Portfolio Manager for the DNR Capital Australian Equities Income Portfolio and Fund, Scott Kelly, provides a current market update for income equities. Scott discusses how the strategy is currently positioned in addition to the effects of the Russian invasion and rising inflation on the current market.
Well, global equity markets have corrected by over 10% year to date, and initially it was a change in language from the Fed indicating it’ll soon raise rates that was the initial catalyst, but escalating geopolitical tensions resulting from the Russian invasion of Ukraine has clearly furthered that decline. But meanwhile, here in Australia, equities are outperforming global markets. We’re down just 5% year to date, and the key reason for the outperformance is our higher exposure to late cycle and inflation beneficiary sectors like banks and resources, as well as our lower exposure technology stocks which have been hit hard as inflation risks rise. There’s still obviously significant uncertainty resulting from the war in Ukraine. However, a very likely outcome is that it’s leading to higher energy prices. Russia supplies around 10% of the world’s oil and gas and 40% of Europe’s gas. This is being disrupted, and it’s increasing the cost of energy. The impact of higher energy prices on demand likely has a negative consequences for economic growth, and this increases the risk of economic recession and the risk of stagflation.
When the background was still being met by the reality of more persistent inflationary signals and Central Bank intent to normalize monetary policy settings, there are also big shifts occurring in market forces that could unwind decades of globalization efficiencies, and these include things like the renewable transition which is driving demand for commodities and resulting in higher prices, companies building resiliency and production and sourcing, protecting supply chains following years of disruption from COVID lockdowns, and higher energy prices which are resulting from the war as well as increased defence spending. These are all additional inflationary pressures that could easily take investors back to a future that are heavily influenced by rising yields and rising rates, and many investors have just simply not seen this.
Well, geopolitics and increasingly hawkish central banks are pushing market volatility. That’s evidenced by large intraday moves, and whilst investors are rightly wary about the escalating situation in Ukraine, at times the shock of war can cause markets to overreact and that leaves opportunities for level-headed investors and forward-looking investors. So, as an active portfolio manager, we would regard volatility as a good thing. Volatility provides opportunities, and we’ve been selectively increasing exposure to our high-conviction positions. In fact, we’ve reduced the number of stocks held in the portfolio to around 20 from 25 previously and increased our portfolio active weight from 60% to over 65%. This represents our increased confidence around specific high-conviction ideas that have attractive risk return metrics.
Well, we continue to position the strategy in high-quality businesses that offer a combination of growing dollar income, franking benefits, and attractive valuations. However, given the uncertainty, we’re obviously maintaining a balanced portfolio, and we’re balanced across three broad thematics. The first is quality defensives. These are industry-leading stocks that should be able to win market share regardless of economic cycle and pass inflation on to customers, and a good example of this is IPH. It’s a leading intellectual property services group in the Asia Pacific region. The long life cycle of IP provides a high degree of revenue, visibility and annuity-like earning streams. It’s highly cash generative, capital light, and it drives incremental return on capital over time. It’s trading relatively cheap and has a balance sheet capacity for M&A which could add a further 20%, four to 5% dividend yield, high single digit growth. It’s a very attractive stock and it’s one of our largest actives in the portfolio.
The second thematic is COVID recovery plays, and these are stocks that have been oversold following negative impacts from lockdown and are still in the early phase of recovery. CSL’s a great example. It’s a quality company with defensive attributes, but has the addition attraction of COVID recovery embedded into its future earnings. It’s been driven by plasma collections which are recovering as economies reopen. Meanwhile, the demand for IG remains robust and we’re expecting double-digit growth over the next five years, and whilst its current dividend yield is low single digits, the growth profile over the next five years drives a very attractive dollar income over that period.
And then finally we have inflation beneficiaries, and clearly these are stocks that should benefit from higher inflation and higher interest rates and where valuations are still attractive. Woodside Petroleum, it obviously has benefited recently from the situation in the Ukraine and that share price appreciation has largely reflected the higher energy prices that we’re experiencing. But meanwhile, there’s still a number of fundamental reasons we like Woodside. The proposed merger with BHP represents a significant opportunity given its cashflow benefits, operational synergies, and the Scarborough project progression, and indeed the Scarborough project is set to provide low cost, low carbon LNG for decades to come, and that helps satisfy the strong future demand for an undersupply of natural gas as we transition to the net zero carbon economy.
We think the dividend outlook is still very attractive for investors. Equities remains attractive on a risk return basis, and that’s indicated by the spread between the 12-month forward earnings yield on the market which is over 6% relative to 10-year bonds which are around 2% and that’s quite stretched relative to historical norms. So, clearly, dividends have recovered from the 40% decline in 2020. However, we’re expecting further growth over the next three years, and the market’s forecasting gross yields of 5 to 6% over that period which is very attractive compared to alternatives. Look, we are well-positioned to derive high levels of income compared to our benchmark which is the ASX 200 industrials as well as the broader market over this period.
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 www.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.