income stocks

Downturn in income stocks is cyclical


Over the past year, global and growth investors have been well-rewarded. However, many shareholders feel left out, particularly if they are not exposed to the popular investment styles and sectors.

Those who invest in income stocks have felt this way for the past 18 months. While local and global markets soared, they were left to contend with disappointing returns. The protracted length of this underperformance, the correction and looming headwinds have many questioning whether investing in the sharemarket for income is a dying strategy.

On the surface, things look good for income investors. The current median average dividend forecast yield for the All Ordinaries is a healthy 3.4 per cent. Including franking credits, this rises to 5.3 per cent. With 208 companies (41 per cent of the index) paying above that average, plus the proliferation of many listed investment companies (LICs) and funds focused on income, it is not difficult to find a company or vehicle that is paying its investors a better-than-average income on their investment.

However, the challenge has been from a total return perspective. For the past 12 months the median average total return for the All Ordinaries (including dividends) has been 12.9 per cent. The 208 companies that have paid a higher yield have produced a total return of 6.7 per cent. In other words, excluding dividends, capital returns have been modest. This widening gap has many assessing the drivers of the divide and whether it will abate anytime soon.

income stocks

One concern is the threat of rising global interest rates and its impact on the so-called bond proxy investments.

Drag reduction

Although domestic interest rates may be low, in an increasingly global market, a rising rate cycle will act as a drag on income stocks. That said, one could argue much of this drag has already been priced in. Given that rates are still at historically low levels and we are only at the beginning of the rate rise cycle, the downside may have been overplayed.

It is also important to remember that the drag on the performance of some of these businesses is due to factors other than their yield. The telecommunications sector has the lowest earnings growth expectation for 2018 of any sector, as shareholders of Telstra, the market darling for income investors, will tell you. The banks, insurance and property sectors – the traditional heartland for income stocks – have similar low earnings growth expectations over the coming year and this has been reflected in the price.

Front of mind for many is the potential removal of franking benefits for investors on a low marginal tax rate, should Labor win the next election.

Seasoned income investors will realise they are facing a market cycle that is currently against them. We share this view. Rather than condemning income stocks to the sharemarket scrap heap, we see this period as a cyclical shift, supported by broad macro, sector and psychological factors. At some point, we believe income stocks will return to favour.

When assessing a business for inclusion in our Star Income Stock portfolio, we don’t simply look for companies with the highest yield. We seek financially healthy businesses that demonstrate underlying growth and are expected to continue to deliver stable earnings. We seek companies with sustainable payout ratios and strong cash flows. This should at least support dividends and most likely trigger an increase in dividend payments into the future. We feel these businesses have their destiny in their own hands and will be the quickest to rebound when the cycle turns.

 

Published Tuesday, 3 April 2018
www.afr.com. | Financial Review

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