In a low-rate world, generating income is more difficult than ever. With bond markets changing daily and cash rates close to zero, cash and fixed income can no longer do the heavy lifting for income-focused investors.
Against this backdrop, how can investors use equities to generate income and reduce volatility?
First Sentier Investors’ Equity Income Fund is designed to address income investors’ three key needs: higher income, lower volatility and long-term total returns.
The Fund aims to provide sustainable income over the long term by focusing on total income, not simply dividend yields. The strategy uses fundamental research to identify stocks that have the potential to generate long-term earnings, while minimising volatility, and uses equity options with the aim of delivering higher income from a portfolio of our best investment ideas.
This equity income approach ignores dividend yields and allows the strategy to target the best opportunities across the market.
The disruption of the last two years has highlighted that the future is hard to predict, so investors need a strategy that cushions the downside, and helps to navigate an uncertain market outlook.
We believe that the strategy is well placed to address a number of emerging themes for the year ahead:
Earnings growth remains a key focus
In 2021 companies reported large earnings growth numbers. However, we must remember that this growth was off a low base due to the COVID disruption. Moving into 2022, we expect the focus will be on the sustainability of this earnings growth. The current market valuations suggest that the market expects buoyant earnings growth rates to continue. Hence any shifts in this view will play a huge role in determining the Australian share market return outcome for 2022.
Inflation will be the risk to watch
Inflation is the most likely trigger for volatility, depending on how the story plays out around the world, the flow-on impact to interest rate expectations and ultimately, equity market valuations. We believe this risk is heightened given the elevated valuation levels the equity market is currently experiencing. Interestingly, this volatility risk may be experienced both in the market as a whole, but also extend into higher volatility between differing investment styles or sectors in the market.
Housing boom offers opportunities
A particular area of interest for us is the building materials sector, with positive expectations for continued improvement in detached housing activity and home renovation activity. The sector stands to benefit from the continuation of the strong housing cycle supported by record savings, fiscal stimulus tailwinds and a record low interest rate environment. Australian investors can access this thematic in both Australia and the US. For example, James Hardie remains an attractive exposure as it continues to drive growth through its expansion into adjacent products and geographies in the US. Meanwhile CSR is a top pick for an exposure to domestic activity where we believe challenges stemming from lockdowns and supply chain issues merely extend the housing cycle. This may prolong elevated earnings as demand is pushed back and building timelines are extended.
Return on capital should be a focus for management
As economic conditions remain solid, we believe this should provide a supportive backdrop for companies willing to invest capital. The best opportunities will be from companies that can demonstrate an ability to invest in their business, in projects that generate high returns on capital. At the same time they will need to navigate the headwinds related to emerging signs of rising labour and input cost.
Note: References to specific securities are included for the purpose of illustration only and should not be construed as a recommendation to buy or sell the same. Any securities referenced may or may not form part of the holdings of First Sentier Investors’ portfolios at a certain point in time, and the holdings may change over time.