It’s obvious. Retirees need income. With cash and fixed interest offering low yields, equities are a good place to look for income. On the surface, it may seem easy creating an income portfolio from shares – just select stocks from a list of high dividend yielders. However, setting up an income portfolio for retirees is harder than you think.

A high yield equity portfolio for retirees will certainly deliver higher income, however, it may put their other objective of capital preservation at risk. If risk is ignored, capital losses may outweigh the income delivered. For example, owning Telstra in 2015 delivered a 6% fully franked yield over the next twelve months, but investors lost 50% of their capital over the next three years. Who cares about the income when capital is destroyed.

So here is the challenge: how does one create a high yield portfolio while preserving capital in the most volatile asset class?

We know for a fact that delivering income is easy but capital preservation is hard (think about how your portfolio fared during the recent market correction in the last quarter of 2018).

Hence, retirees who want a more holistic retirement solution should have their income portfolios mitigate risk first - and only then screen for yield.

Step 1: Invest in low-risk stocks 

Capital preservation is the outcome of the stock selection process. There are several investment styles which may deliver good returns at certain times, but they may not be for the faint-hearted.

For example, chasing the latest momentum stocks (eg. Afterpay) where expensive stocks become even more expensive. Or bottom fishing for deep value companies (eg. Myer) where investors get lured into seemingly cheap companies with structurally challenged earnings. Both investment styles are very different, but they have something in common – they have a wide range of possible outcomes.

A low-risk investment style requires investing in quality companies with a margin of safety. To deliver the desired lower risk outcomes it’s critical to have a strong valuation framework. For example, high-quality companies can be poor investments if their valuations are very high, and lower quality companies can be good investments if their valuations are extremely cheap.

The art is understanding the balance between a company’s quality and the margin of safety required to make the investment. At Vertium we spend a great deal of our research time identifying whether the market may have overreacted or underreacted to company fundamentals.  

This low-risk investment style may not shoot the lights out in a raging bull market, but it will preserve capital better in bear markets. Given the recent share market correction, the following are a few stock suggestions for an income portfolio:

Amcor (AMC)

AMC is a global packaging company with a simple investment case. The merger with its US competitor, Bemis, will drive greater earnings growth and a stronger balance sheet.

Source: Vertium

The beauty is that the improved fundamentals can be bought on valuation multiples that are at five-year lows.

Source: FactSet

Caltex (CTX)

Caltex has undergone a significant change over the years. Two decades ago it was more of an oil refiner, but now most of its profits are derived from boring petrol retailing. The company still produces volatile refiner profits, but it currently represents only about 20% of total EBIT.

Like AMC, CTX’s valuation multiple is also trading at five-year lows.

Source: FactSet

At current prices a patient investor can own a cheap business with multiple value drivers to be realised over time:

1. Asset-rich company – property is worth about $2 billion and franking credits is worth around $1 billion,
2. Refining profits likely to rebound in the medium term given that global refining margins are at two-year lows,
3. And a free option on the growth delivered from its Ampol trading business

Boral (BLD)

BLD is a building materials company that is currently suffering from the effects of an economic slowdown. To minimise capital risk in the long term, the time to buy industrial cyclicals is in the midst of an earnings downgrade cycle.

The caveat is that there are no structural issues with the company or the industry as this could lead to value traps. Hence, if the reason for the earnings downgrades is the economic cycle then that will be the same reason for earnings upgrades when the cycle improves.

Boral’s PE is trading close to its 15-year lows, on downgraded earnings. The low PE multiple on downgraded earnings highlights that the market is not pricing in mid-cycle earnings.

Source: FactSet

Coronado Coal (CRN)

CRN is the fifth largest coking coal producer in the world. From a contrarian point of view CRN looks interesting for the following reasons:

1. It floated at the bottom end of its IPO price range at $4 in October 2018
2. Vendors sold down to the minimum amount (20%) because of subdued demand. Hence, they have significant skin in the game.
3. In its pre-IPO documents, it had net debt of $500 million; while at IPO the company had no debt
4. The stock price collapsed by about 30% from its IPO price to its December 2018 lows.

The low share price highlights weak investor confidence despite the coking coal price being relative resilient. At current prices, the company is one of the cheapest stock on the market trading at 3x EV/EBITDA multiple.

Of course, CRN’s profits are hostage to coking coal prices. The bears may say that the company trades at a low multiple because of peak earnings at cyclically high coking coal prices.

On the other hand, the bulls may argue that coking coal prices are structurally higher because of the war on climate change, which has resulted in a reduction of global supply.

For example, China has curtailed coal supply to (i) reduce pollution and (ii) engineer high prices to help their Coal SOEs reduce their high levels of debt. Furthermore, western world banks are withdrawing funding from coal companies, which makes it harder to increase supply when prices are high.

While we are not bullish on coal demand, we think the market may have underestimated the positive structural issues around reduced long term coal supply.

Ausnet Services (AST)

Historically, periods of falling bond yields have coincided with yields compressing (stock price rising) for defensive stocks. This year, though, Australian bond yields have fallen but strangely the yields for some defensive stocks have risen. AST, a regulated utility, is one such defensive stock. It seems like the market is pricing AST in a 3.5% bond yield environment (like in 2014) even though the current bond yield is around 2.2% and, importantly, is falling due to a slowing economy.

Source: FactSet

Step 2: Screen for yield

Now for the easy bit – screen for yield.

Source: FactSet

Done!

Conclusion

The overarching goal for retirees is to ensure that their nest egg lasts throughout their retirement. Both high levels of income and capital preservation are essential ingredients to a retirement strategy. Hence, chasing income alone can lead to dangerous outcomes for retirees.

Bullet-proofing an equity income portfolio requires careful stock selection with a strong valuation framework. Given that capital preservation is harder to execute it should be a core focus early in the investment process.

Screening for yield should be performed later. The outcomes of such a process will lead to more consistent performance over time, and help avoid giant yield traps like Telstra in 2015.