COVID-19 has created one of the biggest drawdowns in Australian Equity earnings in history, even bigger than during the Global Great Financial Crisis. Income investors are thus understandably concerned about the impact the shutdowns and ongoing social distancing will have on the ability of Australian equities to pay dividends.
The Legg Mason Martin Currie Equity Income strategy’s aim has always been to provide a stable income for our clients by investing in a diversified portfolio of high-quality companies with sustainable dividends which can steadily grow distributions to match rises in the cost of living.
In this paper we discuss how the Legg Mason Martin Currie Equity Income strategy is navigating this unique moment with the objective of providing a stable and growing income stream for the future.
Why Active Management for Income Today
As active managers, we stand in a unique position to help our clients through this unprecedented situation both in the near-term and long-term. This is because, for an income-oriented strategy, successfully navigating these market conditions requires a balancing act that entails a nuanced approach satisfying both of the following two conditions:
- Ensure that the long-term of income potential of the portfolio remains robust, i.e. we need to focus on the long-term business outlook and dividend potential of the portfolio companies.
- Deliver the best possible income stream over course of the near-term business disruptions caused by the COVID-19 pandemic, i.e. to ensure that there is a reasonable level of income in the coming 12 to 24 months to support our clients income requirements.
The need to optimise across these two parameters illustrates an important benefit of active management over passive or ‘smart beta’ strategies at this critical juncture.
For example, a passive manager who indiscriminately sells stocks where the dividend is cut to $0 will likely be selling uniquely profitable and monopolistic businesses at historically low valuations; in effect, throwing the proverbial baby out with the bathwater. Similarly, buying stocks in sectors where dividends haven’t been reduced to chase higher short-term income will entail paying a significant valuation premium and must be done with a discriminating eye towards long-term dividend sustainability. The combined effect of such a robotic approach to income investing is likely to result in a significant impairment of the long-term income potential for investors in these passive, yield chasing strategies.
What’s called for at this moment of market dislocation is a case by case assessment of each company’s prospects by a seasoned team of sector specialists to parse the likely winners from losers.
Quantifying Dividend Sustainability & Long-Term Income Potential
Even prior to COVID-19, we built our Income portfolios from stocks based on their ability to pay what we call a forward looking “Sustainable Dividend” rather than a current or consensus dividend.
Our team of fundamental analysts judge each company’s dividend paying power by assessing their free cash flow generation through different stages of the economic cycle and explicitly model a two-year bear-case scenario, i.e. can a dividend be paid in 8 out of the next 10 years, rather than the “worst case” dividend because that is always going to simply be zero for every company.
The advantage of our 8/10 approach is it allows us to consider a significant downside scenario for each company and what level of dividend they can pay post a crisis.
The unprecedented and unexpected impacts from COVID-19 mean that for a number of companies, short-term expectations for dividends have fallen below our Sustainable Dividend forecast, but where we have confidence, we are able to continue to hold them as when they do recover they can help to protect the future income stream.
Deep Fundamental Analysis of Short-Term Impact
Our existing Sustainable Dividend analysis is complementary to the specific work the team has been undertaking since the start of the COVID-19 crisis. The team has been carefully looking at each and every stock in our portfolio and our also our investible universe to create a “2020 COVID-19 Dividend Profile” to accompany their Sustainable Dividend analysis.
The objective of this analysis is to more precisely calibrate each securities downside income risk, and understand which stocks should see dividends recover relatively quickly versus those that are likely permanently impaired.
Our recent focus has been on the following market segments:
- Companies that “make money while you sleep” rather those that have a more “transactional” nature;
- Exiting positions that we were most vulnerable to the adverse outcomes from social restrictions; and
- Purchased undervalued companies that have not acted as defensive as they genuinely are
The Result: A Portfolio with A Stronger Income Outlook
Using this dual track analytical framework has helped us craft a portfolio that achieves an intelligent balance between long-term dividend potentials and short-term income protection. Using this analysis, we have carefully re-positioned our Equity Income strategy and since the start of the crisis, we have achieved a much lower reduction in our dividend stream than the broader market.
Our Equity Income & Australian Dividend Outlook
Still, it must be acknowledged that the near-term outlook for dividends remains challenging. At the time of writing, based on broker consensus estimated for next 12 months dividends, the dollar dividend stream for the Equity Income strategy will be down ~24% from the February (pre- COVID-19) peak. For the broader market (i.e. S&P/ASX 200), it is down more than 32%1.
We expect the income stream to come down further as dividend forecasts published by stockbroking analysts have yet to fully account for the effect that the reduced company earnings will have on dividends.
Our 2020 COVID-19 Dividend Profile work, and our proprietary Profit Pulse Indicator suggests that the full extent of downgrades to the income stream for the broader Australian market will be in the order of approximately 40% down on February estimates, whereas our Equity Income strategy will likely fall only ~30% from the peak2.
A Crisis and An Opportunity
We recognise that the fall in income is a critical issue for investors such as retirees who rely on that income for their living expenses. However, without minimising the seriousness of that issue, we would also point out that we believe this crisis is an opportunity for active managers like ourselves to build a diversified portfolio of businesses with the ability to generate sustainable dividends at once-in-a-lifetime valuations.
Learn more about the Legg Mason Martin Currie Equity Income Strategy (available as both a Fund and ETF) at our website:
1Source: Martin Currie as of 29/05/2020, Next 12 Months (NTM) Income yield is calculated using the weighted average of broker consensus forecasts of each portfolio holding –because of this, the returns quoted are estimated figures and are therefore not guaranteed. Assumes zero percent tax rate and full franking benefits realised in tax return for Martin Currie Equity Income.
2Source: Martin Currie estimates as of 29/05/2020.
Past performance is no indication of future performance.
Legg Mason Asset Management Australia Ltd (ABN 76 004 835 849 AFSL 240827) is part of the Global Legg Mason Inc. group. Any reference to ‘Legg Mason Australia’ or ‘Martin Currie Australia’ is a reference to Legg Mason Asset Management Australia Limited. ‘Martin Currie Australia’ is a division within Legg Mason Asset Management Australia Limited. Legg Mason Australia is the responsible entity of the Legg Mason Martin Currie Equity Income Fund (ARSN 150 751 821). Martin Currie Australia is the fund manager of the Fund. Before making an investment decision you should read the Product Disclosure Statement (PDS) for the Fund carefully and you need to consider, with or without the assistance of a financial advisor, whether such an investment is appropriate in light of your particular investment needs, objectives and financial circumstances. The PDS is available and can be obtained by contacting Legg Mason Australia on 1800 679 541 or at www.leggmason.com.au. This product has not been prepared to take into account the investment objectives, financial objectives or particular needs of any particular person. Neither Legg Mason Australia, nor any of its related parties guarantees any performance or the return of capital invested. Past performance is not necessarily indicative of future performance. Investments are subject to risks, including, but not limited to, possible delays in payments and loss of income or capital invested. The information in this article is of a general nature only and is not intended to be, and is not, a complete or definitive statement of the matters described in it. The information in this article does not constitute specific investment advice and does not include recommendations on any particular securities. These opinions are subject to change without notice and do not constitute investment advice or recommendation.