Building a sustainable income portfolio

Since 2010 traditional blue-chip yield stocks have become notoriously unreliable for consistent income.

Take for example NAB's dividend, which peaked at $1.98 in FY 14 before being chopped to $1.66 and then $1.13 in the prior two financial years. That's a 42% pay cut compounded with a significant decline in the bank's share price. Meanwhile, Telstra and Woolworths' dividends are 48% and 32% lower, respectively, since peaking some five years ago.

This volatility of income underscores why it's critical for investors to assess the sustainability of cash flows when considering dividend stocks, especially now given the level of stimulus sloshing around the economy, according to Neil Margolis of Merlon Capital Partners and Michael O'Neill of Investors Mutual.

In this thematic, they break down what they look for in yield stocks, how they manage risks within their strategies, sectors they’re looking at today for income, and their top ex-20 ideas for sustainable dividends and capital growth.

Notes: Watch, read or listen to the discussion below. This episode was filmed on 23 September 2020.

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Edited transcript

Jessica Amir: Welcome to Buy, Hold, Sell brought to you by Livewire Markets. My name is Jessica Amir from Bell Direct. Today, we're talking about what investors should be thinking about when it comes to building a sustainable portfolio of dividend stocks. I'm joined by Michael O'Neill from Investors Mutual and Neil Margolis from Merlon Capital. 

Gents, to kick off with, let's think about the Top 20. So we've got banks, we've got Woollies, Telstra. Now, their dividends have been quite volatile over the past 10 years. Although, in terms of growth the stocks, looking at the ASX20, they've gone up about 25%, but there's so many challenges. We've got the pandemic and technological change. What do you guys see are the biggest challenges or the biggest obstacles driving dividends lower? Let's start with you.

Neil Margolis: We don't think about it as top 20 or ex-20. I think one of the problems with the Australian market is it's quite concentrated in some big stocks. So with News Corp, people might forget News Corp was the biggest stock before the tech bubble and then you had the miners, very large part of the index. Then you had the banks and there's a lot of concentration. And particularly, the miners and the banks are quite macro sensitive and that causes volatility in the dividends.

So we prefer a non-benchmark approach where we think the hundredth biggest company is as important as the biggest and equal opportunity. And that's why our portfolios, we could own the very big stocks, but only if they offer sustainable dividends. Otherwise, we're happy to own ex-20 stocks.

Jessica Amir: What about you, Michael?

Michael O'Neill: Neil makes some good points and really the impact on dividends depends on the industry and by company. The banks obviously have had some very big structural impediments to their dividends, whether it's through falling rates, falling fees, rising remediation costs, and rising capital requirements. And we're heading into a loan lifecycle now, which compounds things. Telstra certainly has had some headwinds with the rollout of the NBN. It's a structural issue. And, equally, Woolworths has seen Aldi as a new entrant. Funnily enough, Woolworths is one of the few beneficiaries of the pressures of COVID through their transition to online shopping. 

But the one thing I would say stepping back is when you look across the boards of ASX companies, there's been a lot of conservatism, whether it is in paying out dividends in the short run, retaining or raising capital. So we do see a lot of potential for recovery in the dividends of non-bank industrial stocks.

Why iron-ore linked stocks aren't a good income bet

Jessica Amir: And Mike, we mentioned paying out dividends, the biggest payers of dividends, and now mining stocks have changed the dynamics completely. But I've noticed that both of you gents actually don't hold diversified miners in your top 10 holdings. Michael, let's start with you. Why is that?

Michael O'Neill: Well, we don't see diversified miners as an appropriate place at the moment for a few reasons. First of all, we're seeing unsustainably high commodity prices, particularly in iron ore. So, if iron ore prices correct, and certainly when the supply-demand imbalance works itself out, when supply returns, we see those dividends as vulnerable. 

We do accept that these are better companies than they were in the past because they've raised their capital, improved their balance sheet, and increased their dividends. But at the same time, if you're investing for income, you've got to think about the volatility of your capital base going forward because commodity stocks follow commodity prices. So we think we don't need to take that level of volatility.

Jessica Amir: And what about you, Neil? Why do you think it's not appropriate to hold diversified miners?

Neil Margolis: Yeah, well, actually I think it's because the diversified miners, BHP and Rio Tinto, they're not that diversified. They're predominantly iron ore players, as Michael mentioned. Iron ore prices are very high relative to the cost of producing iron ore. And as Michael said, there are temporary reasons why that the supply in Brazil has come back due to COVID and the dam wall issues. That's not sustainable. 

But having said that, outside of iron ore, we actually hold more investments in mining stocks than we've ever held. We've increased our weighting in oil stocks. Oil has obviously been quite heavily impacted by demand from COVID. But in contrast to iron ore, the Australian oil producers are quite low cost, the American producers are quite high costs. They're hurting much more. They're probably going to exit the market.

So we think there's going to be upside risk to oil as demand recovers, and because there'll be some underinvestment. We've also, for the first time, invested in aluminium, a little bit of copper as well. So I think iron ore looks unsustainably high, but I think there are some opportunities in other mining stocks at present where commodity prices are temporarily depressed due to demand and underinvestment.

Value in the ex-20

Jessica Amir: Neil, we'll stay on you. When it comes to opportunities for income ex-top 20, what percentage of your portfolio makes up income stocks?

Neil Margolis: Our portfolio is about 85% different from the index because we don't start with the index. As I said, if the top 10 stocks were very out of favour and undervalued and had limited downside risk, we'd own all top 10 stocks. But at the moment, we've gravitated probably a bit more outside the top 20. 

In times of crisis, but just like we saw in the GFC, the market tends to hide in bigger stocks and that pushes the valuations a little bit higher. So this whole low interest rate environment has increased the valuations of very large stocks. So you can never put a blanket over it, but as a general rule, the very large stocks are a bit more expensive relative to the smaller stocks than they have been.

Jessica Amir: So what percentage of your portfolio is income?

Neil Margolis: Probably more than 80%.

Jessica Amir: And Michael, what about you, the portion of your portfolio for income?

Michael O'Neill: We've got at least 75% of our portfolio dedicated to income stocks. Again, I mean, on a similar thread, we see the index is not a natural default for an income investor because of the concentration in banks and resource stocks. We see better risk-return opportunities when we step out and look at the ex-20, non-bank industrial part of the market.

Screening for sustainable income

Jessica Amir: Michael, in saying that, how are you actually screening for income stocks that make up that 75% of your portfolio?

Michael O'Neill: So in the first instance, we try and get the stocks right in terms of a strong franchise, balance sheet and cash flow to provide that sustainable income base. So that means we steer away from the cyclicals towards the defensive sectors, whether it's packaging, utility, staples, and healthcare stocks. 

And at the same time, we do screen out some parts of the market, whether it's the speculative companies, the companies whose earnings are being held up by short term themes, particularly at the moment with the level of stimulus in the market, which is propping up the retail sector. 

We do steer away from sectors with overcapacity. So, importantly, the office REIT market is seeing overcapacity. And finally, we're very wary of companies whose industry is operating at peak cycle margins. Again, the iron ore miners are the best example.

Jessica Amir: Thanks, Michael, what about you, Neil, seeking income stocks. What are your metrics?

Neil Margolis: Look, sustainable, what does sustainable dividend mean? It actually means once you receive a dividend, your capital value is preserved, and ideally grows. Sustainable dividends by definition can only be paid out of sustainable cash flow. So that's our focus - what is sustainable cash flow? We try and take in as much history as we can. We don't like investing when we don't have at least 10 years' history. We try and normalise for the macro environment, whether it's inflated or depressed. We want to understand the industry and whether that's changing the company's position. But, importantly, identifying sustainable cash flow and valuing it is only the first half. The other half is combining that with when expectations are very low.

So we think a good investment that will pay sustainable dividends is one where the sustainable cash flow is under-appreciated but the market is overly pessimistic. And by doing that, we look at not just the central case valuation, but the worst-case outcome for the stock. And often that's already been priced in, and those are the best opportunities for us to get dividends and capital growth.

Managing risks when income investing

Jessica Amir: So you mentioned the worst-case scenario. What about risk? How are you managing risk?

Neil Margolis: Yeah. Well, I guess, the first starting point for risk is actually buying companies that you believe are undervalued. That's a good starting point rather than just investing in the index. And the second element of risk is buying companies where the share price is trading at the bottom end of a range of valuations that assumes a really bad outcome. 

And then there's a third level of risk, which we do inside the fund, which is actually we use derivatives to reduce the overall risk by about a third over and above what our stocks are doing. And we do that by selling call options and buying put options or buying insurance. And the objective is that, if every stock in the market had a full 10%, the fund would fall 7%. So we're trying to move about 30% of the risk. 

Why do we do this? Because we're trying to give investors access to the fully franked yield on 100% of the portfolio, but only have 70% of their capital at risk. And that's, I guess, the objective of the income portfolio.

Jessica Amir: Thanks, Neil. Over to you, Michael. In terms of managing risk, what are you doing?

Michael O'Neill: We agree with Neil. The first thing you need to do is get your stocks right. You need to focus on quality and value to protect your capital base. We do use options as well. So we take a bit more of a diversified approach to income starting with dividends, but then also using options to add to income, particularly at a time like now where volatility is higher and where dividends are uncertain. 

We also avoid swapping capital for income, which can be a trap if you're using systematic strategies that strip dividends, or if you're using higher turnover option strategies. And the last thing we would always avoid doing is gearing or shorting our portfolio using options because we never want to be a forced buyer or seller of stock.

Jessica Amir: Michael, let's stay on you for last but definitely not least. What's your best pick for a sustainable dividend?

2 ex-20 stock ideas for sustainable income and capital growth

Michael O'Neill: So we think AusNet Services (ASX:AST) has probably the best characteristics in terms of sustainable dividend. It's got a yield of about 5.5%. It is 50% franked and it's growing at 2% to 3% per annum. Now, it's an essential energy infrastructure provider. Their returns are guaranteed on five-year windows with smoothing by the energy regulator. They don't take much in the way of credit risk and they also have some growth in their transmission asset base, as we see incremental new renewable providers attached to the grid.

Jessica Amir: Nice. Thank you. And what about you, Neil? What's your big pick?

Neil Margolis: I'll give you something maybe a little more controversial. So IOOF, which has just bought MLC from NAB for a pretty big price, the market value of the company is actually lower than it was before they bought that transaction, which roughly doubled the earnings. 

And so to put it simply, IOOF paid a 45 cent dividend last year. And we think they can get back to 45 cents in three years time, but obviously on more shares on issue, but the stock share price is around $3. So when you include franking credits, that's a 15% to 20% yield. That's assuming flawless execution. I mean, MLC is a difficult business to integrate, but having said that, the old adage, if you bought something from National Australia Bank, you're probably getting a good business and at a good price. 

So I think we're happy to think that, that is one where you could get a really good dividend and some good capital growth out of it. But it's certainly unpopular. But to our theme, you're combining valuation with low expectations, I think is the key to getting the dividend and some capital growth.

Jessica Amir: And there you have it. Thinking outside of the square to get capital growth and dividends might just be the trick.

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