Seek out: ‘Growers’, ‘Compounders’, ‘Cows’ and ‘Yielders’ to build income in 2018

Scott Kelly

Australian investors need to consider a higher allocation to Australian equities with strategies focused on sustainable and growing income generation to maximise income in 2018 and beyond according to DNR Capital portfolio manager Scott Kelly.

“Despite our underweight positions in the big 4 banks and Telstra the12-month forward yield of the DNR Capital Income Portfolio is currently around 6.3% including franking,” said Kelly.

“Assessing a company’s dividend sustainability and growth potential is the core focus of our Income Portfolio. We want to have reasonable certainty of a company’s underlying cash generation and dividend profile over the next 3-5 years,” said Kelly.

DNR Capital categorises income generating companies as the following:

• Growers: A company that is delivering below market income, however delivers above market income growth. For example, Macquarie Atlas Roads Group (MQA).
  Compounders: A company that is delivering an average market income, with sustainable above market income growth. For example, IPH Limited (IPH).
• Cows: A company with a solid balance sheet and capital management potential (i.e. – higher payout, special dividends, buybacks). For example, Caltex Australia Limited (CTX).
• Yielders: A company delivering above market income, however with minimal (or no) income growth. For example, National Australia Bank (NAB).

“Income investors can be attracted to high yielding companies on the stock market, however a high yielding company can often indicate structural or cyclical challenges and the potential for a dividend cut if it is not sustainable,” says Kelly.

“Whilst  yields of around 6% (excluding franking)  in the Media, Retail, Telecommunications and Bank sectors appear attractive, they are all facing significant structural challenges and indicate that both dividends and capital may be at risk:

• Media / Broadcasters stocks are facing substantial competition from Facebook, Twitter and Netflix;
• Retailers have to weather the entry of Amazon;
• Telecommunications face heightened competition in a post-NBN world and other technological advances; and
• Banks are facing an over-leveraged consumer, property headwinds, cyclically low bad debts, regulatory / political risks, as well as technological threats.”

The following chart shows the relative performance of the portfolios ‘Compounders’, ‘Cows’, ‘Growers’ and ‘Yielders’ (excluding franking) over the last 5 years, highlighting that a portfolio focused on yield alone would not have resulted in an optimal outcome for investors.

Growers: Gross dividend yield below the ASX200 Industrials Index with dividend yield growth above the ASX200 Industrials Index.

Compounders: Gross dividend yield within 1% of the ASX200 Industrials Index with dividend yield growth above the ASX200 Industrials Index.

Cows: Net Debt / EBITDA less than 1.5x and FCF yield above the ASX200 Industrials Index.

Yielders: Gross dividend yield above the ASX200 Industrials Index with no or declining dividend yield growth.

DNR: DNR Capital Australian Equities Income Portfolio XJI: S&P/ASX200 Industrials Accumulation Index