Where to for Income in 2021?

Building better income portfolios than the index

While our LM MCA Equity Income Fund also disappointingly provided lower income to clients in 2020, due to this focus on quality and dividend sustainability, our -22% dip was a much better income stream outcome than the -36% fall in S&P/ASX 200 income and delivered a 5.6% income*.

We were also able to help protect the future income earning potential of the portfolio with high levels of active management throughout the year.

Fundamental research and diversification

For an income investor, we believe that finding companies with high quality and dividend sustainability, while ensuring diversification at the portfolio level, has been the most important thing to focus on in this difficult environment, rather than just seeking the highest spot yield at the time or following index allocations.

The ability to pay high sustainable dividends is really all about the quality of a company and its cash flow dynamics. It takes good fundamental analysis to really understand this. For example, we look for businesses with a wide ‘moat’, lower debt levels, low threats to its cash flow dynamics and more domestic revenue, which is important given Australia’s better control of COVID-19 relative to overseas. Compare these characteristics with those in cyclical, capital intensive industries with unreliable dividends, or growth stocks that really struggle to have enough excess free cash flow to pay out dividends at all.

The Australian stock market’s overall yield is notoriously concentrated in just a few big stocks, so we haven’t focused on the index weights to build our income portfolios. By diversifying away from large index weights, we have also been able to avoid outsized impacts on portfolio income if company dividends are cut due to top of cycle unsustainable earnings or structural headwinds, or if companies simply blow up their opportunity to generate earnings that can turn into free cash flows.

Things are looking better for income in 2021

2020 was clearly a difficult environment for income, but the outlook is for Australian company earnings and dividends to rebound strongly as the economy reopens.

Consumer confidence is back at 10-year highs, wages, salaries, savings and house prices have continued to rise, and this all bodes well for economic activity to re-accelerate. We are expecting double digit earnings and dividend growth, the strongest outlook we have had for quite a while.

Pre-COVID-19, Australian market earnings and dividends growth hadn’t been particularly inspiring, and if anything, dividend payout ratios across the market had been declining since they peaked in 2015.

The COVID-19 reduction in earnings has resulted in an even sharper decline in payout ratios, but this has begun rebounding since earnings revisions bottomed in the August reporting season.

Like consumers, companies were very conservative in 2020, hoarding cash against the economic uncertainty and paying down debt. They now have more free cash flow available to pay dividends and it is therefore likely that dividend payout ratios will be much higher in 2021 than 2020.

Focus on stocks with quality and dividend sustainability

Looking forward, we are seeing strong dividend opportunities coming from both the COVID recovery names and the COVID winners, many at attractive valuations.

• The discretionary retailers such as JB H-Fi and Harvey Norman who have benefited from the spend in the domestic economy, but we believe will continue to be strong and grow dividends materially year on year given their low debt levels and that the ongoing WFH thematic is going to be stronger for longer, especially in the furniture space.
• Private health insurer Medibank Private, where COVID has meant that there have been less elective surgery / private hospital procedures, and the provisions taken in anticipation of normalisation puts them in a strong defensive position to grow dividends going forward.
• The banks, which we haven’t been fans of in the past from an income growth perspective, but the conservative level of provisioning that they have taken for COVID loan losses that didn’t materialise to the extent expected means that are likely to deliver strong year on year dividend growth for a number of years.
• Among the miners, we prefer BHP over other potential exposures such as Fortescue Metals Group and Rio Tinto, who all are benefiting from high iron ore prices, but BHP has more diversity in their business. Any oil price improvement would provide an offset to the anticipated decline in the iron ore price.

An active portfolio solution for high and sustainable income

2021 is set to see a strong rebound in Australian company earnings and dividends and the LM MCA Equity Income portfolio is well positioned to capitalize on the dividend potential of companies in the Australian market.

The LM MCA Equity Income Fund is offering an attractive franked next-twelve month forecast yield of 6.4%.compared to the S&P/ASX 200 franked yield at just 4.7%, the yield premium that the LM MCA Equity Income Fund has over the index is still close to record highs†.

Given the current low-rate environment, we see the Legg Mason Martin Currie Equity Income Fund as very compelling relative to other income options available today, especially as worldwide stimulus is building inflationary pressures into fixed interest.