A vast opportunity for sustainable income

Global equities are not normally known for high income, with the MSCI World ex Australia providing around a 2 per cent annual dividend yield. However, if one looks more closely, the global universe offers a vast opportunity set to search for sustainable income. This range of opportunities is simply not available domestically. This allows investors to diversify their industry, country and currency exposures away from the narrow Australian market which is dominated by banks and resource stocks. 

To give you an idea about these differences, let us just consider the top six income stocks in Australia versus the top six income stocks in the MSCI World ex Australia. In 2018, the top six Australian stocks – the big four banks, BHP and Telstra – represented almost half of all dividend income paid by all stocks in the ASX/S&P 200 Index. That is an incredible concentration of income in just a handful of names, and, in particular, in one industry - banking. Globally, it’s like chalk and cheese. The top six stocks represented less than 10% of the income of the MSCI World ex Australia, and only one of those names (HSBC) was a bank. The other five names were Apple, AT&T, Exxon Mobil, Microsoft and Verizon Communications, suggesting great diversification versus Australia’s top six stocks. 

 And, of course, the breadth of global income is huge compared to Australia. For example, domestically we track around 300 companies and 500 dividend events per year, whereas globally we track around 5,700 companies and over 10,000 dividend events. So, we believe global equity income provides great diversification benefits for Australian investment portfolios which have traditionally been focused on Australian equities.

How we add value

Rather than adopt a buy and hold strategy, our approach in dividend income investing is to opportunistically rotate our portfolio into stocks which are expected to pay dividends in the near future. This fits well with a global universe. Globally, many stocks pay dividends in any given month of the year, whereas domestically dividends tend to cluster around the reporting seasons in February and August. This means that globally there are always plenty of dividend opportunities for our dividend rotation strategy and we also can pay those dividends out to our investors on a monthly basis, which can be very useful for retirees replacing their previous monthly salary payments. Our research finds that many attractive dividend paying stocks tend to outperform in the lead up to their dividend ex-date, therefore we look for attractive opportunities in stocks about to pay dividends. Our value add is selecting the best dividend opportunities from a vast opportunity set.

Diversification and rotation

Given that diversification is a key benefit of investing globally, we try to ensure that we provide our investors with a well-diversified portfolio of global stocks. With Australian investors typically already having considerable exposure to the banking sector, we don’t believe adding a stack of high yielding banks and utilities will provide good diversification. So, we look to build a well-diversified portfolio of stocks across different industries and countries, and many of our portfolio construction rules seek to ensure good diversification. To ensure good stock-level diversification, we typically hold less than one percent in each investment.

One of the benefits or our dividend rotation strategy is that enables us to maintain good diversification whilst still generating good income. A static buy and hold income strategy has to invest in high yielding stocks to generate high income. This means that not only would the strategy be always overweight high yielding sectors like financials and utilities, but it would also always be underweight low yielding sectors like IT and Healthcare, industries which are poorly represented in the Australian equity market.

Where we're finding opportunities today

We are currently seeing plenty of good dividend opportunities in Continental Europe. Many European companies pay single annual dividends rather than two (interim and final, which is common in Australia, Japan and the UK) or quarterly dividends (US and Canadian companies). These big European dividend payments tend to cluster around March to May and this is where we typically generate the largest levels of dividends in our own fund distributions as we pay out these large dividends.

And what we're avoiding today

Avoiding stocks that don’t pay dividends is generally a good strategy. Our research has found that dividend paying stocks perform better than non-dividend payers, as dividends are a sign of sustainable earnings. In the US this isn’t always the case. For tax reasons (dividends tend to be more heavily taxed than capital gains in the US), many profitable US companies have never paid a dividend. Rather, they prefer to return cash to investors via on-market share buybacks. Interestingly we find the opposite in Australia. The proportion of stocks paying dividends backs this up, with 85% of the stocks we follow in Australia paying dividends in 2018, versus only 55% of US stocks.

The other things we try to avoid are dividend traps. Dividend traps are stocks that look like they pay attractive dividends, or at least they have in the past, but are expected to significantly cut or even completely omit their dividends in the future. As a yield investor it is incredibly important to avoid dividend traps, as not only will they pay less or even no income in the future, but the announcement of reduced dividends will likely negatively impact capital values. Avoiding dividend traps is a key to successful equity income investing.

Some potential pitfalls to keep an eye on

We have already discussed the importance of avoiding dividend traps, which is a pitfall of equity income investing be it domestic or global. At the asset class level, one also needs to be aware of the impact of currency on returns. Currency risk can be good or bad. In fact, for investors who are fully exposed to Australian dollar investments, having some offshore currency exposed assets is actually a good diversifier. If all your assets are denominated in Australian dollars, one is seriously impacted by a fall in the value of the Australian dollar. Having some exposure to overseas assets/currencies provides a good hedge against a weaker Australian currency. As one invests more in overseas assets, the risk of a rising Australian dollar (which reduces the value of those overseas assets) becomes more of a concern. Of course, if one could accurately forecast future movements in exchange rates, currency risk could be eliminated by actively hedging portfolios when one expects the Australian dollar to rise. Unfortunately, our experience suggests that forecasting future currency moves is extremely difficult.

Asset class returns

Given relatively stretched valuations, particularly in the US, and the recent strong share price growth in 2019 YTD, we would expect somewhat modest long-terms return expectations of around 5-7% p.a. We would expect long term returns of 8-10% p.a. if valuations were normal.

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As one of Livewire’s valued contributors, Plato Investment Management has committed to educating investors about income investing through this installment in the Livewire Income Series. 

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