Fund Manager Q&A

Telstra, NAB and AMP have cut their dividends... so, which 'bluechip' will be next on the chopping block? With the majority of ASX dividend income coming from a very short list of big caps, it's no wonder equity income investors are nervous. 

You may have seen Chris Hall, CIO at Ellerston Capital discuss finding dividend champions and letting your winners run on Livewire in recent weeks. These snippets were from a much longer interview looking at how Chris generates equity income by investing in companies with more sustainable dividend streams. 

You can now access the full discussion for the first time below, and read how Chris achieves a low volatility income strategy, how he finds dividend champions (with a few examples), his sell process and a recent divestment, and why he's keeping clear of the big four banks.


Q: So, Chris, how do you think about investing?

The one thing I've really focused on the last seven or eight years is that volatility of cash flows, particularly in developed markets, because what we're seeing is the level of disruption to businesses is happening at a much faster rate, due to better technologies, regulation and the like.

That volatility is having a far more pronounced impact on share price movements than perhaps it has in the past. That is where my passion has grown for investing in low volatility income strategies.

If you look at the top 30 dividend payers in the Australian market historically, the payout ratios have edged up to about 85%, so there's very, very little room for slippage. If you have an earnings hit, if you have an earnings disappointment, not only are you going to get a decline in earnings, you're going to also get a decline in the dividends.

What I like to do is focus on the income dollar generation, the compounding effect of income, rather than just using the absolute yield as a key input into the strategy. 

It's all about, for me, the volatility and sustainability of dividends and dividend growth.

Q: What are some of the screens you use?

When I look to put the portfolio together, I'm looking at the historical volatility of earnings and dividends firstly, and then I'm looking at the dividend growth rates and the potential of those companies which go into the portfolio.

Then I have a series of knockout screens based on earnings quality and balance sheet quality, and my own set of specific filters, to get down to my desired 40 stock list which we then do all the fundamental analysis on. What that means interestingly from a portfolio standpoint is - and this is really important - the yield of my fund is actually below the market. Not by much, but probably around about 50 points below the market.

But the growth rate of dividends within my portfolio is three times that of the market, and I have a lot of confidence around that growth rate, because of my volatility measures and checks that I've put in the process.

Q: So, is the capital growth of your fund higher?

That's right. In theory, that's exactly what should happen, because if you have earnings disappointment in this market, because of the prevalence now of index funds and quant funds, the ratio's about 1.6 times the movement in the share price, the downgrade. If you have a 10% downgrade, in theory you're moving around about 16% on the downside with your share price.

So, by having that focus on not having those, as you know, portfolio management is as much about what you don't own as what you do own, and it's avoiding those stocks which have higher volatility and propensity to disappoint.

Q: What are the 3 categories you classify income stocks by?

The three categories for income stocks are cyclical yield, defensive yield, and dividend champions.

For cyclical yield, you normally want to be more heavily weighted towards that when you have bond yields rising, and economies improving, in a normal cycle. The cyclical side would have been more materials and financials and consumer discretionary.

For defensive yield, you're more normally in that bucket when yields are falling, bond yields are falling, economic conditions are slowing, and that puts you in sectors like A-REITs and consumer staples and utilities and the like.

Then you have the dividend champions which are good throughout all cycles. And they're ones that have just got really, really resilient business models, which can generate great sales revenue, great margins, great revenue growth, great cash flow, and most importantly, great dividend growth without too much influence happening from the economic cycle. They're not easy to find, those stocks, but they are out there. 

Q: Can you outline a few examples of dividend champions?

If I take a company like Aristocrat (ASX:ALL), which we hold in the portfolio, the compound dividend rate for that stock over the last five years is about 20% per annum. Now, it's not a high yielding stock optically, it's on about 2% yield, but the compounding effect of that is extraordinary over that time frame. That's the case in point that I'd single out. As a business model which I think has got a great deal of longevity, because of the nature of their business and their competitive advantage in gaming, and in gaming software, that I think that's sustainable.

Another one that you could put in that camp would be CSL (ASX:CSL), for example. It had a really good result recently and has delivered a very, very decent compounding dividend growth over time. They're in a very, very unique position with their business model. Their competitors are struggling with regard to getting adequate plasma supplies, so their business structure looks really compelling over the long term. If you look at it one year out, its PE of around 33 times is definitely expensive, but this is a stock which could have earnings upgrades post the result, and normally with that stock, that's exactly how it behaves as you go through the year and the share price reacts accordingly.

Q: Can you tell me about your sell disciplines and your process for selling a stock?

Sure. If a stock was in the portfolio, if there was a dividend cut that was obviously against my expectations, that would be a very strict sell discipline firstly.

If I thought that the growth trajectory of the dividends was going to flatten out, that would also be a knockout. It's not just about having a flat dividend profile, because that's what the banks have essentially got now. It's about meeting a dividend growth profile. They'd be two things that would be a knockout for me.

A recent disposal example is Star Entertainment (ASX:SGR), the casino company. Now again, optically that was looking like it was on a dividend yield of around about 5% or a bit over that. But it became pretty apparent to me a few months ago that the earnings momentum was stalling, and that was a reflection of what was happening in the economy domestically, and also what was happening with the VIP, the big premium players that were coming out of China. 

They're also in the process of a big Capex spend for their casinos in Queensland, and we have Barangaroo, which one of our Crown Casino's obviously businesses opening up in the next 12 months. That means the competition's going to rise, so I think there's some real headwinds there. Therefore, I think the dividend trajectory's going to be different to what we first thought, so that was exited.

Q: What are the biggest mistakes income investors make?

The first one is selling really, really good businesses too early, and thinking that stocks are overvalued, that have got structurally strong tailwinds, and structurally strong business models, and then have this structurally strong cash flow and dividend profile. Because the compounding effect is missed. CSL's a classic example of that. Same with Macquarie Bank. It's the same sort of argument. That's the first lesson: Let your winners run

The second lesson is trying to use yield, optically high yield, as a major part of your selection process. Because as I mentioned before, the rate of disruption with business models and the dividend cover that's now prevalent with a lot of these names, and where payout ratios are, there's very, very little cushion to be able to sustain or grow the dividends when the earnings come under pressure because of those changing conditions.

The third one is to be very wary of picking cyclical turnarounds if the businesses haven't got a really good position of strength in what they're doing. I might envisage a time where I might own some resource stocks. Now, if I look at BHP and Rio, they've got really, really strong market positions, and so you can look at their sustainability a lot more favourably than just perhaps a small retail cyclical stock which has got no real competitive advantage, which is going to be a lot more susceptible to the economic conditions than the big miners, given the market structure.

Q: What is your view on the banks’ ability to keep paying dividends?

Firstly let's start at the top line, the credit growth. Credit growth is incredibly anaemic in Australia. That's a function of a) obviously a lot of indebtedness already in households. People are already highly leveraged. That's the first point. And b) the availability of credit is now a lot harder than it was. We've obviously had the Royal Commission, we've had their own banking standards internally which are making access to funding a lot more difficult.The credit growth is just not there, that's the first point.

The second point is the cost structures. Now, the banks are doing their best to try and cut costs, and you see people being laid off in the banks continually. But the problem is because of this fallout from the Royal Commission, the compliance costs are rising at a really, really high rate. The regulatory cost burden of participating in the banking industry, having a banking licence, is becoming increasingly high, so the propensity to be able to pay dividends again becomes more restrictive.

The third point is we haven't really had a credit cycle yet, and given what we said before about the economy slowing, and given what the central banks are telling us, and given what we're seeing in Australia, we've obviously had rate cuts here, we're going to have a credit cycle. Which means that bad debts are going to start to rise, and that's going to be another serious headwind for earnings.

When I throw that all into the mix, I see a profile of at best, flat earnings, but I think probably risk to earnings downgrades or negative earnings, year-on-year, and then because the pay ratios are so high with those banks, the dividends will go with it. 

Don't get caught in a trap

The Ellerston Low Vol Income Strategy (ELVIS) has a clear focus on delivering low volatility, sustainable income for investors through the market cycle. For further information use the contact button below, or visit their website.



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Mark Cardell

Excellent analysis