Income

When compulsory super was introduced 25 years ago you could rely on cash and fixed income. These days, the RBA cash rate is 1.5%, 10-year bonds yield less than 2% and you can get 2.5-3% with online savings term deposits or investment grade bonds. 

Hybrids and capital notes now pay on average less than 5% inclusive of franking. Distributions can be discretionary, and hybrids can be converted into equity in times of distress. 

With people living longer, these are very low rates of income for 20+ years of retirement, particularly given risks of rising costs of health and aged care. Investors don’t appear to have any alternative but to allocate some portion of wealth to equities as an income-generating asset class. If you can generate a decent income from equities, it would seem an appropriate choice in this environment of low rates.

Interest rates stuck to the bottom – yields provide an investor with a foundation

Source: FactSet; As at 22 March 2019

I think the attractive components of the Australian equity markets are the quality and value stocks in which you can invest to generate lower risk income. 

Equities can be a risky asset class, but if you take an active approach, you can generate income from equities with relatively low risk. If you look at the ASX 300, and you carve out the more concentrated and cyclically exposed sectors such as the Financials and Resources, you can actually get better risk/return outcomes than you would investing in the market as a whole.

If you can avoid poor quality stocks with unsustainable dividends, and avoid overpaying for stocks, such as Utilities, Infrastructure, or some of the developers in the Listed Property sector, you can achieve a better outcome. 

Generating income and finding value

We invest in quality companies with an enduring competitive advantage, recurring earnings and an ability to grow, and we avoid overpaying for such stocks. We start with a diversified portfolio of stable industrial companies with less volatility and more sustainable dividends than the overall market.

Diversity of income sources provides for smoother quarterly distributions

Sources of equity income can vary over time. However, our approach means that you can generate income from a diverse range of sources through the cycle. We expect about 4% through dividends (pre-franking) which tend to be the steadiest component of income.

Because we take a fundamental approach to valuation, we can supplement the income of our portfolio by writing options and further reduce market exposure. At a portfolio level, we can achieve 2% through simple options strategies which tends to be higher in flat or bear markets.

We also aim to add 1% through realised capital gains, noting that capital gains will be higher in bull markets. The diversity of sources provides for a steadier quarterly income stream and importantly, we can minimise drawdowns and better preserve capital. This results in a smoother ride for investors.

Investors Mutual Equity Income Fund diversified sources of income

Source: IML; as at 29 February 2019. Past performance is not a reliable indicator of future performance

The importance of valuation discipline to generating income through options

Everything we do with options is always tied to our valuation discipline. For example, if we invest in a good quality stock like Coles and the stock price appreciates to our valuation target of around $12 as it has done recently, we can write a simple, three-month call option with strike price of $12. We take the risk that the stock continues to rally and our option counterparty exercises the right to buy Coles from us at $12, but we have earned an additional premium in advance of around 40c. 

That is, we have targeted an exit price in Coles of say $12.40 at which we would have been selling the stock in any case. In some cases, we also sell put options on stocks that are starting to look cheap, as Coles did when it fell below $11.60 in January. We take the risk that the stock falls and our counterparty exercises their right to sell us the stock. Here our entry was the strike price of $11.25 less the 31c premium received in advance. As you can see from this simple example, our option activity is tied directly to our valuation discipline.

Source: IRESS & IML; As at 28 March 2019

Turning modest dividend stocks into high-income generators

If you take good quality companies which pay reasonable yields and write call options on these positions you can generate yields of around 8%, and the highest cash-flows need not come from the stocks with the highest dividend yields. The table below shows four examples where writing 3-month at-the-money call options can add up to 4% income potential. 

Dividends + option income = high income potential

Source: IML; as at 28 March 2019

5 important rules to follow

We don't deviate from the population of quality and value stocks that have passed through IML’s rigorous research process. However, the use of options to enhance income introduces a different set of rules:

1. Option strategies are always tied to stock valuations

First of all, everything we own, we own based on fundamental valuation. Our option strategies are therefore tightly integrated with our fundamental stock research and portfolio construction process. When we stick to our valuation discipline, and use options against our valuation, we enhance income while keeping volatility low. The strategies provide flexibility to add to income, reduce market exposure and target specific entry and exit prices.

2. We are not systematic traders

We generate income through collecting dividends and writing options, but importantly, we're not systematically stripping dividends or franking credits, which can lead you into the trap of overpaying for stocks with unsustainable dividends and putting capital at risk, particularly with cyclical or heavily indebted companies. We also avoid covering our entire portfolio with call options to extract as much income as possible as this can lead to high turnover and substantial realised capital gains.

3. We only use simple ASX exchange-traded options strategies

We limit ourselves to simple ASX exchange-traded options and strategies such as selling call options over shares we own and sometimes selling put options. We do not take counterparty risk with investment banks.

4. We don’t gear or short our portfolio with options

We don’t gear or short our portfolio, which requires us to always have our call option exposures covered by stock and our put options covered by cash. We therefore aren’t falling into the trap of having to buy stock after share prices spike, or sell stock after they collapse, in order to meet our obligations to our options counterparties.

5. We limit our effective cash range

Our cash range requires added flexibility to account for the chance of option exercise. We allow ourselves an effective cash range of 0-50%, including an allowance for the chance of call options being exercised and stock exposures reducing. It is important for us to not write too many options over stocks such that we get called out on all our positions and are left with no exposure to a rising share market. On the flip-side we also tend to keep some powder dry in the event that markets fall so we can take advantage of opportunities.

Buy/sell discipline: Effective Cash levels (%) of IML’s Equity Income Fund (EIF)

Source: IML; March 2018 – Feb 2019

Emerging opportunities – the importance of being selective

Things are tough at the moment. The market is currently showing signs of excess and complacency, with the ASX 300 back near its August 2018 highs and the “fear-index” (VIX) back at low levels. The economic environment is also challenging with record low interest rates, low growth and inflation, and a heavily indebted Australian consumer. In this environment I think it pays to be selective. The economy is no longer going to drive earnings, and companies are not getting free kicks in terms of pricing power. Cost-cutting measures can help support earnings for some companies but it's not a way to grow over the long term.

In this environment, we're targeting companies with more resilient and defensive characteristics. Our portfolios have been skewed to sectors like Healthcare, Packaging, Gaming, Consumer Staples and Utilities, which are under-represented in the index. We get greater diversity and better risk/return outcomes in our portfolios because of that.

1. Coles: new management investing in distribution efficiency

Coles is a new holding for our funds, having been spun out of Wesfarmers in December 2018. It is the second largest supermarket operator in Australia with over 800 stores. Earnings are defensive as they are heavily skewed towards supermarkets, and only 13% of earnings are exposed to liquor and petrol. The company has a strong balance sheet, strong cashflow and a new management team committed to driving efficiency improvements.

Management have committed $950m of capital expenditure on warehouse consolidation and automation. With three grocery distribution centres in both NSW and QLD plus two general merchandise facilities in both states there is plenty of room to improve Coles’ earnings and dividends.

Coles’ current margins are close to 10-year lows and 1.5% below Woolworths despite the two businesses having similar sales productivity. This is a result of cost and inefficiencies in distribution and we see the newly committed investment driving margins and hopefully returning them somewhere closer to Woolworths’ over the longer term.

2. Crown: being paid to wait for Barangaroo

Crown is a leading integrated casino and resort operator in Australia with exclusive long-term licenses in Perth and Melbourne. The company has refocused on mature domestic casinos and stepped away from investments in Macao and Las Vegas.

They have a very strong balance sheet with no debt and around $300m net cash. In addition to high quality assets in Melbourne and Perth, they also have upside from the Barangaroo development, with 150 tables in Sydney, expected to complete in 2021.

We bought the business due to the strength of the cash flow. Because they had invested heavily in their assets, accounting earnings under-stated the cashflows of the business. With a yield over 5% at time of purchase, are effectively being paid to wait for the upside from Barangaroo. The company has since become a potential takeover target for global operators such as Wynn.

Some areas to avoid

The one thing we are very cautious of is cyclicals and heavily indebted companies, and as a rule, we've held very little in Financial and Resource stocks within our Equity Income portfolio.

We've got an index which is top heavy with 31% Financials and 7% Listed Property Trusts, so that's a pretty heavy cyclical exposure to housing. Add to that 19% in Resources and that’s a substantial concentration in cyclical sectors. With 28 years since Australia’s last recession, and markets back to their highs, we don't think having that level of cyclical exposure is prudent for an investor planning for a 20-year retirement.

Moreover, these sectors have enjoyed tail winds which are likely to turn into headwinds. Unemployment and bad debts are at cyclical lows, commodity prices are strong due to fixed asset investment in China, and property prices are very high by world standards.

Banks look relatively cheap and pay decent dividends, but you are taking a fair exposure should unemployment increase, house prices fall and bad debts spike. Property developers like Goodman Group have rallied on peak cycle development profits. Goodman now earns 40% of profits through development, and the stock has rallied over 35% this financial year to date. Similarly, resource stocks like RIO have been strong as markets capitalise unsustainably high spot iron ore prices which are contingent on China’s continuing investment in fixed assets.

The market seems very complacent of these risks with cyclical stocks having rallied on short-term earnings growth. We prefer to take a 3-5 year view. We don't think we can capitalise short-term profits for such cyclical companies at this late stage in the cycle.

We see our role as an active value manager to step away from the benchmark, and to invest in the broader economy as the ASX is a highly concentrated index. I think the second risk is valuation risk, particularly in some of the growth stocks, and also in the Listed Property, Resources and Technology sectors. The market is priced for growth, yields are very low, and the VIX indicates a level of complacency.

Our approach is different. It is directed at long-term investors, who are conscious of downside risk and looking for more consistent income and capital preservation through the cycle, as opposed to those looking to participate in short-term speculative growth. Rather than try and time the market, we prepare our portfolio for a correction by investing in quality and value stocks with sustainable dividends that are likely to weather the storm.

Our approach may lag more growth focussed styles at this late stage of the cycle, particularly in our Equity Income Fund where we have the ability to write call options to further reduce our exposure to a rising market. We see our value-add is preserving capital in the event that markets do correct.

What to expect from Australian equity income over the long-term

We target a yield 2% above the ASX 300 yield, after fees and before franking and with lower volatility than the ASX 300 index. This is what we've achieved over the last eight years. We've done so with reasonable capital growth, and we've been able to pay a relatively steady quarterly distribution with franking and relatively low drawdowns. Our expectation is that we will continue to achieve this.

Certainly markets are high, but we are conservatively positioned, so in the event of a correction we would hope to maintain our capital base better than the market and continue to meet our yield objective. I think the time of double-digit market returns and low volatility is coming to an end.

Source: IML; As at 31 December 2018. Past performance is not a reliable indicator of future performance

We have record low cash bond yields and these low-risk asset classes don’t pay enough income to fund retirement. So we believe, the proportion allocated to active equity income strategies should be higher than it was a decade ago. 

With market valuations stretched at this late stage in the economic cycle, a retiree who has one-third of assets allocated to domestic equities should consider allocating this entire exposure to a lower risk equity income strategy. 

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Comments

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Patrick Jackson

Good article, thank you.