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• September was a tough month for investors in Listed Property and whilst the Fund is designed to navigate market turbulence, the unit price did decline by -0.5%. In weak markets such as we saw this month; the Fund’s risk management strategies acted as expected and reduced volatility.
• Over the month the Australian Listed Property sector declined by -1.8%, the sector’s first decline since March. We note that Trusts with earnings backed by development profits, rather than recurring rents, saw greater price falls in September.
• The Fund paid a distribution of 4.84 cents per unit at the end of September, roughly in-line with the June quarterly distribution.

 

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

 

We look at the question of dividend sustainability very closely when constructing the Atlas Core Australian Equity Portfolio. One of the main factors in building the portfolio is identifying companies that can deliver consistent distributions that are growing ahead of inflation, whilst actively avoiding companies with distribution risk. Aside from wanting a consistent yield for our investors, as we have seen with Telstra over the past few years, high current distributions do not compensate investors for the capital fall that occurs when the dividend is cut. Indeed we often see that a small dividend cut has an over-sized impact on the company’s share price.

In investing terms, buying companies that have a chance of cutting their dividend this is a bit like picking up pennies in front of a moving steamroller, you may snatch a few coins but eventually your arm will get crushed by the roller! In this week’s piece we are going to look at dividend sustainability.

 

 

Key indicators for dividend sustainability

The dividend payout ratio divides the dividend by the earnings per share and this is something that we look at closely to gauge if a company can both maintain and grow its dividends. When a company paying out 90 to 100% of its earnings faces a small change in profitability, it will have to cut its dividend, whereas a company with a payout ratio of say 50% not only can handle the inevitable changes in market conditions, but also has the scope to increase dividends without an increase in company profits. With some companies such as Transurban, for accounting reasons, you will want to use free cash flow instead of earnings, which are impacted by accounting items such as a high depreciation charge.  Over a number of years up until 2018 Telstra maintained a dividend around 30 cents per share, however this was achieved via paying out all of its earnings in dividends and indeed in some years the company was borrowing to pay the dividend. A position that was clearly unsustainable in the long term.

Leverage is another factor that we look at when evaluating whether a company can sustain and grow their dividend. Here we are looking both at standard ratios such as debt to equity and interest coverage; as well as when the debt is due. Whilst leverage magnifies returns to equity (and thus dividends) when times are good, when conditions deteriorate and the heavily indebted company’s bankers come hammering at the door, cutting the dividend is inevitably their first action. For example, in 2015 rising debt levels forced grocery wholesaler Metcash to cancel the dividend for a number of years in an effort to reduce gearing.

Finally, we look at earnings and cash flow growth, as if a company is not growing earnings it is obviously not in a position to increase dividends and this may be the sign that the company operates in a stagnant or declining industry. Ultimately investors buy shares in a company in the anticipation of receiving a stream of earnings that will grow ahead of inflation. If dividends are static, then their real value (i.e. value after deducting inflation) declines annually. One of the reasons why we like toll road company Transurban is because the revenue they receive from road tolls automatically grows each year which feeds into rising dividends. For example,  the tolls on the M2 motorway in Sydney increase quarterly by the greater of quarterly CPI or 1%; in effect a 4% annual increase.

Amcor ticks many of the boxes

Amcor is a company that we own in the Australian Equity portfolio offering a solid 4.6% yield that ticks all of these boxes. Amcor has a dividend payout ratio is 70% with an extensive history of providing growing dividends. The company has an interest cover of 7.5 times and net debt divided by earning of 2.9 times, which indicates that the company does not face any imminent balance sheet stress.

Continued growth in in flexibles packaging in the US and Europe as well as the developing markets for this market leader will allow Amcor to continue to grow the dividend for shareholders.  Additionally, further weakness in the AUD will boost profits for Australian investors, as the packaging company generates all of its earnings outside Australia.

What about Telstra and its 8% yield?

Whilst we are looking at Telstra as at some stage it may represent good value, it still looks too early despite the company currently offering a 8% fully franked yield.  Telstra 2022 will be a complicated process with high execution risk and Telstra as a company has a poor long-term record of executing on complex projects. Historically companies have struggled to successfully make significant changes to their business without slipping up whilst their core offering is under pressure. Additionally, Telstra attracts a higher degree of political scrutiny than most firms face which may hamper their ability to reduce their headcount by the planned 8,000 staff members.

In 2018, Telstra is expected to pay a dividend of 22 cents per share but falling earnings from increased competition and restructuring charges may necessitate further cuts in 2019. Additionally, from 2020, NBN payments which are being used to support the dividend begin to taper off. Given this environment, we see that there are other companies that will offer safer and more stable returns for investors seeking income from Australian equities

Our Take

Despite our focus on delivering high fully franked distributions we have avoided some high dividend payers such as Telstra, as our investment process focuses on dividend sustainability and precludes investing in companies that may pay a high current dividend, but have a probability that this will be reduced in the medium term. One of the lessons that that we consistently observe is that when a company cuts its dividend (often for the right reasons) their share price frequently gets punished excessively by vengeful yield investors. Here the several years of high dividends is normally outweighed by the heavy decline in the dividend-cutting company’s share price.

• In June, the Fund gained +1.4% which makes for an 8% return for the quarter. This is ahead of expectations given the Fund’s lower risk portfolio and high cash weight.
• After having a weak start to 2018 due to concerns about rapidly rising interest rates and the impact of Amazon, the listed property sector continued to rebound in June due to increased corporate activity in the sector. Additionally, domestic retailers should see a benefit from 1 July 2018 onwards as GST will now be applied to all imported goods.
• The Fund has increased its distribution for the June quarter and has been active in reducing risk over the last month.

 

Go to Monthly Newsletters for a more detailed discussion of the listed property market and the fund’s strategy going into 2018.

• The Fund gained +3%, which was ahead of expectations given the Fund’s lower risk portfolio and high cash weight.
• After having a weak start to 2018, the Listed Property sector has stabilised over the last quarter aided by positive market updates and takeover activity in the sector.
• The main news over the month was the approval by shareholders of the Westfield takeover and the bid by Blackstone for Investa Office Trust.

 

Go to Monthly Newsletters for a more detailed discussion of the listed property market and the fund’s strategy going into 2018.

The last few months have been tough for shareholders in the major Australian financial services companies, who have seen their share prices drift lower throughout March and April. Evidence of misconduct presented at the Royal Commission on Financial Services has fed market fears that bank profitability will be diminished in the future. However, over the past ten days, the major banks have reported their profit results for the past six months, showing the market how their underlying businesses are performing and how the management teams plan to address the issues raised at the Royal Commission.

In this piece, we are going to look at the common themes emerging from the banks in the May reporting season. We will differentiate between the different banks and hand out our reporting season awards to the financial intermediaries that grease the wheels of Australian capitalism.

Simplification

The main new theme to emerge from this reporting season was that banks are looking to reduce their footprint on the Australian financial services landscape, by divesting businesses that are deemed to be non-core. This results season was characterised by complexity arising from either announcements of new significant moves, or that were complicated by sales made in 2017.

In May Commonwealth Bank announced plans to spin off their wealth management business Colonial First State, which followed the sale of the life insurance business in 2017. ANZ’s result was complicated by the sale of both their wealth management and life insurance businesses in 2017. NAB also announced plans to sell MLC wealth management by 2019. Additionally, Westpac continued to reduce its stake in BT Investment Management (now renamed as the Pendal Group). These moves can be seen as acknowledging that the costly exercise of creating vertically integrated financial supermarkets was a mistake. Whilst some of these moves to sell these carefully constructed divisions may be attributed to the events of the Royal Commission, some of these sales were consummated well before the titans of Australian finance faced the harsh light of the witness stand.

 

Profit growth

Across the sector profit growth was roughly in-line with the credit growth in the overall Australian economy. Westpac reported the strongest cash earnings growth across the banks courtesy of keeping costs under control, very low bad debts, and the sound performance of their core domestic businesses. NAB brought up the rear in May due to the combination of weaker revenue and elevated costs even when the restructuring charges are excluded.

 

 

Gold Star

Bad debts

One of the biggest drivers of earnings growth over the last few years has been the ongoing decline in bad debts. Falling bad debts boost bank profitability, as loans are priced assuming that a certain percentage of borrowers will be unable to repay and that the outstanding loan amount is greater than the collateral eventually recovered. Bad debts fell further in 2018, as some previously stressed or non-performing loans were paid off or returned to making interest payments. This resulted primarily from a buoyant East Coast property market and higher commodity prices. Further, at the big end of town there were no major corporate collapses over the past six months which kept corporate bad debts low.

Westpac gets the gold star with a very small impairment charge courtesy of their higher weight to housing loans in their loan book. Historically home loans attract the lowest level of defaults.

 

 

Gold Star

Shareholder Returns

Across the sector dividend growth has essentially stopped, with CBA providing the only increase of 1 cent over 2017. With relatively benign profit growth a bank can either increase dividends to shareholders or retain profits to build capital (thereby protecting banks against financial shocks) – but not both. In the recent set of results, the banks have held dividends steady to boost their Tier 1 capital ratios to get close to the APRA mandate of a core tier 1 ratio of 10.5%.

Looking ahead, there may be some capacity to increase dividends as the rebuild of bank capital to APRA’s standards is largely complete. ANZ shareholders can expect capital returns in the form of further on-market share buy-backs as the proceeds from the sale of their wealth management and insurance businesses are received. The major Australian banks in aggregate are currently sitting on a grossed-up yield (including franking credits) of 8.9%.

Gold Star

Interest Margins

The banks’ net interest margins [(Interest Received – Interest Paid) divided by Average Invested Assets] in aggregate increased slightly in 2018, despite the imposition of the major bank levy. This was attributed to lower funding costs and repricing of existing loans onto higher rates. In response to regulator concerns about an overheated residential property market – and in particular the growth in interest-only loans to property investors – the banks have repriced these loans higher than those repaying both principal and interest. For example, Westpac currently charges 6.3% on an interest-only loan to an investor, which contrasts to the 4.44% being charged to owner-occupiers paying both principal and interest. This has had the impact of boosting banks’ net interest margins, though these gains will tail off as borrowers switch to principal and interest loans.

One of the key things we looked at closely during this results season was the impact of the May 2017 Major Bank Levy on the various banks’ margins. It was apparent from looking at the numbers that this levy was passed on both to borrowers in the form of higher rates, and to depositors by offering lower rates on term deposits.

 

 

Gold Star – Australian banking oligopoly

 

Total Returns

In 2018 all the banks have delivered negative absolute returns, while also trailing the ASX 200 which has gained 2%. The uncertainty around the outcomes from the Royal Commission, rising compliance costs, and slowing credit growth has weighed on their share prices. CBA has been the worst performing bank as it has seen its CEO ushered to the door, faced fines for not complying with anti-money laundering laws, and has faced uncertainty around the potential impact of changes implemented based on recommendations from the Royal Commission.

No stars given

Our Take

How to approach investing in the Australian banks is one of the major questions facing both institutional and retail investors alike. We expect the banks to deliver around 3-5% earnings growth as they face low credit growth, increased regulatory scrutiny, and the sale of some of their insurance and wealth management divisions. However, if investors examine the wider Australian market the banks look relatively cheap, are well capitalised, and unlike other income stocks such as Telstra should have little difficulty in maintaining their high fully franked dividends. Additionally, their share prices are likely to see support over the next 12 months from share buybacks, as the proceeds from the sales of non-core assets come through.  The key bank overweight positions in the Maxim Atlas Core Equity Portfolio are Westpac, ANZ and Macquarie Bank.