There's no doubt in anyone's mind that the past year has been an extraordinary period for markets. Casting his mind back 12 months ago, Ausbil Investment Management chief investment officer, executive chairman and head of equities Paul Xiradis had expected equity markets to move higher.
And he was right – they sure did. But the journey upwards was a little bit different to what he had first expected. Xiradis had forecast that global growth was going to continue at a reasonably solid clip, that interest rates were going to be higher, while earnings were going to grow.
While he may have got the part right about markets pressing higher, he never expected to see interest rates tick down to levels approaching zero. And despite the widespread doubt and uncertainty plaguing markets at the moment, there seems to be consensus on at least one view – that rates are going to go lower and stay lower for a "hell of a lot longer".
Today, almost one-third or US$13 trillion of global bonds have a negative yield. But what worries Xiradis in situations such as this, when there is such a one-sided consensus view, is that any hiccup can be "really quite disturbing" to markets.
"But I still think rates will remain lower for a good period of time and perhaps we may see assets which have been clearly sought after in this rally since 23 December last year – which has all been yield and the chase for yield – actually have a bit of a hiccup," Xiradis told a recent lunch gathering in Sydney.
"So, that's the risk as I see it, but I put that as a low probability, just in the short term. I think what is likely to occur in the coming months is there will be some agreement among the US and China … but I don't think it's going to be resolved," he says.
"So, by kicking it down the road as far as the agreement is concerned, it is likely that markets will still be driven by the data … and it's likely that we'll see the Fed cut rates, it's likely that we'll see rate cuts here, and more QE discussion in Europe. So, it does mean rates are going to be lower."
Xiradis argues that if this is the case, those sectors which have performed pretty well recently are likely to continue to perform in the near term, particularly the likes of REITs and infrastructure issues.
"And let's not kid ourselves – the valuations associated with some of these companies are incredibly high. But when there's no alternative and people are still chasing yield … and they're still yielding 3.5-4%, for some that's quite attractive and will continue to be attractive."
But what is usually the case when rates go lower, is that markets see a bit of a bounce back in economic activity.
However, as Xiradis points out, we're not necessarily seeing that at this stage:
"What we are seeing is rates being cut because of the uncertainty – and no bounce back. And anything which is cyclical is still not being bought, which means some of the value companies are really under pressure, and there seems to be absolutely no appetite for those just in the short term."
Bulk resources: the place to be for yield
So, when there's a one-way bet as far as rates are concerned and asset allocation also seems to be pretty much one-way, this creates some anomalies in valuations and prices. At the other end of the equation, stocks which are missing out on this thematic are getting cheaper both in absolute and relative terms.
" … we were underweight the banks and now we're overweight the banks, which is a little bit controversial in some people's thinking. But if you think about yield … they're still yielding 6%," Xiradis says.
"We still like resource names, particularly the bulks. And that really is the likes of iron ore … for a number of reasons, iron ore prices will remain elevated for a longer period of time than the market is thinking at this point".
"We think this dislocation that occurred in Brazil will be with us for another two or three years and we'll actually learn that iron ore prices will be higher than they otherwise would have been … we're still reasonably comfortable with bulks, but there is risk associated with that I must say."
If you're hunting yield, Xiradis says these stocks are the ones to be in. He expects BHP Billiton (ASX:BHP), Rio Tinto (ASX:RIO) and Fortescue (ASX:FMG) to deliver very strong results in the upcoming reporting season, including very high dividends.
And while Xiradis believes market expectations for earnings growth of around 10% next year is achievable, it is the composition of that 10% that will no doubt vary as the year wears on. And if interest rates still remain low, this will provide a good backdrop for equity markets on a 12-month basis.
All up, Xiradis says the real challenge is that rates aren't going to go up in a hurry. And for those retirees who require a "real" income, they're not going to get that from fixed interest investments and/or deposits. Ausbil's answer to this challenge facing those who need income in such an environment is the Ausbil Active Dividend Income Fund.
Battling the burden of a long life
When first tasked by Xiradis with establishing the Ausbil Active Dividend Income Fund, Michael Price, Portfolio Manager, Equity Income at Ausbil, says retirees were the target client.
With this as his starting point, he eventually reached the conclusion that both total return and growth were important to these clients, and that retirees not only wanted higher levels of monthly income, but to grow both income and capital over time in line with inflation.
"Now, why is growth important in this low-inflation world? Well, according to the Institute of Actuaries, if a 65-year-old couple go see a financial adviser, there's a 50% chance one of them will get to 93. So, the halfway mark is 93, means the retirement midpoint is 28 years after the age of 65" Price explains.
"So, you can't just worry about income. You've got to look at total return and growth as well."
The Ausbil Active Dividend Income strategy aims to provide a monthly dividend income stream that's 25% ahead of the market, while also outperforming the market over time.
As it's designed for retirees, Price includes franking credits in his assessment of both return and how he analyses individual companies. In practice, what this means in a normal year is a minimum of 7-8% income, including the franking credits, and roughly 2% growth with inflation.
"If we outperform the market, we can provide more income. This year, we've managed to outperform the market by about 4% and that's come through in the form of extra income as well," he says.
So, how is this strategy different to the existing dividend income funds out there? Price knew there were clients who certainly wanted more of their return in the form of income, and who cared about the split between income and growth, or income and total return.
But there was something he thought was overlooked – the fact that none of those clients actually wanted a lower total return.
"So, they might have been told that, 'If you want more income, you're going to have to accept a trade-off – you're going to have to give something up somewhere.'"
Have your cake and keep it active
Xiradis challenged Price in conversation before setting up the fund. Was it possible to provide the extra income and still maintain the total return? Price found that as long as franking credits could be included in the strategy, then it could be done.
Hence, the Ausbil Active Dividend Income Fund was born. Price explains that the key to making the strategy successful was ensuring that it was "active".
"There are three ways that we're active. So, we start with an active, top-down sector allocation. That's the Ausbil way, that's how we manage money … it then continues with active security selection. We've got 12 analysts, we've got models of over 300 companies, and we want to make sure we stick with our stock selection standards," he says.
"We've got to have high-quality stocks in the Active Dividend Income Fund. We certainly don't want a stock in the fund just because it pays a dividend – total return is pretty important".
"So, if we're going to do that, how are we going to get the extra income? Well, the third active aspect is the active management of dividends to get the extra income. And by that, I mean, you want to collect more dividends, rather than higher dividends."
In order to do this, Ausbil says Price takes advantage of two factors: "First of all, to make the obvious point, you don't have to hold a company all year to get the dividend, you've just got to hold it on the ex date."
"And when you look at the ex dates over the years, there's actually quite an interesting pattern – there's no single month that has more than 20% of the total dividends paid or going ex in that month".
"In fact, eight out of the 12 months either have 10% or more of the dividends or 10% or more of the securities, so 20 securities or more pay their dividends or go ex-dividend in that month. So, you've got eight out of the 12 months which have significant levels of dividends available to be received."
Therefore, when constructing the portfolio, after starting with the top-down sector views, then deploying both a stock and dividend selection screen, Price needs to ensure that over the next month the fund is going to get higher dividends than the index.
"Passively sitting there looking out over a year, I'm really concerned that over the next month I am tactically positioned to get that dividend, that extra dividend I'm looking for, that 25%."
To illustrate his process, Price employs two property trusts as examples: Stockland (ASX:SGP) and Charter Hall Group (ASX:CHC), the former sitting on a 6.1% dividend yield and the latter on a 3.4% yield. He says a manager's natural inclination would be to include the stock with the higher dividend.
However, he points out that since January 2019, Charter Hall has returned 52%, while Stockland has only returned 28%. "You're now starting to think, 'well, maybe the fund should have Charter Hall rather than Stockland.'"
Price then looks at the portion of the return that had come from dividends over the period, which was the same for both stocks – it's zero.
"So, this is the problem with passive funds. It's bad enough that some funds buy a stock just because they're paying a dividend or are about to go ex-dividend, but what's worse I think is that you'll sit in a company for six months because it's got a high dividend, even if over that period it’s not paying a dividend," he says.
"So, the key to active management of dividends is that we reject that idea. We focus shorter term, one to two months ahead, and make sure we get the extra dividends over that period."
Price is also quick to point out that with every stock in the strategy, Ausbil would be happy to hold it for the long term – not just while the dividend is being paid.
"Through the active management of stocks, active management of sectors, and the active management of dividends, we've been able to provide very high levels of income and excellent total returns as well."
Does your income strategy also provide capital growth?
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