Rudi's View | May 14 2020
Dear time-poor investor: the impact from this year’s tragedy for income investors is worse because of faulty strategies
In this week's Weekly Insights:
-Investing For Income: The Smart Way
-It’s A Relief Rally
Investing For Income: The Smart Way
By Rudi Filapek-Vandyck, Editor FNArena
Bad news hits the weakest the hardest.
Australian investors already endured a rather disappointing latter half of 2019 when companies, including banks and resources companies, announced sizeable cuts to dividends.
It shows not all was well even before the covid-19 pandemic spread across the globe and forced countries into lockdown.
Now 2020 is shaping up as the worst year on record in Australia as far as corporate profits and shareholder dividends are concerned, in particular hitting those shareholders hard whose strategy is aimed at receiving sustainable income from the share market.
However, the truth, no matter how painful for those impacted, is that many of those investors blissfully ignored the very basic number one rule when making investment decisions:
(to quote Warren Buffett from a long time ago)
-Rule number one: never lose money
-Rule number two: never forget rule number one
What the great legend from Omaha tried to tell us all through this seemingly facetious and simplistic two-rule mockery is that successful investing is about “managing” risk; not about “taking” risk or ignoring it.
And many an Australian investor, including, sadly, their financial advisors, have ignored the risk that comes with investing in high yielding stocks on the share market for far too long.
Many now facing serious budgeted income shortfall would not necessarily have realised, but buying 5% or 6% yielding equities (forward looking) in the share market pre-corona implies a serious step up on the overall risk ladder.
This is because government bonds, theoretically the ultimate low risk financial instrument available beyond cash under the mattress, are now yielding so little, financial markets have pulled back all yields across instruments and markets accordingly.
Years ago already, I tried to illustrate this process through the diagram below (first published in 2015).
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The validity of this general assessment of risk as implied by stock market pricing of securities follows through the observation that most cuts in dividends last year and in 2020 are from the higher yielding cohort on the ASX.
Plus most dividend cuts announced tend to be much larger than for lower yielding equities.
Investors would be wise not to underestimate this process of absorbing the fall-out from the lockdowns and the subsequent economic recession still has a lot longer to run.
Dividends will still be absent and cut next year and in some cases maybe even in 2022.
Maybe this is as good as any time to pause and reflect on what went wrong, and set out on a better strategy for the future.
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A faulty income strategy starts with the wrong focus. Priority number one, for all kinds of investors, no matter experience, age or specific strategies, is to look after your capital.
Step number two is to adopt a total return strategy whereby everything is taken into account, including costs, fees and taxes.
Step number three is to incorporate potential income.
Too many investors, panicked by the change in the yield/income landscape post 2012, ignored the natural order for setting up a robust investment portfolio and moved straight to step number three. And many an advisor failed to inform or educate their clients otherwise.
Even prior to last year’s dividend cuts, and this year’s Bear Market for equities, the failings of strategies with a sole or extreme focus on income “right now” had already revealed themselves in spades.
Look no further than the fact three of the Major Four banks’ share prices had lost about one third of their value since April 2015, prior to sinking near GFC lows in March this year.
Many a stock held for the sole attraction of the dividend has fared a lot worse, including the likes of AMP, G8 Education and, indeed, Telstra.
Even those investors hiding behind the fact they purchased their initial shares many moons ago at much lower prices still cannot deny that any strategy providing income while the capital base erodes away is not a good strategy.
Especially not when after the fall in capital comes the realisation there will not be a dividend at all this year, or a substantially reduced pay-out.
A much better strategy is one that incorporates the one key element that separates equities from bonds and other income providing investment products: growth.
Investors should consider there are two ways for creating income from owning shares: one is through dividends, the second is via selling at a higher level than the purchase price.
The best way to combine both key share market characteristics is through adopting a wholistic approach: by constructing a portfolio that combines growth with income and income with growth.
The end result should be a strategy that is much more protected against negative developments, including capital erosion, while offering growth of capital and income instead.
A truly superior outcome.
Sounds too good to be true? I’ve done the ground work over the past five years. I can report from first hand experience it’s not a theoretical chimera. Get the basics right and you too can grow your capital while enjoying a steady income.
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Past research indicated the share market’s sweet spot lays between 4%-4.5% in forward looking dividend yield (see also the diagram earlier).
But because of the significant drop in global bond yields, I believe the optimal point where risk, income, growth and return meet on the ASX is probably now around 3%.
Even with franking credits added on top, 3% won’t be sufficient for most retirees and pensioners. So we have to be smart and add-in growth.
Growth adds two key features to our portfolio: share prices for companies that grow rise to a higher level plus today’s dividend payouts will be higher in the future as well when supported by growth.
By combining income with growth, a portfolio that today yields 3% (for the portfolio as a whole) can yield 4%, then 5%, and more as time goes by.
In the meantime, the capital inside the portfolio grows to a higher level and investors can sell a portion each year to make up for the initial shortfall in income from dividends.
In case you are still not 100% convinced, I’ll meet you half-way.
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A simple ETF (Exchange Traded Fund) that mimics the ASX200 Accumulation index would have done a better job than owning large overweight portfolio positions in banks and energy companies and retail REITs and the like over the years past.
The ASX200 combines CSL with CBA and other financials, BHP, Woodside, JB Hi-Fi, and others (200 stocks in total) for an average dividend yield of circa 4%.
Assuming most investors are aiming for 6% plus franking, they would have to sell circa 3% initially each year to generate the same income (there are some costs to take into account as well). Dividends received through an ETF equally apply for franking credits.
Starting in January 2015, such a basic index following strategy would have generated the following returns (ex-dividends)
-2015: -2.13%
-2016: +6.98%
-2017: +7.05%
-2018: -6.90%
-2019: +18.38%
The above returns are ex-costs, but ETFs are low cost and it is not inconceivable costs will only go down in the future. Also, because of the significant underperformance by yield stocks in recent years the average dividend yield for the ASX200 has actually been closer to 4.5%, which makes the past return from an index ETF even more attractive.
Even without the spectacular outcome in 2019, anybody can instantly see (I hope) a simple ETF would have provided a superior total return than your average ill-conceived, dividend-oriented strategy over the past five years.
Because of the heavy overweight positions for the banks, Telstra and other large cap dividend paying stocks in the index, we’d have to assume that a carefully constructed portfolio with less exposure to the share market’s weak spots can generate an even better outcome.
The FNArena/Vested Equities All-Weather Model Portfolio, which has been managed and run in accordance with this smart income principle in mind, has done better than an index ETF over the period, including this year when losses incurred are significantly lower.
On Friday, the All-Weather Portfolio return for the running financial year (starting July 1, 2019) moved into positive territory. The ASX200 Accumulation index is still down -16.35%.
For the record, here are the returns from the All-Weather Portfolio for the past five years (including dividends, pre-fees):
-2015: +7.20%
-2016: +4.12%
-2017: +13.80%
-2018: +0.75%
-2019: +21.31%
Admittedly, constructing a low-risk basket of stocks during a time when dividends are being deferred, reduced or cancelled, and when company profits are expected to fall by most since the GFC is more of a challenge this year, but I’d still maintain the outcome from combining growth with dividends will be superior over the years to come.
Note: Part Two of this week's Weekly Insights, to be published on Friday, will focus on dividend stocks with sustainable payouts.
It’s A Relief Rally
The liveliest discussion on social media over the weeks past has been whether the equity markets’ upswing from the March lows will prove to be sustainable or not.
In what might yet prove to be a telling sign, the bearish warnings (with conviction) have virtually disappeared and the bulls are making fun out of everyone who still carries doubt and hasn’t joined in as yet.
On my observation, equity markets are now shifting into the next phase whereby money flows into stocks that have been lagging thus far. This, I believe, will make markets increasingly vulnerable to negative news or developments.
It’s not necessarily something that will break the uptrend, but it might, at some point, the longer it continues.
Within this context I note the market strategist at Longview Economics, up until recently rather bullish about global equities, is now cautioning that markets are setting themselves up for major disappointment.
Longview suggests the pandemic-induced supply-side shock to the global economy will soon be replaced with a demand-side shock as investors come to realise the V-shaped recovery that is being priced-in the longer this rally continues, will actually look a lot more like a U-shape.
For this rally to be the real deal that ends the Bear Market and starts a new Bull Market, Longview argues it has to be reflected in other market signals such as high yield bond spreads, 10-year benchmark government bonds, banks share prices, transportation stocks, the JPMorgan emerging market currency index, et cetera.
Right now, highlights the strategist, none of these additional market signals backs up the optimism that is conquering the minds and hearts of investors in equities.
Conclusion?
[The] “message is that this rally is a relief rally – and not the start of a new bull market.”
(This story was written on Monday 11th May, 2020. It was published on the day in the form of an email to paying subscribers, and again on Thursday as a story on the website).
(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website.
In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: info@fnarena.com or via the direct messaging system on the website).
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