Financial Repression and Falling interest rates

In 2019 we have seen the Australian 10-year bond rate fall from 2.75% to 1.75%, a significant move given that in April 2018, the market was expecting that interest rates would be rising throughout 2019 and 2020. While this sounds a bit esoteric, falling bond rates depresses term deposit rates. At the moment the market expects that the RBA will cut the cash rate later on in the year (currently at 1.5%), possibly at their meeting on Melbourne Cup Day in November.

Further cuts to the interest rate will only intensify the hunt for yield among investors, especially those in pension phase looking to live off the income delivered by their investments. As term deposits roll off and investors are faced with pretty meagre reinvestment options, we would expect investors to rotate investments out of cash and into other yield assets such as shares and listed property trusts. In this week’s piece we are going analyse what to look for when assessing the sustainability of a distribution from equities.

Financial Repression

Financial repression is a term used to describe measures used by governments to boost taxation income, economic activity and demand for government debt. These measures include attempts to hold down interest rates to below inflation and represent a tax on savers, conferring a benefit on borrowers. The positive impact of these measures is that it becomes cheaper to borrow money to invest possibly boosting economic growth, however this effectively becomes subsidised by the nation’s savers.

Over the last month the falling bond yields have filtered through to term deposits rates with some major banks cutting six-month term deposits to rates to around 2%, with one major bank even as low as 1.2%. Even at interest rates around 2%, even wealthy retirees who have amassed $1 million in a superannuation account face a very meagre retirement, if they are looking to live off risk-free income rather than eat into capital.  Indeed according to the Australian Council of Social Service’s Poverty in Australia Report, this fictional retired couple with $1 million in term deposits who own their own home would be surviving on an annual income of $20,000, which is below the poverty line of $33,748!

While the 2% rate on one-year term deposits in Australia looks grim (especially in light of inflation running at 2%), spare a thought for investors in other major Western nations.  Retirees in the USA are currently being offered 0.03% from Bank of America, in Germany a touch higher at 0.05% with HSBC in the UK offering 0.55% all for the same six-month term deposit. Near zero rates in Europe, Japan and the US (and historically low rates in Australia) are positive for middle-aged borrowers, asset owners and corporates refinancing debt at lower rates; but represent a significant negative cost for savers.

Stable and Growing Distributions

When we look at dividend-paying stocks and high-yielding listed property trusts we are not overly concerned with the trailing or next period payment, but rather in understanding whether a company can maintain their distribution over the long term and importantly grow it ahead of inflation. Indeed, picking a basket of stocks or trusts solely based on their historical dividend yield has been a path to under-performance. When looking through the list of the highest yielding securities in the ASX200, a common factor is usually a high payout ratio (dividend per share divided by earnings per share).

Payout Ratios too high

Companies with a high payout ratio generally possess fewer options to grow a distribution or maintain it over a variety of market conditions. High payout ratios are often attributed to companies that are either mature or in operate in low-growth industries with few investment opportunities to grow their business, or management looking to maintain the dividend in an environment where the company’s earnings are deteriorating and thus prop up the share price. In some situations, these companies are even borrowing to pay their dividend may be retaining insufficient cash to maintain their assets. This was the case with Telstra for several years, until they bit the bullet and cut their dividend from 28 cents per share to 22 cents per share in 2018.

Looking at other well-owned high yielding stocks on the ASX, it is tough to see NAB maintaining their dividend in the future.  In 2018, NAB paid a dividend of $1.98 on cash earnings of $2.02 per share, given NAB has just taken on a new CEO and need to build their capital position by retaining earnings, we would be very surprised if the bank does not cut their dividend later on in 2019.

Maintaining asset quality for property trusts

When assessing the quality and sustainability of the distribution of a property trust you have to look at the percentage of the distribution covered by earnings less the costs of maintaining the quality of the trust’s assets such as replacing lifts, escalators and indeed incentive payments necessary to retain tenants.  Before the GFC a large number of property trusts were paying out virtually all of the rental income they collected and were not retaining sufficient funds to cover maintain the quality of their assets.  Trusts with higher distributions saw their share prices re-rated higher.  In the short term these capital improvements were covered by borrowing money and issuing new equity, but eventually these high distributions proved to be unsustainable and were cut.

Franked dividends = tax payments

Franked dividends have a tax credit attached to them which represents the amount of tax the company has already paid on behalf of their shareholders for the profit they have earned in any given year. While companies can make a range of aggressive accounting choices that can boost their earnings per share (and dividend per share), a company is extremely unlikely to maximise the tax that they pay to the government.

Firms that pay franked dividends have significantly more persistent earnings than firms that pay unfranked dividends, as it indicates that a company is building up tax credits by generating taxable earnings in Australia.

A great example of the role that franking plays in indicating the sustainability of a dividend occurred in 2014 where steel company Arrium paid unfranked dividends in 2013 and 2014. Despite paying dividends and reassuring the market as to the company’s future, Arrium conducted a massive capital raising in late 2014 to shore up a shaky balance sheet and ultimately went into administration in 2016 with debts of $4 billion. Here the lack of franking could be viewed as an indicator that the quality and sustainability of the company’s dividends was not high. However, this measure is not useful for companies such as CSL and Amcor who generate large proportions of their profits outside Australia are unable to pay fully franked earnings.

Our View

When constructing a portfolio designed to deliver income above the meagre returns being offered by term deposits, Atlas see that it is not enough simply to pick high yielding securities. In selecting yield stocks investors should make a detailed assessment of the ability of a company to continue paying and growing distributions ahead of inflation.

Demographic change will see more investors are moving from the accumulation to the retirement phase, which will increase demand for equity fund managers to deliver income to investors. This could be very interesting as in the fund’s management world, the vast majority of the focus is on growing capital by buying stocks that the fund manager believes will rise dramatically. This growth approach typically results in swings in the value of portfolios and minimal dividends. Alternatively an “income approach” to investing involves thinking about how an investor’s capital can be deployed to deliver ongoing income necessary to fund a comfortable retirement.

March Monthly Newsletter Atlas High Income Property Fund

  • The S&P/ASX 200 A-REIT index had a very strong month in March returning +6.2%, a significantly better outcome than the overall ASX200 that gained 0.7%, aided by falling bond yields globally and once again large price gains in the stock prices of the developers.
  • The Atlas High Income Property Fund gained 4.9% in March which was ahead of our expectations given the Fund’s conservative stance and low beta compared to the index. Over the last three months, the Fund has gained +7.3%, which we believe is close to the maximum achievable through a buy-write strategy utilising capital protection.
  • For comparative purposes this month we have compared the returns against RBA cash rate +3% (see table below), as the Fund is primarily managed towards delivering consistent quarterly income with lower volatility to investors, rather than mimicking an index which is increasingly being dominated by trusts with characteristics outside the Fund’s investment strategy.

Go to Monthly Newsletters for a more detailed discussion of the listed property market and the fund’s strategy going into 2019.

IOOF goes through the Quality Filter Model with Hugh Dive from Atlas Funds Management

IOOF goes through the Quality Filter Model with Hugh Dive from Atlas Funds Management

IOOF (IFL.ASX), the vertically integrated financial advice and financial services supermarket, was beaten an battered throughout the RC. Yet in February, IFL became the top performing stock in the ASX 100 in February 2019 gaining 36% after the Hayne report did not provide negative recommendations around vertically integrated financial advice.

IOOF (IFL.ASX), the vertically integrated financial advice and financial services supermarket, was beaten an battered throughout the RC. Yet in February, IFL became the top performing stock in the ASX 100 in February 2019 gaining 36% after the Hayne report did not provide negative recommendations around vertically integrated financial advice. Is IFL a buy?

Reporting Season Themes

Over the past month around 2,000 Australian companies listed on the ASX revealed their profit results for the six months ending December 2018 and in many cases guided as to how they expect their businesses to perform in 2019. While the ASX’s continuous disclosure requirements mandate that listed companies update the market when they become aware of new information that would impact their share price (though waste disposal company Bingo didn’t seem to remember this requirement, and saw their share price fall -48% on results day after surprising the market), reporting season always brings positive and negative surprises. In this week’s piece we are going to run through the key themes that have emerged over the last month.

Outperforming low expectations

In the lead up to the February reporting season, the overall mood was quite pessimistic as the summer break was dominated by talk of slowing global growth, a trade war between the US and China and fears that the Hayne Report to be released on the 4th February would be very negative for Australian financial companies. We had a different view and indeed were looking forward to the release of company financial results, as many companies had seen their share prices fall on vague global macroeconomic fears despite these factors ultimately having minimal impact on their business’ sales and profits. While a trade war between the US and China is likely to result in a decline in the demand for iron ore, it is unlikely to change demand for CSL’s haemophilia therapies, Amcor’s food and drinks packaging, or doctors ordering pathology tests from Sonic Health.

The February 2019 reporting season was pretty solid for Australian listed companies with the companies in aggregate reporting earnings growth of +4%. This growth, however, was propped up by the resource sector (+13%) which outweighed falling earnings in the industrial companies, and the financials sector which came in close to the ASX 200 average. In February the ASX 200 gained by 6%, the strongest monthly return of any developed share market, principally due to a better than expected reporting season and a rally in the financial stocks after the Hayne Report made few recommendations that are likely to impact their business models.

Give me my money (and franking credits) back!

Capital management was the dominant feature of the recent reporting season, with companies opening up their purse-strings in moves that appear designed both to reward shareholders and to get franking credits into the hands of their shareholders before a change of Federal government. New share buy-backs were announced by Brambles, Qantas, Caltex and Janus Henderson. Additionally, Rio Tinto, Wesfarmers, Flight Centre and Suncorp announced special dividends. Atlas expects capital management again to feature heavily in the August 2019 full-year profit results, especially with companies such as Commonwealth Bank receiving the proceeds from selling Colonial in June and therefore having a large number of franking credits sitting on their balance sheet.

Across the ASX, the dividend payout ratio remains high at around 76%. Increasing dividends and buying back stock boosts share prices in the short term. Such a strategy may allow some management teams to achieve share price hurdles related to their bonuses. However, in the longer term, companies do need to retain cash to reinvest in their operations to grow. In contrast to the ASX’s high payout ratio is the lower 36% dividend payout ratio of the US’s S&P 500. A lower average dividend payout ratio reflects both a greater prevalence of buy-backs as a means of returning capital to shareholders and a higher reinvestment in growing company earnings. However after ten years of growth coming out of the GFC and rising global asset prices stemming from quantitative easing, in 2019 we would prefer to see capital returned to shareholders rather than being used on significant acquisitions that may not be value accretive.

Rising Costs

Another key theme coming out of February and subsequent meeting with management was rising costs and their impact on profit margins. Unsurprisingly the financial stocks highlighted rising compliance and customer remediation charges stemming from the Royal Commission into Financial Services. Commonwealth Bank announced risk and compliance expenditure had increased to $432 million and AMP announced remediation provisions of $780 million. Embattled financial services company IOOF revealed a $10 million provision resulting from the Royal Commission which saw its share price jump by over 30%, though we suspect that when a new CEO is appointed the level of provisions will increase substantially. Across the rest of the ASX companies experienced higher raw material prices (Amcor and Pact), higher wages (Coles and Woolworths), and increasing energy prices (Rio Tinto and Boral).

Rock diggers solid, but is this as good as it gets?

The miners reported solid profit growth in February, but this was expected as they continued to benefit from elevated commodity prices. This elevation is associated with the tail end of a Chinese stimulus plan from late 2016 and rising iron ore prices in 2019 courtesy of a tailings dam collapse in Brazil.

On the conference calls to investors, management teams from the mining companies promised to maintain capital discipline, pay down debt and not waste the windfall of temporarily higher commodity prices. This approach was positively received by shareholders who have seen windfalls from successive resource booms being squandered by successive management teams. Over the past six months, BHP reduced their net debt by 36% to US$9.9 billion and RIO Tinto ended the period in a net cash position. Additionally, both companies have been returning capital to shareholders over the past six months, which is a nice change from their traditional strategy of making a major acquisition at the peak of the commodity price cycle.

Domestic outlook murky

Companies exposed to domestic consumer confidence mostly reported minimal profit growth and revealed heightened concerns about future earnings growth. Over the past year, we have seen house prices fall 11% in Sydney and 9% in Melbourne, which appears to have resulted in a wealth effect where declining perceptions of personal wealth have hurt consumer spending. Companies exposed to residential property such as Boral and Stockland provided very cautious outlooks as to the future. Subdued revenue growth from supermarket companies Coles and Woolworths indicate a cautious consumer. New car sales fell in late 2018, as weaker hose prices deterred consumers from using their mortgage offset accounts to purchase a new vehicle. The impact of this can be seen in the profit results from car retailers Autosports and Automotive Holdings.

In February the news was not all bad for companies exposed to the increasingly nervous consumer with Bunnings recording profit growth of 8%, an impressive outcome given the deteriorating residential market. Similarly JB Hi-Fi – which is one of the most shorted stocks on the ASX – posted profit growth of 5%, which was above the pessimistic expectations of many in the market. While the nervous Australian consumer is cutting back on new car purchases, they are still spending on home hardware, lawnmowers and electrical devices.

Best and worst results

Over the month, the best results were delivered by Magellan, Cleanaway Waste, A2 Milk, CIMIC and QBE Insurance. The common theme amongst these companies was management being able to keep costs under control while growing revenue at a rate greater than their competitors. IOOF’s and Ramsay’s share prices suggested that these companies delivered strong profit results, but the price reaction was more due to these companies beating low expectations.

On the negative side of the ledger Blackmores, Pact, Bingo and Cochlear all reported disappointing results compared with other companies. The common themes amongst this group were either high price-to-earnings rated companies not delivering on high expectations or companies that reported lower profit margins as management struggled to contain cost growth.

Our take

In contrast to other reporting seasons, this one was a relatively benevolent one for quality-style investors who eschew high priced growth stocks and focus on owning companies that are likely to return capital to investors. In February we were pleased to see the companies in the portfolio growing dividends by +32% on an average weighted basis excluding special dividends. While we expect companies with offshore earnings to have a solid 2019, commodity prices (which we expect to weaken) and the impact of a Federal election are likely to put pressure both on the miners and on those companies exposed to the domestic economy