Rudi’s View: More Choice For Income Hunters

This story features VANGUARD AUSTRALIAN PROPERTY SECURITIES INDEX ETF, and other companies. For more info SHARE ANALYSIS: VAP

In this week's Weekly Insights:

-More Choice For Income Hunters
-December Index Review Preview
-Conviction Calls
-AIA Investor Day In Sydney

By Rudi Filapek-Vandyck, Editor FNArena

More Choice For Income Hunters

The year of the Grand Yields Reset, otherwise known as probably the worst bear market for global bonds – ever, is starting to deliver investors genuine alternatives for regular income outside the share market.

This is a major change from recent years when a common phrase used on Wall Street was that of TINA – There Is No Alternative (to equities).

Increasingly, asset allocators and strategists are again warming towards government bonds and even cash deposits as implied returns (through income) have become competitive with stocks, and at a much lower risk profile.

Investors are being reminded that economic recessions, expected in the year ahead, bring along a lot of uncertainty for corporate profits and valuations, which, all else remaining equal, lifts the overall risks for individual companies, and their dividends.

Bonds traditionally benefit from tougher economic conditions, with both inflation and central bank tightening expected to change course over the year ahead.

A recent strategy update by Wilsons highlighted several fixed income alternatives investors might consider as a lower-risk option for their non-active cash on the sideline, including:

-JCB Active Bond Fund (CHN0005AU)
-Western Asset Australia Bond Fund (SSB0122AU, BNDS)
-iShares Core Composite Bond ETF (IAF)
-Floating rate hybrids

In addition, Wilsons strategists also highlighted the following alternative asset allocation options:

-AMP Capital Core Infrastructure Fund (AMP1179AU)
-BetaShares Gold Bullion $AU hedged ETF (QAU)
-CIPAM Multi-Sector Lending Fund (HOW6713AU)
-Alium Market Neutral Fund (DCA7894AU)
-Yarra Private Capital Discovery Fund

The strategists also did not hesitate to recommend investors use term deposits for any cash not allocated. Quant analysts at Citi recently went one giant step further; in their view, cash is back as a genuine asset, alongside all the usual suspects of property, stocks, and fixed income.

Admittedly, the situation for investors in Australia is not quite the same as for peers in the US or New Zealand where government bond yields are currently above 4% (the ten year yield is 4.50% in New Zealand) with the Aussie ten-year yielding circa 3.85%, not too dissimilar to bond yields in Canada and Great Britain.

Plus, of course, income derived from Aussie shares on average is among the highest in the world, today's average dividend yield of 4.8% well exceeding the sub-4% on offer through domestic government bonds (franking not even included).

However, the underlying message remains the same: for those investors looking to diversify and to spread risk, or who feel uncomfortable with the outlook for the share market, alternatives elsewhere are steadily becoming more attractive, and expected to receive a boost when central banks stop hiking rates.

Yield alternatives are equally popping up through Exchange Traded Funds (ETFs) with the FNArena/Vested Equities All-Weather Model Portfolio recently adding the Vanguard Australian Property Securities Index ETF ((VAP)). This selection of 31 ASX-listed REITs, property owners and developers has been sold off aggressively this year on the back of rising bond yields.

According to indications published by Vanguard on the dedicated website, the implied dividend yield on offer is now 5.1% with individual risks spread across Goodman Group ((GMG)), Scentre Group ((SCG)), Dexus ((DXS)), Stockland ((SGP)), Charter Hall Long WALE REIT ((CLW)), National Storage ((NSR)), Waypoint REIT ((WPR)) and 24 others, of which many are household names among Australian investors.

What about Australian shares?

This year's bear market for bonds has equally thoroughly shaken up the local share market.

Viewed from the top down, the ASX200 is not too far off from where it traded at the start of the calendar year, but underneath a Big Reset in valuations has occurred, reducing the average PE ratio closer to 13x from 17.7x in January and from above 20x in 2020.

As a result, the average forward-looking dividend yield for the ASX200 has now risen to 4.8%. For comparison; the long-term average since 2006 is 4.6% but in the two years preceding that percentage had been fluctuating between 3.5%-4% as banks and other companies had been cutting dividends while average valuations were much higher.

In normal circumstances, insofar they are ever genuinely 'normal' on the Stock Exchange, investors are usually reminded above-average dividend yields also imply above-average risk.

History shows the worst investment experiences usually stem from buying into high-yielding shares before the company announces a reduction or suspension of its dividend payout.

This time around, the Australian share market has a number of unusual set-ups that deserve to be highlighted.

Super Profits Facilitate Super Dividends

Resources companies, because of their extreme leverage to economic and sector-specific momentum, seldom feature highly on investors' radar when it comes to options for sustainable, regular income from shares.

But iron ore companies have proven in recent years that when prices surprise to the upside, and stay higher-for-longer, this generates an absolute cash bonanza for the companies involved, and their shareholders.

As such each of BHP Group ((BHP)), Rio Tinto ((RIO)) and Fortescue Metals ((FMG)) had moved into the Global Top Ten of dividend payers. Though with the price of iron ore pretty much halving since March, those dividends will not be repeated from here onwards.

As illustrated by the -35% fall in the Fortescue share price since July, the temporary benefits during the extraordinary good times can disappear quickly, even without the board announcing a change in payout.

Implied forward-looking yields remain (very) high for each of the large iron ore producers on the ASX, but the trend is now clearly south, unless the outlook for China's property market, and demand for steel and iron ore, makes a turn for the better; post next year's recession, maybe?

Extraordinary conditions for the iron ore producers have now shifted into the coal sector where shares in companies such as New Hope Corp ((NHC)) are trading on forward-looking implied dividend yields of 26.5% and 17% respectively for the two years ahead, while the share price is also supported by the company's on market buyback.

History strongly suggests today's extraordinary market dynamics are but temporary and indeed, the key reason as to why the implied yield is so high is because investors refuse to price-in these extraordinary, mind-blowing conditions in full.

But while they last, and for as long as they do, investor rewards can be huge – as long as one doesn't hang around for too long when the tide turns.

See also Fortescue this year.

A similar cash bonanza has this year been building for Woodside Energy ((WDS)) inside the oil & gas sector, through the fortunate combination of the European energy crisis and the merger with BHP Petroleum.

On current consensus forecasts, Woodside's dividend payout will reduce slightly in 2023, but still yield 9.6% from today's share price of circa $39.

Needless to say, anyone considering resources companies for income needs to have a stomach for volatility, and the ability to leave before the party is over.

Come-Back Banks

Australian banks are definitely back as reliable, solid and trustworthy dividend payers, also because dividends have been steadily rising from reduced payouts in late 2019 and 2020. Add the benefits from rising bond yields and dividends from the sector haven't looked this solid for years.

Here the risk lays with the downturn in property markets and the big reset in fixed interest mortgages next year. But probably fair to say, bad news is more likely to hit share prices, not necessarily impacting on the banks' ability to continue paying out oversized dividends to shareholders.

The Big Four in Australia are currently offering between 4.2% (CBA) and 6.3% (Westpac) but as yet again proven on Monday, the higher yield comes with higher risks attached.

Equally important: the local bond market does not see an economic recession on the horizon for the Australian economy.

FNArena's Sentiment Indicator

Australia may not experience economic contraction next year, there's virtually no one around who doubts economic growth will slow down, and probably very much so.

The overall expectation is that inflation and falling house prices will force households into spending less and on cheaper products, which can have a significant impact on sectors and segments of the local economy.

Elsewhere, economic recessions in the UK and in Europe are pretty much a given, while aggressive tightening by the Federal Reserve is thought to make avoiding economic recession in the US improbable (as also indicated by US Treasuries).

Meanwhile, central bankers are still messaging more rate hikes are forthcoming.

These considerations need to be kept in mind when assessing the pros and cons of today's dividend paying "opportunities" on the ASX.

Outside of selected segments such as financials, and producers of coal and energy, earnings forecasts for next year are sliding downwards, and they might yet prove a precursor to Australian companies having to cut dividends next year.

FNArena's Sentiment Indicator has the ability to rank ASX-listed companies according to forecast dividend yield and today's ranking is both a representation of the Big De-Rating forced upon by the bond market, as well as exceptional conditions for coal and investors' worries about what might lay ahead next year.

I don't check these ratings daily, but I cannot imagine there having been many precedents over the past two decades when the highest yield on offer was 31% from Coronado Global Resources ((CRN)) and 66 places further down the list the yield offered by South32 ((S32)) is still 4.87%, above the 4.80% market average.

Ranked number 100, Reliance Worldwide ((RWC)) is still offering 3.39% (on a prospective cut of -35% in FY23 from FY22).

In between, there's Viva Energy Group ((VEA)) offering 10.44%, Stockland ((SGP)) 7.75%, CSR ((CSR)) 7.31%, Centuria Capital Group ((CNI)) 6.91%, Abacus Property Group ((ABP)) 6.80%, Nine Entertainment ((NEC)) 6.61%, JB Hi-Fi ((JBH)) 5.95%, Insurance Australia Group ((IAG)) 5.07%, and Telstra ((TLS)) on 4.34%.

Unless we are facing a mini-Armageddon for corporate profits and cash flows next year, these numbers seem to suggest there's incredible value on offer in today's share market, in particular with those companies able to lift their performance in the years ahead while share prices are priced for failure.

In the same breath, investors will need to be extra-vigilant in order to avoid the value traps. Magellan Financial ((MFG)), for example, sits high on today's ranking, with an implied forward-looking yield of 9.30%.

Telstra Unlocking Value

Odd as it may sound, a high yield is not by definition the most important factor to consider for income-hungry investors. Often a lower yield with more certainty (less questions) offers better return, or at least: less sleepness nights.

Early in 2021, the FNArena/Vested Equities All-Weather Model Portfolio added Telstra on the expectation that spinning off infrastructure assets would unlock value for shareholders. 1.5 years later, asset sales are likely to safeguard the dividend throughout tougher economic times.

Telstra managed to surprise positively this year by lifting its dividend faster than expected. Some analysts believe there could be more increases on the horizon. Meanwhile, the prospect of ongoing asset sales provides protection to the downside for the share price.

It is for those reasons investors might not be fussed about Telstra offering less than half of the yield on offer through Magellan Financial – the odds of Telstra having to cut its dividend are pretty close to zero.

The offset is that even if Telstra manages to further increase its dividend in years to come, it likely won't be spectacular and it won't happen annually or even regularly. For these reasons, I think the inclusion of Telstra in the All-Weather Model Portfolio will be subject to re-assessment, once the asset sales and economic downturn have run their course.

Investment decisions don't always have to be made for eternity; not even when it involves regular income.

FNArena's Dividend Calculator

One of the additional features available through Stock Analysis on the FNArena website is the Dividend Calculator which automatically shows the average growth in dividends over the past three years, as well as today's yield on shares purchased three years ago.

The idea behind this feature is to show investors the value of investing in dividend payers that manage to grow their profits and dividends, while not necessarily starting off on an elevated yield.

The Dividend Calculator also projects the average growth into the next five years, which can lead to some spectacular outcomes in case there has been tremendous growth in recent years (which may or may not be repeated).

As per always, context is everything and investors should always mind the details when using such applications. But don't let this stop you from using them.

December Index Review Preview

Equity indices have seen quite a large number of changes this year, but if Morgan Stanley's research can be relied upon, the upcoming December review will be a very quiet affair.

The broker predicts there could be as little as one adjustment only for the ASX200, and none for other indices managed by Standard & Poor's in Australia. The S&P300 is traditionally not reviewed in December.

The one, potential, change could be St Barbara ((SBM)) out and Monadelphous ((MND)) in.

Equally noteworthy, the addition of miners and energy producers -resources stocks- thus far this year has never been as high over the past twelve years, according to Morgan Stanley.

Not surprisingly, for the first time since 2016 Australian indices have experienced more removals than inclusions for technology stocks.

Conviction Calls

Market strategists at Citi have dubbed next year probably the most widely anticipated recession in recent history.

They are, of course, referring to the US economy. On Citi's modeling, the US will experience its Fed-induced economic recession in the first half of 2023.

And while earnings expectations still need a lower reset, Citi also finds the compression in valuations generally because of higher bond yields has largely run its course.

While volatility is expected to remain with us for a while yet, Citi believes US equity markets, overall, will prove more resilient, also because the economic recession will be largely consumer-led, and benign.

Citi's targets set for the S&P500 speak volumes: 4000 for year-end 2022, 3800 by mid-year and 3900 by year-end 2023.

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Morgan Stanley has published a deep-dive into Australia's best known and broadly owned defensive consumer-spending companies; Coles Group ((COL)), Endeavour Group ((EDV)) and Woolworths Group ((WOW)).

And they all start life at the broker with an Underweight rating, share price targets between -12.5%-15.5% below current share prices and EPS forecasts some -10% lower than market consensus.

Morgan Stanley thinks consumers changing their spending habits to cheaper alternatives in combination with margin compression (inflation continues to bite) and a general sector-derating on the back of food product disinflation will weigh on all three stalwarts in 2023.

But there seems to be no hurry to switch out of these stocks just yet, with the broker acknowledging the weeks leading into December/year-end look okay.

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Market dynamics have not been kind for so-called long duration assets, otherwise known as technology companies, acknowledges Jarden.

A recent preview of market updates by NZ-based technology companies still exhibits an overwhelming dose of caution as macro concerns continue to linger over the sector.

The broker's sector update mentions two potential positives. Gentrack Group ((GTK)) has the best odds to surprise positively with its upcoming FY22 financial result, scheduled for November 29.

Vista Group International ((VGL)) is the sole stock currently rated Overweight in the sector.

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Portfolio managers at Wilsons have increasingly warmed towards data centres operator NextDC ((NXT)) with the ever-cheaper share price of this "quality growth stock" considered a longer-term opportunity.

Wilsons Focus Portfolio increased NextDC's weight to 3% from 1% while reducing exposure to Qantas Airways ((QAN)) by -1% to 3%.

The timing proved a-synchronous with share market momentum in October, with NextDC joining OZ Minerals ((OZL)) as the worst performer in the portfolio for the month, both falling by -6%.

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Strategists at stockboker Morgans have used a better-than-forecast banking reporting season in Australia to add both CommBank ((CBA)) and Westpac ((WBC)) to their selection of Best Ideas for the ASX.

The selection now consists of 45 companies, including well-known large caps BHP Group, Macquarie Group ((MQG)), Wesfarmers ((WES)), Seek ((SEK)) and Santos ((STO)), as well as lesser-familiar minnows Dalrymple Bay Infrastructure ((DBI)), GQG Partners ((GQG)), Mach7 Technologies ((M7T)) and PeopleIN ((PPE)).

For more insights on who's in and who's not:

https://www.fnarena.com/index.php/2022/09/15/rudis-view-bega-cheese-computershare-nextdc-playside-studios-treasury-wine-and-qantas/

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Technology sector analysts at Goldman Sachs recently initiated coverage on three newcomers, but only one starts off with a Buy rating; Data#3 ((DTL)).

Both Dicker Data ((DDR)) and Macquarie Telecom ((MAQ)) received a Neutral rating, as the broker attempts to balance quality business models and long-term favourable trends with near-term cyclical risks.

The Data#3 first price target was set at $8.95, suggesting some 30% potential upside. Targets for Dicker Data and Macquarie Telecom were set at $12.25 and $64.60 respectively.

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Resources sector analysts at Citi have laid out likely market dynamics under different recession scenarios for 2023.

Assuming economic recessions will remain mild and brief, Citi argues both miners and the energy sector look attractive under such a scenario, which is also the broker's base case assumption.

Considered most attractive are Rio Tinto, South32, Santos, Mineral Resources ((MIN)) and Allkem ((AKE)). Least attractive are Whitehaven Coal ((WHC)), New Hope Corp and Pilbara Minerals ((PLS)).

If it turns out the recession is deeper and it lasts longer (ie 'hard landing scenario'), then oil & gas producers stand to benefit most with Santos and Woodside Energy considered most attractive. Least attractive are now South32, Fortescue Metals, 29Metals ((29M)) and Sandfire Resources ((SFR)).

In case of a 'soft landing', otherwise known as it was all a scare, but nothing untoward is going to happen, more upside will present itself among miners with lower margins and higher operating leverage, explain the analysts.

The latter scenario favours companies including South32, Fortescue Metals, 29Metals, Newcrest Mining ((NCM)) and Mineral Resources. Least preferred under this scenario are Santos and Woodside Energy.

AIA Investor Day In Sydney

I won't be presenting this time around, but I might make a surprise attendance at the Australian Investors Association's (AIA) Investor Day in Sydney later this month.

Those interested in attending, use coupon RUDIpromo for a super early-bird ticket price of $59 only – includes lunch, morning and afternoon tea and networking drinks at the end of the day.

Sydney, on November 25:

https://www.eventbrite.com.au/e/aia-investor-day-2022-sydney-tickets-438541508457

(This story was written on Monday, 7 November, 2022. 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).

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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BONUS PUBLICATIONS FOR FNARENA SUBSCRIBERS

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– The AUD and the Australian Share Market (which stocks benefit from a weaker AUD, and which ones don't?)
– Make Risk Your Friend. Finding All-Weather Performers, January 2013 (The rationale behind investing in stocks that perform irrespective of the overall investment climate)
– Make Risk Your Friend. Finding All-Weather Performers, December 2014 (The follow-up that accounts for an ever changing world and updated stock selection)
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Subscriptions cost $480 (incl GST) for twelve months or $265 for six and can be purchased here (a subscription to FNArena might be tax deductible):

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