Since the Tyndall Australian Share Income Fund’s inception in 2008, it has maintained a leading position against income-focused funds in the category, with the fund described by Morningstar as having “consistently excellent execution.” The Tyndall Australian Share Income Fund is characterised by Tyndall’s value focus but with a distinct income bias. The portfolio typically holds 40–70 stocks, which aids diversification. Turnover has been between 40% and 70% per year, supporting a tax-conscious strategy.

“We are incredibly proud of this recognition of the Fund’s success in continuing to deliver positive alpha relative to the category benchmark index. Our investment team is specialised and collaborative and our true to label products ensure there are no surprises for clients. It’s a strong validation of our team’s relative value approach to delivering an income stream for clients over the long term,” said Malcolm Whitten, Portfolio Manager for Tyndall AM.

The Fund’s straightforward bottom-up analysis seeks out stocks offering the best value on an internal rate of return (IRR) basis. In addition to scrutinising financial data, the Fund also conducts thorough industry and risk analysis, a holistic research approach favoured in market. The approach has been recognised as clear, robust and repeatable.

“Our strategy allows us to build portfolios with diversified sources of high dividend-paying stocks and helps to produce lower volatility returns versus the S&P/ASX200 Index over the life of the Fund,” commented Michael Maughan, Portfolio Manager and Senior Analyst for Tyndall AM.

The Fund is co-managed by Malcolm Whitten and Michael Maughan. Both Whitten and Maughan have more than 20 years of industry experience with complementary skill sets and run the portfolio collaboratively. The two are backed by an 11-person investment team, including Tyndall AM’s Head of Australian Equities, Brad Potter.

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The dividend drought has broken – green shoots emerging for dividends.

Dividends have recovered a third of what they were pre-COVID-19, but as the economy bounces-back, these should return to prior levels, making income generation from equity income funds look attractive compared to bonds.

Growth in dividends set to return

Earnings expectations have recovered half of the COVID-19 decline while dividend expectations have recovered only a third due to current conservative dividend payout ratios. Payouts should rise as the economy re-opens, confidence increases, and earnings recover. Combined with rising earnings, distributions in the hands of shareholders should increase, and as a result income generation from a diversified equity income fund looks attractive compared to bonds.

The journey last year was an adventure. It is worth reflecting on what happened to prices, earnings, payout ratios, and dividends.

The Australian market declined sharply from a February 20 high of 7160 to a low of 4536 and has since recovered to just shy of 7000 in early April 2021. The decline was driven by fears and the uncertainty of the extent of the medical crisis and the economic consequence of isolation and social distancing measures intended to slow the contagious new COVID-19 virus. The severity of the share price moves has largely been a function of the sensitivity to the shut-down. The recovery rally has been driven by responsive health policies, Reserve Bank monetary policy, Federal government fiscal policy, and community acknowledgement of risk. Together these succeeded in cushioning the Australian economy from the negative effects of COVID-19. Through a combination of good policy and good luck, Australia has weathered the crisis better than most nations.

Now to the potential longer-lasting economic and financial effects of policies intended to counter the detrimental effects of COVID-19. Top of the list is greater government indebtedness, input price rises (the costs that go into producing a good or service), and consequence of rising real rates (the interest rate that takes inflation into account).  Markets are now reflecting the potential longer-lasting economic and financial effects of these policies.

How sustainable is the recovery?

What then is the future durability of the cash flow, earnings, and dividend recovery? Across the market, cash preservation strategies in response to the shutdown went deep, well beyond dividend suspension and cuts.  Temporary reduction in advertising, brand promotion, and travel expense are less likely to face a spending catch-up.  Less discretionary and longer-term commitments that temporarily conserved cash included delayed capital expenditure (CapEx), maintenance CapEx, releasing cash through running down inventory are more likely to be re-activated and be a drag on available cash and consequently limit future dividend payments and payout ratios.

At face value, the broad recovery in dividend payments reflected improving operating conditions as the economy has re-opened. The dividend payout ratio observed at the February company reporting season remained low versus history and reflected a cautious stance.  Future durability of the cash flow and earnings rebound is a key question for investors as they shape the dividend yield expectations for the year ahead.  The recent company reporting season was notable for the high percentage of earnings beats vs misses and the rebound in dividend payouts. Australian market consensus earnings per share for the next 12 months declined 20% due to COVID-19 and held this depressed level of expectations through to September 2020 when the earnings recovery commenced.  Earnings expectations have risen and just eclipsed their pre-COVID-19 level. The recovery was due to emerging optimism regarding vaccine candidates, clarity regarding the US election result with victory to President Biden with a clear majority, and a growing recognition of the success in health and economic policy packages in containing the virus and economic effects of the shutdown.

Whilst the broad market aggregate earnings expectations have recovered the drop, the composition in terms of timing, depth of trough, and extent of rebound differed by market segment.

Similarly, for dividend expectations over the next 12 months, the extent of the dividend drought and subsequent recovery reflects industry-specific forces.

The summary tables below show the change in indexed earnings and dividends from February 2020 before the crisis, the trough, and subsequent recovery. Dividend payout ratios show their lowest point, most recent level as well as the prevailing payout ratio pre-COVID-19.

The earnings decline and recovery

Each of the major market segments suffered earnings expectation declines of 17-23% from February 2020 with growing recognition that COVID-19 would have global consequences.

The first segment to recover was Resources in August 2020 and is the only sub-segment to re-take pre-COVID earnings levels and exceed pre-COVID-19 levels. Earnings expectations for the year ahead are now 32% higher than before COVID-19.

The resources sector performance has been driven by a powerful rally in the iron ore price due to ongoing COVID-19 related supply disruption in Brazil, combined with ongoing strong demand from China as they entered and emerged from the pandemic crisis earlier. A re-opening rally in the broader commodities sector including aluminium, copper, nickel, and oil has also contributed to positive resource sector earnings.

The Bank earnings expectations had been weak leading into February 2020 and fell an additional 23% in April 2020 due to COVID-19. The Bank downgrades were in anticipation of compressed net interest margin (NIM), expectations of rising bad debts, remediation charges, and charges against earnings for anticipated forward provisioning of loan losses.

Bank earnings expectations remained depressed from lows in May through to October and have since retraced 8% of the downgrades. It is noteworthy that earnings expectations remain 15% below pre-COVID-19 levels with the least amount of recovery.

The dividend decline and recovery

The bluntest assessment of the impact of COVID-19 and the subsequent re-opening show consensus S&P/ASX 200 Index dividend per share expectations for the next 12 months bottomed in August 2020 having progressively declined 26% from a year earlier.

The estimated deeper dividend decline than that of the earnings decline of 20% reflected a cut to the dividend payout ratio for the same period. The subsequent recovery in earnings and dividends has not yet seen an equivalent recovery in payout ratio. The lag in payout ratio recovery is illustrated in Chart 1 where the dotted dividend index lines have not caught back up to the solid earnings index lines.  The varying degree of separation for each market segment is reflective of the change in payout ratio.

Each of the broad market segments except Resources shows the dotted dividend lines below their equivalent earnings indicative of lower payouts than before COVID-19.  The rising slope since August 2020 of most of the dividend series greater than earnings suggests that a recovery in payout ratios has commenced. The notable exception to this broad improvement in payouts is Real Estate Investment Trusts (REITs) where dividend expectations slid sequentially over 2020 and are now 39% below pre-COVID-19 levels.

Retail-based asset exposure within REITs face a period of downward rental reset risk. Combined with unsustainable payout ratios, and commitments to prioritize debt reduction, these factors have seen dividend expectations continue to fall, while the rest of the market earnings and dividends have begun to recover.

Office asset rent expectations have been reset lower with uncertainty regarding occupancy as CBD businesses re-configure for ongoing greater propensity to work from home. Office re-leasing spreads have opened, and incentives have been pushed out to cycle highs. The construction of new capacity has been delayed. Despite observed strength in direct market transactions, the listed market faces strong earnings headwinds.

The larger dividend payout picture is shown explicitly in Chart 2 which aggregates the rolling earnings and dividends over the last twelve months from pre-COVID to the conclusion of the February reporting season.  A feature of the most recent February 2021 reporting season was one of a greater increase in dividends than earnings. Share price response to the positive dividend surprise was greater than that to earnings with the market seeming to have already anticipated the earnings strength.

Boardroom confidence in the re-opening has been signalled through raising dividends. This has been well received and suggests higher dividend payouts in the future.  Forward-looking indicators of business confidence such as the NAB Business and Roy Morgan Business Confidence survey have shown rapid improvement to multi-year highs in business confidence which is also supportive of increased dividend payout ratios.

In July 2020 APRA restricted bank payouts to 50% of earnings to preserve capital due to the COVID-19 crisis. The effect of this is shown in Chart 2 with bank payouts falling the most from 85% to a low of 60%. This exceeded the limit due to the restriction being applied after CBA had already gone ex-dividend and being in force for only 5 months.  The bank dividend restriction was lifted in December 2020 with APRA pointing to evidence that suspended loan repayments under emergency relief waivers have rapidly recommenced repayments.

The APRA action was a precautionary and temporary reduction in the bank sector payout ratio. This payout ratio should rise in the future in an environment of rebounding economic growth, robust housing loan growth, and benign defaults.  The timing of a reversal in additional provisions taken in the face of COVID-19 is uncertain.  A reversal in the precautionary provisions will boost reported earnings for the Banks.

Dividends for Resources have eclipsed their pre-COVID-19 levels. The payout ratio is already at a historically high level and less likely to increase further. Future resource dividend resilience, therefore, depends on the prevailing high commodity prices and earnings being sustained. Transitory COVID-19 supply interruptions to production in Brazil ending and new iron ore mines sponsored by the Chinese could release some tension in that market, with the latter being many years out.

The 73% payout ratio of the Non-Bank Industrials has been remarkably stable in comparison to the other segments. This group is more numerous and diversified across the industry admittedly with winners and losers from the lock-down.  The meagre rise in expected earnings and dividends also reflects the many crosscurrents to the different industries within the Non-Bank-Industrials sector.  For example, the re-opening and stimulus upswing in detached housing-related companies is offset by a retreat in activity from stay-at-home winners, such as consumer staples and some discretionary retail.

Path of dividend yields and outlook

The historical path of expected dividend yields is shown for the market and major segments since March 2018 in Chart 3.

The longer-term downtrend in dividend yield has followed a greater reach for yield trade. Aside from the apparent blow-out during the worst of the March – April 2020 sell-off, combined with lagging updates to estimates and Resource earnings, the overall trend has also been for a narrowing in dividend yield. Differentiated portfolio positioning on yield alone is more challenging as yields converge.

The net effect of the potent share price rally since November 2020, and partial recovery in dividends has seen the expected dividend yields compress back to 3.7% at March 2021.

Investors should take note of the strong price gains which have far exceeded the recovery in earnings and caused compression in most dividend yields. The dividend yield of Resources currently leads the other market segments but is reliant on an iron ore price which is far above the industry cost curve and provides unprecedented incentive to add production capacity.

Portfolio positioning

A ‘goldilocks’ scenario of re-opening driven earnings growth, interest rate normalization without an inflation/wage-price spiral seem necessary conditions to support the current pricing regime.  The Nikko AM Australian Share Income Fund (Income Fund) has continued to be run with the aim  to generate of generating a yield above that of the market and consistent with our comparative value analysis (CVA).

A valuation distortion brought by fears of the economic impact, a flight to safety , and a ‘stay-at-home’ focus has unwound rapidly.  The outperformance of ‘Value’ over ‘Growth’ has seen the market recover much of the 2020 lost ground.

The market recovery has been predicated on the ‘Goldilocks’ recovery. If consensus is that Goldilocks continues, any contrary evidence would see cracks appear in the recovery which would likely be volatile. This could happen with increases in virus cases and reluctance of the population to vaccinate due to blood-clot concerns.

Possible challenges to the consensus may come from delays in vaccinations, outbreaks of new virus strains, and policy stimulus withdrawal impacting growth. Alternative risks from the economy running too hot are an inflation breakout and an interest rate driven reset in asset prices.

In recognition of the potential for higher volatility, risk in the portfolio has been reduced.

We believe that opportunities remain to reflect our valuation process and the income objective in our Income Fund. To this end and in the spirit of transparency, a summary of our portfolio actions follows.

Actions over the last quarter

Bank exposure has rotated out of the more expensive CBA into relatively cheaper Australia & New Zealand Banking Group (ASX:ANZ), National Australia Bank (ASX: NAB), and Westpac (ASX:WBC).  Position size in Virgin Money UK (ASX:VUK) has been reduced as the gap to our assessed valuation has narrowed.

Our patience in a baseline assumption of the oil market normalizing enabled us to ride out the worst of the oil price moves and we gladly supported calls during the crisis and with the subsequent rally, sold some of the position at higher levels. The subsequent rally in Energy names provided an opportunity to take profits.

Within the defensive Retail names, we have taken profits reducing Wesfarmers (ASX:WES) and Woolworths (ASX:WOW) and bought into Coles (ASX:COL) which has been seemingly oversold in the re-opening trade and offers both valuation and dividend yield appeal.

A rotation within our Insurance positions to better reflect our assessed valuation and spread risk over three names: Insurance Australia Group (ASX:IAG), QBE Insurance Group (ASX:QBE), and Suncorp Group (ASX:SUN), rather than just Suncorp.  Although the current yields are lower, the valuation gaps are greater. Each should benefit from higher investment returns on capital reserves.

Within the Utility/Infrastructure space, we have commenced recycling highly regulated returns with low growth into less regulated higher growth. Examples of this would be selling Spark Infrastructure (ASX:SKI) into less bond-sensitive APA Group (ASX:APA), and Transurban (ASX:TCL) with the ability to inflate toll charges.

The Income Funds’ exposure to Resources has been reduced taking profits in Deterra Royalties (ASX:DRR) and reducing BHP Group (ASX:BHP) ex-dividend to reduce downside risk to iron ore. Despite the spot iron ore price resilience, we do not expect the price to hold longer-term.

The Income Fund re-entered CSL (ASX:CSL) via a buy-write (a relatively low-risk options position owning the underlying security while writing options on it) which has growth attributes longer term. This has reduced portfolio risk-reducing underweight in Healthcare with income generated from the option premium.

Conclusion

Australia has been very fortunate to have acted promptly to isolate and support those companies and individuals most affected.  The dividend drought has broken. Resolve to ride out the COVID-19 episode and stick to process has carried the Income Fund well.

The composition of the market dividend yield stands at approximately 1/3 Resources. 1/3 Banks and 1/3 Non-bank Industrials. There is downside risk to Resources earnings and dividends, upside risk to Bank earnings and dividends, and a flat outlook for Non-Bank Industrials.

The outlook for equity market dividend income looks balanced and attractive at the current level of 3.7%.  The rapid and deep cuts to dividend payout in response to the crisis leave good scope for future dividend payout recovery. This sets a positive outlook for future equity portfolio income generation.

A diversified equity income portfolio can continue to provide a superior yield to 10-year government bonds which are currently yielding 1.8%.  Growth in an equity income portfolio vs bonds is desirable to mitigate longevity and inflation risks.

We remain confident in meeting the rolling 5-year income objective of a grossed-up dividend yield greater than the S&P/ASX 200 Yield with an additional positive contribution to long-term capital growth from our active investment process.

By Malcolm Whitten, Portfolio Manager and Senior Analyst

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“Investors seeking yield will need to adjust their approaches”: Tyndall

At a time of record-low interest rates, chasing high-yield stocks has almost become a national pastime for income hungry investors, with the Australian share market providing attractive dividend yields and concentration of high-yielding sectors.

However, Malcolm Whitten, portfolio manager at Tyndall AM, says income-hungry investors may need to focus more on total shareholder returns to find better value, as quantitative easing and a lower interest rate environment comes to an end.

“The quantitative easing around the world has been a significant driver of global and Australian equities as investors sought higher-yielding stocks as a source of income in the face of low interest rates,” Mr Whitten said.

“But things are starting to change and investors seeking yield will need to adjust their approaches.

“While the focus lately has been primarily on the dividend yield from shares, investors can find better value and more investment opportunities by looking at the total shareholder return.

“For example, companies can increase returns to shareholders by increasing dividends, undertaking share buy-backs and successfully reinvesting in the business. Understanding a company’s future operating cashflow and capital expenditure plans are good ways to ascertain a company’s capacity to return money to shareholders,” he said.

“The strength of a company’s balance sheet, particularly gearing levels, as well as franking levels and pay-out ratios are important indicators of the sustainability of a company’s earnings and dividend stream.”

Mr Whitten added that, with interest rates very low, rate increases delayed and equities having staged a strong rally, it’s hard to see high expected returns in any asset class in the near term.

“However, while returns from equities may be lower than we have recently experienced, they should continue to provide investors with a reliable income source and the potential for some capital growth, as long as investors actively manage their portfolios.

“Actively managed portfolios are more dynamic as they allow investors to respond to changes in market circumstances, as well as helping reduce concentration risk.

“Traditional high-yielding stocks have been key drivers of the strong dividend growth, such as the banks which contributed 36% to all dividends paid in the 2013 financial year, up from 24% five years ago.

“However, at Tyndall all of our Australian share portfolios have reduced their weighting in banks as we feel that, after their incredible run, they are now overvalued.

“Furthermore, such a high contribution from one sector highlights concentration risk in the Australian share market.

“Investors beholden to hold the same stock weightings as the index are potentially exposing their portfolio to concentration risk.

“Within the four traditional high-yielding sectors in the Index (banks, telecommunication services, REITs and consumer staples), just eight ‘high-yielding’ stocks account for around 40% of the Index. The eight stocks are Commonwealth Bank, Westpac, ANZ, National Australia Bank, Telstra, Wesfarmers, Woolworths and Westfield Group.

“While these stocks have delivered marvellous returns and income to investors over the past 12 months, there is a risk that the current attraction of these high-yielding stocks will wane when quantitative easing comes to an end and bond yields rise.“The telecommunication services, gaming, banks and healthcare stocks are all sitting at the top-end of their long-term PE averages and are thus expensive compared to their historical average,” he said.

Mr Whitten said that three alternative income stock names to the banks are Woodside Petroleum, Woolworths and Wotif.com.

“All three stocks returned a significant amount of cash to investors in FY2013 via dividends. Woodside returned 43% of its cashflow to investors, Woolworths returned 46% and Wotif.com returned a very pleasing 84%.

“In addition, Woodside Petroleum and Woolworths continued to invest the remaining balance of their cashflow in their business (57% and 54% respectively) – to provide for future dividends to their shareholders,” Mr Whitten said.

Tyndall AM is an award-winning Australian investment manager, specialising in Australian shares, international shares, Australian fixed interest, international fixed interest and alternative assets.

As at 30 June 2013, Tyndall AM’s investment teams manage approximately A$23 billion in funds on behalf of retail and institutional investors, private clients, superannuation funds and charitable trusts.

Tyndall AM is owned by Nikko Asset Management Co., Ltd. (Nikko AM), a leading asset management company headquartered in Asia, with more than A$169 billion in funds under management (as at 30 June 2013).

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Looking beyond dividends may increase opportunities.

The demand for yield has stretched valuations of traditional high-yielding stocks. Malcolm Whitten, Portfolio Manager at Tyndall AM explains that looking at the total return to shareholders, not just the dividend, may help investors find better opportunities.

Record low bond yields and low interest rates on term deposits have been enticing investors into higher-yielding stocks.

Banks and telecommunications stocks have been major beneficiaries of this trend. In the process these sectors have become expensive with 12-month forward PEs now running at around the top-end of their ten-year average at 15 times. Where can investors find that much-needed income stream but not risk overpaying for it?

Non-traditional sectors also offer attractive yields

In an investment portfolio that is actively managed, diversification and risk management are paramount. In a share income portfolio, banking, telecommunications services and utilities companies will tend to have a large representation. Other sectors can also offer sustainable income opportunities.

Tyndall’s intrinsic value investment process identified a number of quality companies, beyond the traditional high-income sectors, which made a strong contribution to the Tyndall Australian Share Income Fund’s (‘Fund’) performance over the past year, both in respect of dividend yield and total return. These included holdings in such diverse names as Dulux Group, Woolworths, Woodside Petroleum, Henderson Group, Wotif.com and IAG.

Since its inception in November 2008, the Fund has delivered a total return of 10.7% p.a. (after fees), comprising a growth return of 5.8% p.a. and a distribution return of 4.9% p.a. (as at 31 August 2013). When including franking credits, the Fund’s holdings produced a grossed up dividend yield of 8.6% p.a. over the same period. Past performance is not an indicator of future performance.

Looking beyond the headline number

In achieving these returns, Tyndall doesn’t just focus on the headline dividend yield. It focuses on sustainable yields, earnings growth and potential capital appreciation using an intrinsic value process. The strength of a company’s balance sheet, particularly gearing levels, as well as franking levels and pay-out ratios are important indicators of the sustainability of a company’s earnings and dividend stream.

Understanding a company’s future operating cashflow and capital expenditure plans are a good way to ascertain the company’s capacity to return money to shareholders.

The most notable feature over the past five years has been an increase in returns to shareholders at the expense of future investment. This has been achieved through increasing dividend payouts as a proportion of earnings, as well as greater use of share buy-backs.

The challenge for portfolio managers is to find companies with future growth in operating cashflow, healthy balance sheets and the confidence to increase returns to shareholders.

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Disclaimer: This article was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (“TIML”). The information contained in this document is of a general nature only and does not constitute personal advice. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual. The Tyndall Australian Share Income Fund ARSN 133 980 819 is issued by Tyndall Asset Management Limited ABN 34 002 542 038 AFSL No: 229664 (“TAML”). Investors should consult a financial adviser and the information contained in the current Product Disclosure Statement available at www.tyndall.com.au before deciding to invest. TIML and TAML are part of the Nikko AM Group.

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