Rewriting the rules on income

Retiree investors have borne significant financial pain as a result of the COVID-19 crisis and measures to stop its spread. Analysis by JPMorgan predicts that dividends, rental income and interest payments will drop by $135 billion in the 2020 financial year.

Income investing experts Dr Don Hamson of Plato Investment Management and Chris Hall of Ellerston Capital say that factors including COVID-19 have rewritten some of the rules around dividend investing.

Rather than haphazardly relying on the Big Four Banks, investors need to broaden their mindset and consider businesses and sectors where favourable structural shifts are supporting profits and ultimately, shareholder payments. Here, they make the case to consider non-traditional stocks for income and point to mining companies as the "new banks".

Notes: Watch, read or listen to the discussion below. This episode was filmed on 20 May 2020. 

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Edited Transcript

Jessica Amir: Welcome to Buy Hold Sell, brought to you by Livewire Markets. I'm Jessica Amir from Bell Direct, and today we're here to help you find income amid the noise and despite the uncertainty. With me today is Don Hamson from Plato Investment Management and Chris Hall from Ellerston Capital.

Jessica Amir: Depending on who you look at and what analyst report you read, earnings per share is tipped to fall this year in the order of 10%. How are you gents positioning your portfolios despite this uncertainty to continue to get income? Let's start with you, Chris.

Chris Hall: Well, Jess, if earnings fall by 10%, that'd be a pretty good result. I think it's going to be much more than that. More like 30% I'd say is the real outcome. And dividends are going to go with it, potentially more so, given the amount of capital raisings we're seeing in the market.

I don't think we're done yet. I think we've had about $20 billion of capital raisings so far, or maybe a tad over that, but as I said, I don't think we're through that yet. The key to navigating from my standpoint, income has been as much about what you've been able to avoid as what you've owned during these difficult times.

It's about preservation of income

Chris Hall: If I look at how we've been looking at the portfolio, we've really been avoiding for some time now, the banks, which have seen very, very significant dividend cuts obviously. And also the energy space. We've been very underexposed and they've seen obviously very, very significant cuts on the back of a very, very soft oil price. Started to rebound a bit now, but it's still a long way off where it's historically been trading.

And we've been more positioned in the defensive names and sectors of telcos, which have been very, very resilient. Some of the consumer staple names as well. That's how we've been trying to navigate our way through this to try not so much to grow income during this 12 month period, because it's going to be very, very difficult to do that. But it's more about the preservation of income as best as possible, so that's how we're dealing with it from our side.

Jessica Amir:
Just before we go onto Don, any key standout stocks?

Chris Hall: I think again, to avoid, as I mentioned we've been very, very underweight the banks. The retail banks. I think the challenge there is that A, we're about to face one of the most brutal credit cycles we've had since the 1991 recession, B, the capital requirements that the banks have to adhere to are becoming more and more stringent.

As we go through that credit cycle, the level of capital's going to deteriorate, and even before we were going into the COVID crisis, the return on equity profile of banks was diminishing anyway, just through business disruptions. I mean, yes, we'll get some snapback, but I'm very fearful that the dividends and the yields that investors have been wanting from banks in the past just won't be there anywhere near the same level in the future.

Avoid the dividend cutters

Jessica Amir: Banks really aren't cutting the mustard like they were many years ago, but Don, how are you positioning portfolios amid the uncertainty?

Don Hamson: Well again, you've got to avoid the sectors that are cutting dividends significantly, and clearly a lot of the consumer discretionary stocks are getting hit there. Travel, tourism-related stuff, the banks, underweight the banks, but similarly, we're actually back overweight Telstra. We've been underweight a couple of years, but it now looks relatively solid.

Some of the consumer staples are good as well, but we actually find some really good value and some good dividend opportunities in some of the resources area, particularly iron ore miners and gold miners. Less the diversified guys, but certainly stocks like Fortescue to us is a standout.

Jessica Amir: I was just going to ask you that. You took the words right out of my mouth. 

Resources: The new banks

Jessica Amir: Now Chris, you mentioned that you're overweight to the defensives and that's what we've seen outperform. We've seen defensives and tech names outperform and the energy sector has been lacklustre in terms of performance, along with the REITs and the banks. What have you guys been buying of late? If so, what is it and why? Back to you, Chris.

Chris Hall: Yeah, we're adopting more of a barbell approach in the portfolio. I'd sum it up, I've been kind of defensive growth as far as positioning, so not uber defensive. We've got some defensive characteristics in the portfolio but we've also got some growth characteristics. It's interesting where you find income growth these days. Don and I were speaking about that earlier on. The materials, some of the bulks have become really the new banks, because the free cash flow generation is just so powerful.

The balance sheets are in pristine condition. The industry structure is incredibly favourable for the bulk miners, given how fortuitous we've got this fantastic resource base in Australia. I think they've been underestimated for perhaps the longevity of the dividend stream here. I mean, we've both been in the market for a long time, and historically the biggest threat with resource companies is as soon as we get a cycle, they end up buying assets right at the top of the market and end up destroying a lot of shareholder value.

But I do believe this time around there will be some real focus or continued focus on capital management from all of the big players, BHP, Rio, and Fortescue. And that volatility of dividend stream that we've had historically I think is not going to be nearly as high as it's been. That makes them very attractive to me as an investor.

Rio, Super Retail Group and Ramsay well-placed for a "meat and three veg" world

Jessica Amir: Definitely. If I can just stay on you, what have you been buying per se?

Chris Hall: If we look at some of the names there, added some Rio, already had a position there. Started to look at some of the consumer cyclical names which got really beaten up, and one of those names is Super Retail Group. That's recently, have owned that historically, but again the thematic for me there as we obviously begin to open up through COVID, I think we're moving into a meat and three veg world, where people are going to move back towards doing more simple things in life, and that includes camping with a family rather than going off on overseas trips.

I think there's going to be quite a prolonged psychological effect of people wanting to do that. Those businesses within that group are very much skewed towards leisure and obviously the sports market, and kids going back to school, so they'll be required to obviously start getting ready for sport, as well as adults. There's a couple of key drivers there which look attractive to me. The stock's trading on about 11 times, so it's very, very cheap, and it's a decent dividend, too. That's one of the names that look attractive to me.

Perhaps one other I've added recently, as well as Ramsay Health Care, I've owned that in the past, and that was through the placement they undertook a couple of weeks ago or a few weeks ago at $56. And again, it's about the premise of elective surgery coming back now after what's been a very, very quiet period over the last few months. It's as much about their dominance in the market versus their competitors. You've got pretty much healthscope which is owned by private equity, and that's still struggling a bit, and then the not-for-profits are really battling.

I think there's a very strong structural story and the return of capital trajectory from brownfield developments there, from hospitals, is pretty powerful. I think given the state of balance sheets within states, within the states, it's going to be a lot more what we call PPP work, or public private partnership work going forward. Because the states simply can't fund all these on their own.

Adding gold, Macquarie

Jessica Amir: So structural shift favouring Ramsay, behavioural shift Super Retail. Don, what about you with what's going on? With these changes, big changes in markets as well. How are you positioning portfolios? Any big changes? If so, why?

Don Hamson: We've added to our gold holdings. So we were little gold stocks, got some good dividend opportunities there. Gold prices have held up very strongly as they normally do in crises, and we've topped up some of the iron ore miners. I mean, we think Macquarie is a good bank, or Group, is a good stock, so we topped some up in the depths of the market a month or two back, and got into the $70 mark. We thought that was pretty cheap, the 50% selloff seemed excessive for us.

Jessica Amir: Let's stay on banks. Many would argue despite what Chris thinks, banks I guess form the bedrock of a great income portfolio. On the pretence of what they've done in the past. But there's a lot of capital raisings, now $3.5 billion capital raise, Macquarie's coming out and issuing hybrids to the market. What are you making of this? You've snapped up Macquarie. What other value are you seeing in the banks for income?

Don Hamson: Yeah. Well, I think there's good value in banks, long term. I think that's the best positive for them. In the short term, there's going to be a bit of pain. Clearly we've got a lot of significant unemployment levels, so I think there's going to be some more bad debts, no matter what the government's trying to do with JobKeeper and JobSeeker. I think there's a period of pain but longer term, I'm a bit more bullish on the banks. I think they will come back.

I think probably Royal Commission, which is now almost ancient history, they're tightening up their act in areas where they probably should have never ventured in, in hindsight. I think they might come out of this better and stronger. The reality is, you look at ANZ, it didn't pay a dividend but basically it highlighted that its capital levels are double what they were going into the GFC.

I mean, there's no real risk that Australian banks aren't well capitalised. They're very well capitalised. Arguably, Commonwealth Bank's the best capitalised big bank in the world, and all Big Four banks are in the top dozen or so of large banks globally. Very, very strong from a capital position. I'm more bullish on the longer term, but the short term dividend outlook, clearly uncertainty given what APRA has said to them.

Watch for the red flags

Jessica Amir: Definitely. There is I guess a few red flags in the banks, but I agree, CBA said they're stronger than ever before. ANZ looking robust as well. Changing pace to those red flags in the market. Aside from financials, which are scrapping or downgrading, you've also got other sectors, the downtrodden sectors. Let's stay on you, Don. What red flags are you seeing other sectors and stocks?

Don Hamson: Yeah, well I mean clearly the obvious ones are those that are most impacted by the lockdown. I mean, I think the last thing that will happen in the economy will be opening up our borders. Anything that's associated with international tourism and Qantas in that respect, although they'll probably benefit from a pretty weakened competitor. We've got to see what Virgin mark two is, but you've got to think that it's going to be weaker than the original Virgin. Hopefully it makes some profits. We'll have to wait and see.

Clearly I think anything that's in the tourism-related areas is in real trouble, as we've seen. I know you've seen some very deeply discounted issues by the likes of Webjet and Flight Centre, but I think their outlook is very challenged for the next couple of years.

Jessica Amir: And what do you think, Chris?

Chris Hall: Yeah, I agree with Don there. I think the tourism stocks are going to be the last to come out of this, and there's still a fair bit of pain to go through that. I think it's interesting, too, about the ... Talking about the psychological effect of what this does to behaviour, consumer behaviour out of this.

Savings rates could increase as structural shifts accelerate

Chris Hall: I read an interesting statistic last week that around 63% of Australia, or 63% of Australians were not here during the 1991 recession. There was a really interesting paper put out by George Washington University looking at the behaviour of families, and that includes kids living at home, when they see their families go through real stress, real distress, financial distress, and what that means for their own behaviour going forward.

Given we haven't had a recession in 28 years, that really interests me as to what the behaviours are, as we move through this. I don't mean just in one year's time, but is this going to be a two or three year event? Because if I look back at the GFC, savings rates went from 3 to 8 or 9% and stayed there for six years.

Now, if this event's going to be worse than the GFC, we could easily have unemployment remaining at double-digits for a prolonged period of time, and savings rates, because confidence is so low, remaining elevated for a long period of time. That has a real impact on obviously consumer spending and has a lot of impact on also potentially housing and some of the housing prices. That all goes to confidence.

For me, structurally, that's what I'm trying to get my mind around, how that world looks. Not just in one year, but in three years' time. But in the near term, certainly leisure. I'm also thinking obviously some of the REITs are going to ... Which have historically been good yielders, good dividend drivers, I think there's some real structural shifts going on there. Particularly in the office market.

When you have the CEO of Morgan Stanley saying globally, they're going to cut their office usage by 25%, you can take that as a cue that that's going to be one of just many CEOs looking to do the same thing. And obviously the use of retail. I mean, clearly the online's exploded, but what's that social move back to normal shopping going to be like. Is it actually going to revert back to the norm, or is it going to be a different type?

I think that's got to be dependent on how quickly we find a vaccine and just the comfort of people being able to go out and socially mingle and feel comfortable in crowds, but it's something to be very aware of as well.

Goodman Group well-positioned among REITs

Jessica Amir: Just on that, if I can ask, what's one stock that you think really plays to that thematic, this behavioural, psychological shift, aside from Super Retail?

Chris Hall: Well, I think you can look at it ... It's mainly about those that play it in a negative way, what you don't want to own. For my side. I'm very wary of office, some of the office names. I know Dexus has been a bit of a market darling, and again, I've owned that name in the past. They're great assets, but I'm just very concerned as to what the usage rates will be of office space.

If business conditions are going to remain tough for a while, there's more supply coming on stream in the next 12-18 months, the rentals are going to come under I think a fair bit of pressure. Even in the residential space, I mean, people in our office who are getting rental cuts left, right, and centre, 10-15% off the bat, without too much trying.

You can see the ramifications of this, as this journey's just begun, so I'm a bit concerned about the ability to continue to drive dividend growth from some of those selective REIT names. Same in the shopping centre space. But then if I look at something like a Goodman Group, I have a lot more confidence in that, because they're in the industrial market, logistics management, huge beneficiary of online, and food, and data, businesses which have just got long term growth profiles.

That's a name where I see flat dividends for this year, but then I see it resuming back to its 5-7% normal dividend growth trajectory.

JB Hi-Fi stands out among retailers

Jessica Amir: And Don back to you, Chris, not a favourite of the REITs. Does like Goodman Group, though. What are you looking for income?

Don Hamson: Probably agree with Chris' views on the REITs as well actually, and particularly the retail. Again, probably a behavioural change, JB Hi-Fi seems to do very well, and you can actually see those groups that are grasping and doing well in online are actually doing very well. If you think about this COVID, it's just accelerated the trend that's been happening for the last 10 years I suppose, which is get everything going online.

This has made it go at hyper speed. Anyone who can crack that online business, and we like JB Hi-Fi in the consumer discretionary area, it seems to be able to be very nimble and very quick and it's actually benefiting. Its sales are doing very well at the moment. I think that'll continue.

Jessica Amir: There you have it. The gents are divided, but together on some, but all in all, look under the hood.

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