Portfolio Manager for the DNR Capital Australian Equities Income Strategy and Fund, Scott Kelly, takes a closer look at high yield equity strategies and discusses the importance of a balanced portfolio in the search for income.
Well, a number of equity income strategies in the market largely focus on yield and not dollar income, and therefore ignore capital and total returns. And this can often come at investors’ expense. For example, high yield strategies can satisfy retirees’ short-term living expenses. However, we found this often comes at the expense of long-term capital preservation and growth potential. So we would recommend investors stay alert to managers that have a preoccupation with yield, and certainly yield alone. Derivative overlay strategies can manufacture higher income, potentially provide downside protection. However, they can be costly. They’re complicated, and can also limit upside capture. And then there are dividend stripping strategies which can also enhance short-term income. However, that can also come at the expense of capital, and turnover is typically much higher, increased in costs for investors.
Well, DNR Capital, we strongly believe that a growing dollar income delivers the best outcome for retirees as they seek to offset inflation and look to maintain lifestyles into retirement. Capital growth and dividends each play an important role in delivering growth in dollar income over time. Capital is what income grows off, along with providing duration to the retirement funding pool well into the future, countering longevity risk for retirees. So to reflect this, our equity income strategy has a dual objective based on both income and capital, which further differentiates us from our peers.
With the recovery in dividends now underway, it’s important for investors selecting shares for an equity income portfolio to keep in mind that they need to choose stocks that are likely to pay a growing dividend over time, and not just a high yield currently. Pursuing a high yield strategy whilst ignoring other factors, in our view is simplistic and also fraught with danger. High yields can often indicate companies are facing structural headwinds, and dividends are at the risk of being cut, as well as potential capital deterioration as well. Telstra is a great example where over three years ago, the stock was trading at $6 and paying a 31 cent dividend. That represents a 5% yield. Up until 12 months ago, the stock was trading around $3, having cut its dividend to 16 cents per share. That still represents a 5% yield. However, if you invested in Telstra four years ago, your capital’s halved, your dividend’s halved, your yield on investment is around 2%. It’s not an ideal outcome for a retiree or an income seeking investors. So companies paying high dividend yields may actually have a low or even negative earnings growth going forward. And that limits future dividends and likely will impact their share price too. So it’s important to avoid these dividend traps.
So in this following hypothetical example, we’ve taken two investors, A and B. And over a 25-year period, they’ve produced the same total returns, around 8% per annum. However, investor A is generating capital growth of 2% per annum compared to investor B, which is generating capital losses of 2% per annum. So whilst investor A’s headline yield is lower, at around 6%, compared to investor B, whose headline yield is around 10% per annum, investor A is actually producing more dollar income over time as the capital base grows. So this clearly demonstrates the importance of capital in growing dollar income over time.
Well, now more than ever, income seeking investors need to look beyond any single asset class. And we think specifically, consider high allocations to Australian equities, with strategies focused on tax advantage, reliable and growing dollar income. Cash-related products are not offsetting inflation, which means retirees have the unenviable decision to either keep working, cut spending or eat into that capital. Alternatively, retirees need to diversify and consider higher allocations to income generating equities, in our view. In our income strategy, we seek to meet the short and long-term needs of retirees and provide a solid core exposure for income-centric portfolios. And we continue to see the recovery in Australian equity dividends as a unique opportunity, and continue increasing our conviction around equity income, where opportunities rarely seen since the financial crisis are presenting themselves.
This article has been prepared and issued by DNR Capital Pty Ltd, AFS Representative – 294844 of DNR AFSL Pty Ltd ABN 39 118 946 400, AFSL 301658. Whilst DNR Capital has used its best endeavours to ensure the information within this document is accurate it cannot be relied upon in any way and you must make your own enquiries concerning the accuracy of the information within. The information in this document has been prepared for general purposes and does not take into account the investment objectives, financial situation or needs of any particular person nor does the information constitute investment advice. Before making any financial investment decisions you should obtain legal and taxation advice appropriate to your particular needs. Investment in DNR Capital Funds can only be made on completion of all the required documentation. The Trust Company (RE Services) Limited ABN 45 003 278 831 AFSL No 235150 (as part of the Perpetual Limited group of companies) is the issuer of the PDS for the Funds. An investor should obtain and read the PDS and target market determination and consider their circumstances before making any investment decision. The PDS and target market determination are available at the Fund website at dnrcapital.com.au/invest, or a paper copy can be obtained, free of charge, upon request by calling DNR Capital Pty Ltd (‘Manager’), the investment manager of the Fund on 07 3229 5531. Total returns shown for the Fund have been calculated using exit prices after taking into account all of Perpetual’s ongoing fees and assuming reinvestment of distributions. No allowance has been made for taxation. Past performance is not indicative of future performance. The Manager or The Trust Company (RE Services) Limited does not guarantee the repayment of capital from the Fund or the investment performance of the Fund. An investment in this Fund is subject to investment risk including loss of some or all of an investor’s principal investment and lower than expected returns.