Lazard AM: Don't go all-in on stocks with extremely high yields

The decade of low interest rates may have forced income investors into the riskier side of the market, but the more recent rise in interest rates and inflation have kept them there.

There has been little choice in the matter when you think through the practicalities.

“If you’re not generating real income growth, if you’re just relying on fixed income or cash, inflation is going to eat away the dollars you earn every year and that’s simply untenable on a long time frame. 

So while we think people need a mix – I would not suggest someone is all equities – they definitely want to have it as part of the solution,” says Aaron Binsted, portfolio manager for the Lazard Defensive Australian Equity Fund.

But he cautions investors not to simply chase high-yielding stocks. It results in a more volatile portfolio. Not to mention, sometimes the highest yielders are not sustainable or not growing over time.

Some of the largest allocations in Binsted's team's portfolio don’t fall under the standard large-cap dividend darling status – and with good reason. He likes a broad mix of different income streams with different internal drivers across his portfolio – and two of his current picks may take you by surprise.

In this episode of The Pitch, Binsted discusses how income investors, like retirees, should approach equities for income, why a cash allocation is a permanent feature of his portfolio and balancing equity investments with the need to draw down assets. He also shares two dividend picks from metals and mining.

This interview was filmed Wednesday 8 May 2024.

Edited transcript

Why should retired investors maintain an allocation to Australian equities?

From our view, having equities in the mix is an absolute must. These days, people can be retired for upwards of 30 years. If you’re not generating real income growth, if you’re just relying on fixed income or cash, inflation is going to eat away the dollars you earn every year and that’s simply untenable over a long time frame.

So while we think people need a mix – I would not suggest someone is all equities – they definitely want to have it as part of the solution.

What characteristics should retired investors be looking for in their equity investments?

Often with income investing, people target a really high percentage yield and pile in on that. Our view is that can be quite a dangerous way to invest. Just targeting a high percentage yield can result in quite a volatile and risky portfolio. We do own some of those names, but we also want stocks that can grow their capital and income over time. We also want different types of stocks that are not all correlated - things that have different drivers as opposed to having a portfolio full of bond proxies for example. That's all going to work or not work at the same time.

A couple we bought late last year are Nickel Industries (ASX: NIC) and IGO (ASX: IGO) which owns a share in the Greenbushes lithium asset. They are more volatile businesses, but they are at the bottom of the cost curve. They are always going to be profitable and paying dividends. What's really attractive for us, is they are completely uncorrelated to most of the income stocks out there. At a portfolio level, they contribute really nicely because they move differently as opposed to loading up on stocks that either all work or don't work at the same time.

How can investors balance the need to invest in equities - which comes with higher risk - with their need to draw down for pensions?

This is crucial and one of the areas that we really pride ourselves in our defensive Australian equity strategy. It's in the name. One of the goals is to be defensive and defend capital. We do that through our stock selection and portfolio construction. They sound like fluffy motherhood statements, but they can really make a difference. 

Here is a tangible stat I can give you - this strategy has been managed for 12 years. In every negative month, the strategy has only participated in roughly about half the drawdown of the ASX 200. So we really are defending capital. 

If people do need to draw down, they're not selling at the bottom and it gives them a much more stable ride as they depend on that income to fund their lifestyle. 

Some of the larger holdings in the fund fall outside of the usual names people might hold for franked dividends. Why are you finding investing in these companies better for the Sharpe ratio?

You've hit on two really crucial areas and I think it's really important.

Firstly, we think targeting just the high percentage yield is not the right strategy. You need to be growing your capital base over time because if you're not growing your capital base, you're not growing your income stream. A lot of stocks that have a high percentage yield are not delivering that growth, and while we think they are part of the solution, you don't want to be completely loaded up on those stocks. So, just targeting a high percentage yield is risky.

Secondly, in terms of the type of Sharpe ratio that can be delivered, and the risk-return metric - people who are in the pension and pre-pension phase really care about risk. That's something we think is a differentiator for the defensive Australian equity strategy. 

The Sharpe ratio just measures your return relative to your standard deviation. Since inception, over the last three years, and over the last five years against the Australian share income peer group, we've had top decile Sharpe ratios. If you broaden that out and look at the whole Australian active share cohort or even the Australian Balanced Fund cohort, we've been in the top quartile over three years, five years and since inception. We think that is differentiated in terms of what we offer for end investors.

Why do you hold a cash allocation in the fund and would you ever be fully invested in equities?

The cash component is another kind of differentiator. In our view, firstly it is an equity fund and it has handsomely outperformed the benchmark since its inception. We really like to hold some cash for numerous reasons.

1. If valuations are really high and you're risking capital, you're not forced to be in there. We don't like chasing income and putting capital at risk.
2. Sometimes (arguably like now), you can almost get risk-free income from cash.
3. We see cash as an offensive weapon. When you see sell-offs in markets, be they small or large, you have that dry powder ready to take advantage to drive that next leg of income and capital growth.

What is one thing you'd like retired investors to keep in mind when it comes to investing in Australian equities?

One of the most crucial things to touch on is do not chase high percentage yield. Look at the growth in dollar incomes over time and focus on that, because that is what you're going to be living on - the dollars you receive, not the percentages.

Defence is the best form of attack

Aaron's Fund has historically provided capital growth and income that is consistent with the Index with less than half the drawdown, compared to the Index in negative markets. Find out more here.

Managed Fund

Lazard Defensive Australian Equity Fund

Australian Shares

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