Six ways to drive income in uncertain markets

Reece Birtles

Martin Currie

Equity markets year-to-date have been characterised by elevated volatility. This has been caused by a combination of global factors driving uncertainty, including a rapid acceleration of inflation as global economies begin to reopen following prolonged COVID-19 lockdowns, growing expectations for monetary policy tightening over the short-medium term, and heightened geopolitical tensions following Russia’s invasion of Ukraine.

In Australia, the impacts have been amplified by elevated valuation metrics across certain segments of the equity market, most notably in technology and other growth-style exposures, which had been clear winners through prolonged COVID-19 lockdowns. These stocks have now seen quite severe price reversion as the economic reopening gathers momentum.

With uncertainty across markets expected to persist, retirees and investors in need of an income stream must be cognisant of controlling capital risk while generating low volatility income growth to offset the impact of inflation and longevity risk. In this regard, not all equities are created equal.

Six reasons why a different approach is attractive in this environment

The Martin Currie Equity Income Fund has been specifically designed to provide exposure to an attractive and growing income stream, with lower volatility than the broader Australian equity market. We like to call this a ‘sufficient income for life.

The way we think about providing a ‘sufficient income for life’ for our clients means that our portfolio looks very different to both traditional benchmark-aware equities and other lower capital risk income-focused approaches. Our starting point is income needs and income risk, not an arbitrary benchmark.

These differences offer a compelling opportunity for income-focussed investors, especially as higher volatility, inflationary pressures, and valuation dispersions remain prevalent in the Australian market.

We describe the six ways we aim to provide greater certainty in this environment in detail below:

1. Protection against inflation/rising cost of living

By design, we invest in domestic companies that offer strong protection against rising inflation and cost of living increases. This is a key consideration for investors given the rapid acceleration in inflationary measures in Australia.

For the right type of company, higher inflation can lead to increased revenues, but it is vital that they are able to pass on the higher costs associated with inflation to protect or grow their margins, and ultimately grow their dividends. We therefore focus on companies that possess meaningful pricing power in their markets.

The economic sectors that the Fund invests in exhibit these positive inflation trends:

  • Financials companies, such as banks and insurers, can pass through costs via rate increases.
  • Real Assets such as toll roads, shopping centres and utilities will typically have inflation pass-through mechanisms.
  • Industrials benefit from dominant market positioning and gross margin protection.
  • Resources companies will benefit from increasing commodity prices.

This inflation dynamic is a clear income growth opportunity for equity investors, which critically is not a feature of fixed income or term deposits.(1)

Company Spotlight

Telstra (ASX: TLS) management has noted that the company will look to pass through any cost inflation to the customer through price. The company do not consider mobile connectivity to be a discretionary item, so this provides protection for the service to remain within the household budget. Experience in recent years demonstrates that customers value network quality over price and are therefore willing to pay for a superior product, so shifting to lower-priced plans with competitors doesn’t widely occur. These factors demonstrate Telstra’s strong market positioning, and meaningful pricing power in an inflationary environment.(2)

2. A core focus on Sustainable Dividends

Our portfolio construction process places great importance on a stock’s long-term Sustainable Dividend, rather than a current or consensus dividend. This refers to a company’s ability to maintain payments to shareholders through all different stages of the cash flow cycle and considers the risk of the ‘worst-case scenario’.

By investing in the most attractive stocks on this measure, the income component of a stock’s total return, and the total portfolio, will be more stable, thus providing lower-income volatility and therefore greater certainty of the dollar income amount from an investment going forward, regardless of the capital gains or losses on any individual stock. 

For example, National Australia Bank (ASX: NAB) is a key portfolio holding due to its Sustainable Dividend. We expect that the bank will grow its dividend-per-share faster than earnings over the next year, supported by the lifting of APRA constraints and the ongoing economic recovery from COVID. The company is showing a clear path to reducing costs in a reasonable loan growth environment and is leveraged to the Australian economy outperforming on recovery.

3. High-quality companies have lower income volatility

High-quality companies will typically have strong pricing power and high free cash flows, which in turn allows them to generate more attractive Sustainable Dividends.

Rather than just focussing on payout ratios or yields, we have found that screening out stocks with lower Quality and skewing toward higher Quality stocks results in a portfolio that has naturally less income volatility than the broader market, meaning that there will be lower-income risk where a dividend that cannot be sustained ends up being cut.

Company Spotlight

As COVID restrictions have eased, Scentre Group (ASX: SCG) has seen foot traffic and tenant sales recover quickly. Strong tenant demand/occupancy trends are translating to the power to push up retail rents as tenant sales grow. We consider Scentre to be a highly rated Quality company that presents a compelling income opportunity with a strong liquidity and covenant position. Post-COVID, we believe that Scentre can maintain cash flows and win market share in a retail sector under pressure.

4. Franking credits offer investors a free-kick

We extract the full benefit of franking credits in order to maximise after-tax income for 0% taxpayers such as retirees.

We incorporate the value of franking credits directly into our investment process. Our investment process formally values franking credits and penalises unfranked dividends.

The high franking component of our portfolio is another aspect of the income stability we seek from companies with Sustainable Dividends. This means we have been able to consistently provide a franked yield premium to the broader equity market. Relative to the broader equity market, the forecast yield premium for the Fund remains near a record high.

5. Avoiding over-concentration mitigates income risk

When you look at portfolio construction through an income lens, minimising any income shocks is more important than tracking a highly concentrated market benchmark such as the S&P/ASX 200.

We use a benchmark-unaware portfolio construction approach to limit individual securities to a maximum 6% and sectors to 22% to avoid any concentration risk. We believe that this helps to ensure a more stable income stream while mitigating the impact of income shocks caused by any individual stock. In practice, this approach means that we are structurally underweight the largest ASX listed companies, given the weight of stocks such as BHP Group, CSL and the big-4 banks.

CSL (ASX: CSL) is one of the largest companies listed on the Australian stock exchange, currently ranked behind only BHP Group and Commonwealth Bank of Australia by weight in the S&P/ASX200 Index. While CSL has a strong track record of earnings and dividend growth over time, a low payout ratio means that the dividend yield of the stock is very low (i.e., investors are paying more for a dollar of earnings than they would for other companies), and additionally, CSL does not pay franking credits.

Benchmark-relative strategies would necessitate holding CSL to manage stock-specific underweight limits, however, our benchmark-unaware process means that we are able to avoid such an allocation, which would clearly be inefficient from an income perspective.

6. Avoiding impairments to protect the capital base

In an uncertain market environment, an important way to maintain capital growth, and future income-generating ability, is not to take unnecessary risks that might impair capital.

  • Strategies that use derivatives to provide income enhancements or capital protection are in fact potentially detrimental to capital growth, and thus income growth, as the cost is borne by the capital base.
  • Strategies that automatically sell stocks because of an income shock, such as rules-based high-yield ETFs, can result in impaired capital value despite maintaining a steady headline yield.
  • High turnover strategies are also more likely to impair capital due to excessive trading as they are turning capital to income by constantly moving to the next dividend-paying stock.

Volatility is likely to be a feature of equity markets in the near- to medium-term as global economies continue to reopen, while grappling with accelerating inflation and the normalisation of extreme monetary policy settings.

In this environment of heightened uncertainty, it is imperative for investors to seek risk-controlled income generation, particularly given the impact that higher inflation will have on real returns across traditionally ‘safe’ fixed interest exposures.

Learn more about income-generating opportunities

Our equity Income strategy is designed to provide a solution to the uncertainty, offering exposure to a diversified portfolio of high-quality securities that pay higher income, provide inflation protection, and have lower volatility than the broader share market. For further information, please visit our website

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(1) Past performance is not a guide to future returns. The investment vehicles shown may have different risk profiles and a direct comparison may not be appropriate. (2) The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the security transactions discussed here were, or will prove to be, profitable. Important information This publication is issued for information purposes only and does not constitute investment or financial product advice. It expresses no views as to the suitability of the services or other matters described in this document as to the individual circumstances, objectives, financial situation, or needs of any recipient. You should assess whether the information is appropriate for you and consider obtaining independent taxation, legal, financial or other professional advice before making an investment decision. Please read the relevant Product Disclosure Statements (PDSs) and any associated reference documents before making an investment decision. In accordance with the Design and Distribution Obligations and Product Interventions Powers requirements, we maintain Target Market Determinations (TMD) for each of our Funds. All documents can be found via www.franklintempleton.com.au or by calling 1800 673 776. Issued by Franklin Templeton Australia Limited (ABN 76 004 835 849, AFSL 240827). Franklin Templeton Australia Limited as Responsible Entity has appointed Martin Currie Australia as the fund manager of the Martin Currie Equity Income Fund (ARSN 150 751 821).

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Reece Birtles
Chief Investment Officer
Martin Currie

Reece is a Non-Executive Director of Martin Currie Investment Management Limited (MCIM). He is also a member of Martin Currie’s Executive Committee and Investment Executive Committee. Reece has held the role of Chief Investment Officer (CIO) of...

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