In this article, Ben Lofthouse, Fund Manager of Henderson International Income Trust, explains why investors should consider regulatory diversification within their portfolios, including stock case studies that highlight the influence of supportive and obstructive regulators.
Highly regulated industries, like financial services, telecoms and utilities, can often contain companies with attractive dividend yields. Bureaucratic and often complex; regulations are the unseen forces that can protect or disrupt a company’s profitability – and ultimately the dividend it pays to shareholders.
In many cases, regulations are a barrier to entry for outsiders and a competitive advantage for incumbents. So, for income-seeking investors, it makes sense to gain a healthy exposure to companies operating in industries with tough or complex regulations, where it is harder for new entrants to take market share. Global portfolios are best placed to access regulated industries, in our view, as they provide flexibility to diversify regulatory risk across both sectors and countries.
Regulations with disruptive consequences
Investors need to be prudent, as regulations are constantly evolving. Often with new governments and shifting socio-political sentiment, regulations can change and quickly become troublesome to the incumbent market leader(s). You only need to look at one of the UK’s largest energy providers, Centrica, to see the disruptive potential of regulatory change. As well as encouraging new competition over the past five years, the UK energy regulator, Ofgem, introduced a new energy price cap at the beginning of 2019, which has seen the company’s share price slide as investors anticipate pressure on future revenue.
Unlike Centrica, investors can mitigate some of these risks by diversifying their exposure to different regulatory environments within the same sector. So that might mean you own shares in gas companies in the US, Europe and Asia, as well as a UK provider, in order to maintain exposure to the sector without being too exposed to the whims of a single supervisor.
At Henderson International Income Trust (HINT), we have a global (ex. UK) mandate to deliver a growing dividend for our shareholders, as well as grow shareholders’ capital. That means we are looking for companies that pay an attractive dividend or have strong potential to grow their dividends in the medium term. The portfolio does invest in regulated companies, but focuses on diversifying the exposures by country to avoid too much exposure to one regulatory environment.
Roughly 10% of the HINT portfolio is invested in telecom companies (telcos).The varied approaches to telco regulation between countries and regions means the returns profiles of companies within the sector can differ markedly. One of the major discrepancies here is the way in which companies are permitted to access and distribute network coverage.
Telcos rely on radio waves called ‘spectrum’ to provide wireless services to customers. Spectrum at key frequencies is scarce and is allocated via auctions. These auctions can be competitive and costly, with telcos aiming to recuperate the investment over time by selling mobile services. In the US, telcos buy perpetual rights to spectrum, while European telcos purchase the rights for a set time period, after which they must bid to renew their licenses.
The difference between European and US spectrum regulations means that US companies have more time to recover the costs and more certainty around their return on investment. In Europe, competition is often encouraged with auctions being employed as a mechanism to introduce new mobile operators into the market.
More recently, the regulatory environment in some European countries has shifted focus from encouraging competition to supporting investment. In France, for example, the regulator provided an extension of some existing spectrum licenses on the condition that the telecom companies invest to provide service across the country, including rural areas. This serves to benefit the telcos, government and consumers by accelerating the pace of network investment at a lower overall cost.
The Trust holds a position in Orange, France’s largest network operator, which we see as positioned to benefit from the more supportive regulatory environment, as well as the French supervisor’s openness to market consolidation. This could drive a more stable competitive environment, supporting higher returns and providing greater capital flexibility to invest in next generation networks. Orange is also a multinational operator, which means it is exposed to different regulators, thus mitigating the risks associated with operating under a single regulator.
In other countries we have taken profits and decided to exit the market entirely because the pendulum is beginning to swing the other way. In Japan, the regulator is encouraging new competition and pricing pressure, which we feel is unsupportive for dividend growth. The Canadian regulator, on the other hand, has been more consistent, and the three-player market has supported rational competition and gradual pricing growth over the years.
Generally speaking the telecom sector is cash generative and provides attractive dividend yields; we continue to focus on investing in companies that are exposed to a regulatory framework that allows companies to balance cash flow generation and investment.
Financials’ difficult decade
The largest weighting by sector in the HINT portfolio is financials, which includes retail banks, insurers, asset managers and investment banks. This is perhaps the most regulated sector of all, but since the global financial crisis (GFC) of 2007-08, regulators have moved at different speeds and with different areas of focus, giving rise to vastly different operating conditions around the world.
For example, financial institutions on either side of the Atlantic are operating in widely different regulatory environments. For the past two years or so, US regulators have been relaxing some of the more stringent rules introduced around capital reserves post-GFC, affording companies more flexibility on the balance sheet. In Europe, on the other hand, the pace of reform has been much slower and companies are still adapting to complex regulations and their new supranational supervisors, including the European Banking Authority (EBA) and insurance and pensions supervisor EIOPA.
As a result, European financial institutions, including British-based firms, have endured a difficult decade of regulatory reform and tough economic conditions. Some companies, however, have invested well and adapted, putting them in a strong position as the dust settles after the regulatory upheaval in the aftermath of the GFC. One such company we feel has managed this is France-based multinational insurer Axa.
With its European life insurance business under immense pressure, owing to strict capital-intensive rules and ultra-low interest rates, the group has diversified its business mix through a number of takeovers and acquisitions. Last year, the group completed the full takeover of Bermuda-based XL Catlin (formerly XL Group), a property and casualty insurer with large operations in the US; and more recently it acquired a smaller and relatively new underwriter called Vindati, which specialises in US marine cargo.
We believe these deals put Axa in a stronger position to overcome the economic and regulatory hurdles it faces in Europe right now, providing a desirable exposure to US financial regulation and high growth business areas within the insurance industry.
In summary, there is little to gain from owning shares in different companies that have the same regulator; it is far more prudent to find overseas firms with supportive regulators. That’s exactly what we have been doing at HINT. With a mandate to deliver a growing income for our shareholders without investing in the UK, we look for companies operating in cash-generative industries with supportive regulation, which should provide a very healthy diversifier for investors with exposure to UK domestics.