The prospect of short-term dividend cuts highlights the danger of income investors relying on dividend yields alone, according to First Sentier Investors.
In an investor update, Head of Equity Income, Rudi Minbatiwala, said that focusing on yield is not enough to ensure sustainable long-term income from equities.
“The recent material dividend cuts across the market disappointed many income investors, and the coming reporting season remains uncertain. This highlights the limitations of an equity income strategy based yield alone, as that number doesn’t tell the full story about a stock’s delivery of income.
“A retiree’s world is all about long-term income defined as dollars, yet income strategies often focus on yield percentages: a short term concept focused on the current year’s dividends compared to the current share price. Then, when dividends are reduced significantly, it can create a lot of stress for investors who rely on that income for their lifestyle,” he said.
Mr Minbatiwala said First Sentier Investors’ equity income strategy is ‘yield agnostic’.
“We focus on earnings, which we believe will drive long term income. It’s actually longer term earnings growth that underpins dividend returns. So I’m not so worried about which companies will cut dividends in the near-term as much as which ones can generate long term income. This has always been true, but it’s even more apparent now that dividends are under pressure,” he said.
Mr Minbatiwala argues that the market downturn could even have some benefits.
“I would argue that some companies’ payout ratios have been too high. Now, they are motivated to hold back dividends to strengthen their balance sheets. It’s an opportunity to reset dividends to more appropriate level – especially in the context of greater uncertainty.”
The equity income strategy makes use of equity options to boost short term income and helps manage returns through volatile times.
“Income investors are generally seeking a smoother return path than what the equities market delivers. Our strategy can actually benefit from higher levels of volatility as this translates to higher income generation through selling call options.
“One way to think about it is that you don’t want volatility, so we sell some of it and convert it into an income stream, with the options income providing a cushion from the falling market. The other advantage is that it removes the handcuffs from a narrowly defined universe of only high-yield stocks, which are often in the same sectors and exposed to the same risks,” Mr Minbatiwala said.
Mr Minbatiwala said a focus on total return can also provide greater capital protection than a yield-centric strategy.
“Income investors are often retired and therefore focused on capital preservation. Yet investing in a narrow universe of high yield stocks does not provide sufficient diversification and protection from significant market declines, as many nervous investors noted in March and April. When this is coupled with smaller dividend pay-outs, it can really keep people up at night.
“However, our focus during the sell-off was on a range of factors beyond just the dividend yield, including earnings certainty, earnings growth and balance sheet strength. For example, we own a number of non-dividend paying stocks, such as A2 Milk, in order to lower volatility, and this proved effective when the market fell.”