Sat Duhra, Co-Head of the Asian Dividend Income Strategy, discusses the risks and opportunities for income investors in Australia. While many foreign investors have a somewhat pessimistic view of the country’s investment opportunities, Sat and his team, as income-focused investors, have a more positive outlook. While Australia currently faces headwinds including political uncertainty, banking sector concerns and is in the process of transitioning to a non-mining based economy, it remains a compelling market for income seekers: Sat believes that while the dividend payout ratio is high it is not stretched and companies have further capacity to return cash to shareholders.
Australia continues to divide opinion: foreign investors remain sceptical that a transition away from a mining-led boom is viable, while domestic investors continue to favour the market for its high yields. However, there is still much to admire about the reasonably smooth transition of the economy in the face of political uncertainty, fiscal consolidation, a strong currency and likely rising unemployment.
A compelling market for income
Australia has always been an attractive market for income seekers. Currently the dividend payout ratio is at its highest in 30 years and is well above that of other developed markets (see first chart). Australian companies are paying out over 70% of their free cash flow in the form of dividends, while share buybacks remain a small proportion versus the global average (second chart). This reveals that dividend payouts do not seem stretched and companies have more capacity to increase them.
Australia: comparatively high dividend payout ratio
Source: Goldman Sachs Investment Research as at 4 April 2016, Thomson Reuters Datastream.
DPS= dividend per share, EPS= earnings per share. Historical dividends are not an indicator of future payouts.
Australian companies have more capacity to reward investors
Source: Goldman Sachs investment Research as at 4 April 2016, Bloomberg, Factset. FCF= free cash flow.
The Australian market is dominated by domestic investors who are increasingly looking to the equity market for income as deposit rates fall and 10-year Australian bond yields hit record lows. The spread between equity yields and bond yields remains attractive for income investors and looks unlikely to narrow anytime soon. This continues to drive capital towards domestic equities, particularly to sectors offering high, sustainable yields such as utilities, real estate investment trusts (REITs) and telecommunications. Additionally, domestic investors and pension funds benefit from franked dividends, an agreement in Australia eliminating the double taxation of dividends (the shareholder receives credit for the tax already paid by the company and pays any additional tax to match their individual tax obligations).
Weighing up the risks
An imminent concern is the federal election outcome in July, when the possibility of a ‘hung parliament’ will raise short-term political risk. Medium-term risks include slowing consumption growth fuelled by sluggish wages growth and weak business investment, which signals that Australia’s plan to transition from a mining to non-mining based economy has some way to go.
Headwinds for Australian banks
We are also yet to see more evidence of fiscal restraint given recent warnings from credit agencies that the country’s ‘AAA’ rating is at risk. Australia’s government debt rose to 35.1% of GDP in 2015, up from 11.6% ten years earlier. While a downgrade may have little impact on borrowing costs for the government, it would hurt the banks given their reliance on wholesale financing to provide mortgages. Australian banks’ profitability is falling with a number of headwinds impacting operating performance, which is affecting the outlook for dividends. Concerns regarding regulatory capital requirements, loan losses and weaker economic data will impact the dividend outlook as profitability declines. Furthermore, the opposition is proposing a royal commission into practices of the banking and finance sector, which has the potential to add to uncertainty. As a result, we currently have zero exposure to the big four banks.
The Asian Dividend Income Strategy’s allocation to Australia remains broadly equal to the MSCI AC Asia Pacific (ex Japan) Index with a portfolio weight of around 21%. This is because we are valuation-sensitive investors and have only invested in high yielding stocks with reasonable valuations, avoiding stocks where yield is the primary driver of returns.
We recently added a position in Fairfax, a fast-growing online real estate listing business that we think is significantly undervalued given the concerns around the structurally declining newspaper publishing business. The company’s current valuation is compelling and has a dividend yield of 4.3%, with a net cash balance sheet. Another new addition to our portfolios is AGL Energy, which generates electricity and extracts gas providing energy to the east coast of Australia. AGL currently yields around 3.5% with good earnings visibility and is benefiting from rising wholesale electricity prices, natural gas export projects and existing coal supply agreements.
In the short term, Australia continues to defy expectations with resilience in recent growth and unemployment data supported by a pickup in commodity volumes and prices while a weaker currency has boosted services and exports. However, the risk of persistently low inflation has been a negative shock, and this could support calls for the central bank to cut rates further. Against this backdrop, Australia remains a solid source of income for investors and we continue to selectively invest in attractively valued high yielding stocks.
References made to individual securities should not constitute or form part of any offer or solicitation to issue, sell, subscribe or purchase the security.