Yeah, I mean it's bounced back. I mean it looks like there's not going to be a fourth mobile network anytime soon. And so that's assisted it. It has been, had a bit of a bounce. But I think yes, the fact that it's still paying a special dividend is a signal to me, to the market, that there's potential that will cease. And if that's the case, then if you took its special out of the current yield of Telstra it would've cut its dividend nearly 70% from two years ago. So the stock has pulled back strongly this year. But still over the medium term we're not overly positive. We think there's still some hurdles ahead for it.

James Marlay: Don, if you were to go back and give yourself some advice or to someone that was just starting out, particularly with that income hat on. What are some of the pieces of advice or rules that you would give to someone from an investment perspective?

Don Hamson: Well I think key one is be aware of dividend traps. I mean I said it already, but I think that's very important. Don't necessarily always focus on the highest-yielding stocks. Because it can either be a solid stock, like at the moment I think the banks and the resource stocks probably are on pretty good yields, actually. And maintainable for the foreseeable future.

But it's very easy to look at a stock and it's trading at an 18% yield. And it's one that we haven't talked about, but it's in the resource sector. Alumina is actually trading on 18% yield at the moment, and that looks incredible. And we have talked out the resources, but interesting there – aluminium, alumina, and the price of those have come back. So we actually expect that one to probably reduce and trim its dividends. So don't get sucked in by that incredible high yield. Because it's risk and return. And something that's trading on a 15 or 20% yield, gross yield. That's suggesting that there's got to be some element of risk about it or a cyclical risk or longer-term risk.

James Marlay: Thanks for coming and having a chat. Obviously an interesting, and I would suspect, quite a good time to be an equity income investor. So thanks for coming in and sharing a few of your ideas with us today.

Don Hamson: Thank you.