A critical question for income investors

The big iron ore miners have become unexpected favourites of income investors over the last few years. A combination of rising iron ore prices, a lack of new production coming to market, and reduced capex bills have seen miners return huge sums of cash to investors in the form of regular dividends, special dividends, and buybacks. But the share prices of these miners are clearly implying that these conditions are unsustainable.

“In the case of iron ore, ever since the price got above $100 people have been saying, "Oh, it's too high. It's going to come back.," Yet the price has continued to rally to above $200 a tonne now.” explained Peter Gardner, Senior Portfolio Manager at the Plato Australian Shares Income Fund.

Peter and the team at Plato don’t expect these conditions to last indefinitely, but the questions then are how long it lasts, and how long to stay invested. This challenge exemplifies the dual objectives that drive the team at Plato Investment Management – to generate income and protect clients’ capital. A job they take very seriously.

In this Q&A, Peter tells us why rates and inflation are important for investors to watch, and how one subset of companies may underperform in the years ahead.

Key facts about the Plato Australian Shares Income Fund:

• The fund aims to provide an annual gross yield (including franking) that exceeds the gross yield of the Benchmark after fees. It also aims to outperform the benchmark after fees.
• Since its inception in September 2011, the fund has produced an average of 9.4% p.a. of gross income (including franking credits) and a total return of 12.3% (including franking credits).
  
• The fund is targeting 8% gross yield in 2021.

What motivates you as an individual?

What motivates me most is wanting to get good investment outcomes for our clients. A bit of a boring answer, but we have a lot of retirees investing in our portfolios who entrust us with their life savings. In a lot of cases, they don't have the option of going back to work, so they are trusting us to do a good job in terms of producing a high level of income as well as outperforming the market. We take protecting our clients’ income and capital very seriously at Plato.

I’m also fortunate in that I’ve always loved learning new things and I’m in the right career for that, as its pretty much a pre-requisite in funds management.

Could you tell me about your background and how it shaped your investment philosophy?

The first thing to probably note about me is that I'm the son of two actuaries – they were actually the first married actuaries in Australia. If I'd have become an actuary, I would have been the first purebred actuary in Australia, which would be my claim to fame, except it never happened. You can imagine our family outings were very exciting as children with two actuaries as parents. But what that meant is that all five kids in my family have a mathematical bent, which definitely shapes my investment style.

At university, I studied actuarial studies and finance, but decided to move into the finance side, which I enjoyed more. Warren Buffet was one of my university lecturer’s idol, so that got me into Buffett, and I guess cemented my value bent.

Nowadays, I'd say I have a pragmatic value philosophy as after investing in the market for 15 year, you realise that a stock can be as good value as you like, but if its earnings keep on going down, or if it has earnings disappointments, then that's going to far outweigh the value of the stock.

So it's very important to get the earnings momentum correct. The advantage of having a value stock is that when the earnings disappoint they generally fall less than a growth stock. When a growth stock goes through that re-rating process, when it's no longer growing as fast as the market thought, it can de-rate from a P/E of 35 to a P/E of 25 for example. That results in a significant drop to its share price.

What is the investment topic, or theme, or idea that you and your team are debating at the moment?

Being income investors, a big investment topic for us is the sustainability of the income being paid by stocks that have done well over the last year. Currently it’s the iron ore miners and the consumer discretionary stocks. We've achieved a lot of capital growth and income over the last 12 months by investing in those stocks, but the question is how long will that last?

In the case of iron ore, ever since the price got above $100 people have been saying, "Oh, it's too high. It's going to come back." Yet the price has continued to rally to above $200 a tonne now. Through that time, we've maintained the view that the factors causing the iron ore price to be strong are still in place, so we've continued to hold them.

Fortescue is the cheapest stock on the market if the price remains at these levels. It's on a forecast dividend yield of something like 20% for next year. It’s paying out 80% of its earnings, so its P/E is around four using the current spot price. Consumer discretionary stocks have seen similar doubters, albeit not to the same extent.

We definitely don't think those trends will continue forever and neither does the market. The question is how much is priced in and how long will iron ore prices and retail sales remain strong.

Plato has said in the past that if a stock appears to yield over 10%, it's probably a dividend trap. Do you think that the iron ore miners are capable of yielding over 10%?

For the next 12 to 24 months, yes. Obviously it's not sustainable over the longer term, but yes, for the shorter term it is. So the question is, when does the cycle turn? We're very cognizant of looking at the factors coming out of China and the iron ore price, in particular, to work out how long these high prices are going to last.

What are your expectations for Brazilian production coming back online?

I don't have an expectation for when it's definitely going to happen. Our experience is that things always take longer than you think. So with the Samarco dam disaster, owned by BHP and Vale, it's only just come back to full production five years later. Miners often forecast after having issues that they'll be able to get production back quickly, but the reality is these things always take longer than you think. And Brazil has its own COVID situation.

For us, it's more a matter of waiting to see evidence that it's happening, as opposed to assuming that it's going to happen. So yes, Brazilian production will increase, but steel production is also going up and is likely to partially take care of that expected increase in iron ore production. We're not too worried right now, but it's definitely something we're looking out for.

Why is this issue so important and how is it impacting the way that you invest?

It’s important for us because our Australian Shares Income Fund has the dual objectives to maximise income and total returns. We don't want to just collect the last dividend while our capital is dropping significantly, because without the capital it's very hard to produce future dividends. With those dual objectives, it's really important to get the capital moves right as well as just getting income right.

Where are we in the market cycle at the moment?

I'd say we're in the optimistic phase. We went through pessimism with the COVID crisis. Then we went through scepticism when the governments did a lot of stimulus and the Fed and RBA printed a lot of money, but the market was still sceptical about the economic outlook given the health crisis. Now we've got the vaccine rollout occurring and life appears to be returning to normal in those jurisdictions. But there’s still a huge amount of stimulus in the market.

It's just unfathomable how much both money printing and government spending has been going on, and now we’re seeing further government stimulus coming out as well.

So, we think we're in that optimism phase where the economy can continue to be really strong for the next couple of years. There's definitely euphoria in some areas of the market, such as NFTs or cryptocurrencies potentially. But for equity markets, we're in optimism.

What’s the key thematic, or trend, or idea that you think is important for investors to get right over the next decade?

For us, it's inflation and the direction of interest rates. We're seeing the inflation rate ticking up at the moment, and the question is whether that's going to be short-term or whether it's a sign of something more permanent. There's definitely been a shift from both the RBA and the Fed and also the US and the Australian governments. They want more inflation, particularly wage inflation.

They've always wanted more wage inflation, but now I think they're more committed to seeing it happening and that's one of the reasons why I think the federal government has completely shifted the amount of stimulus they're willing to do even though the economy seems to be pretty much back on its feet. Are they going to be able to succeed? Have we moved into a world that's more financialised where we see asset driven inflation, but not consumer price inflation? But if we see sustained inflation and the Fed and the RBA don't initially try and stop it because they're willing to let it run for a while, then you may see it take more interest rate rises in order to get control, as inflation expectations rise.

Now, higher inflation is likely to flow through to higher bond yields and the direction of bond yields is incredibly important, because if you look at any kind of earnings discount models to value a company, you have the earnings of the company divided by the bond yield or the discount rate. So if those bond yields are increasing, that rising discount rate decreases the value of future earnings. 

The reason that's particularly important for investors is that if you own long-duration assets, that is, assets with high forecast growth, if those discount rates increase, that will have a bigger impact on their valuation.

You've already seen that recently with the growth stocks starting to underperform, particularly post-February as bond yields started to rally. And if those bond yields continue to rally, growth stocks are going to be much more challenged than value stocks. But alternatively, if inflation turns out to be temporary and rates go back down again, then you may see those growth stocks rally again. I think that's the biggest thing that investors have to get right, or at least control the risk of, in their portfolios.

What's a practical tip or piece of advice that you think can help investors to be more successful?

My big tip would be to not try to time markets as an individual. It's incredibly difficult. When you look at us experiencing the worst pandemic in a hundred years, and yet markets were up by the end of the year, it's inconceivable.

We think it's very difficult for individual investors to time markets. If you're an individual investor, I would advise you to have a buy and hold strategy, or trust a manager to do it for you.

Could you give us your pitch for one long-term investment idea?

Decarbonisation is a big trend in the market that we're going to see more over the next 20 years. We've done some research looking at decarbonisation around the world. If you look at Europe, when you control for stocks in the same industry, over the last 10 years since the European market has been pricing carbon effectively, you've seen stocks with high carbon intensity underperform stocks with low carbon intensity by about 40%. In the US there has been no such under-performance of high carbon intensity stocks, but carbon hasn't been priced in the US market over that time. So in the future if we see US and Australian governments price carbon effectively we are likely to see a similar result in those markets.

Peter Gardner

Senior Portfolio Manager

Plato Investment Management

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Managed Fund

Plato Australian Shares Income Fund

Australian Shares

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