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Chasing sustainable, long-term dividend investments

Morningstar staff  |  30 May 2017Text size  Decrease  Increase  |  

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We look under the hood at the Morningstar Australian Shares Income model portfolio, which invests in S&P/ASX 200 Index constituents covered by Morningstar Equity Research.


Administered by Morningstar Investment Management, the portfolio focuses on companies with competitive advantages, which are trading at prices that offer a margin of safety to estimated intrinsic value. Additionally, it seeks a net and gross dividend yield that is similar--but more sustainable--or greater than the benchmark index.

"Investors looking for income, particularly those in lower tax brackets, such as retirees or pensioners, might find this strategy well-suited to their needs," says Joel Bloomer, Morningstar's head of discretionary equity strategies, Asia Pacific.

With an emphasis on companies that offer franking credits, to maximise after-tax returns, the portfolio also has minimal turnover, which helps keep costs lower.

"This combination of factors helps to preserve capital while pursuing primarily income-driven returns, supplemented by capital gains from purchasing companies at attractive prices," Bloomer says.

The company research of Morningstar equity analysts--which includes cash flow and dividend payments, fair value estimates, economic moats, and valuation uncertainty--are key components of the portfolio's screening and construction process.

"By investing within the Morningstar equity research coverage universe, we strive to offer a holistic solution that includes professional asset management with supporting written content. This facilitates understanding and communication of portfolio holdings for advisers and investors," Bloomer says.

Morningstar subscribers receive full access to the portfolio, along with the detailed equity research coverage of our team of equity analysts.

Investment style

The Income Portfolio tends to resemble a value or blend strategy, with an emphasis on large-capitalisation stocks--though this is not an explicit target. Rather, the mild value bias is a result of the portfolio's focus on achieving most of its total return from income rather than capital appreciation.

Companies with high dividend yields and payout ratios are usually slower growing, and in normal markets are ascribed lower multiples because of this.

However, Bloomer also emphasises that the team is "very willing to invest in companies with a modest dividend yield today, if it offers attractive earnings and dividend growth prospects".

"More importantly, we prefer to describe the portfolio's style as intrinsic-value focused, rather than value or growth, small or large," he says.

"In this approach, any style of stock can be an attractive investment if it is trading near, or preferably less than, the discounted sum of its future cash flows, as assessed by our equity analysts and portfolio managers."

The portfolio's tendency toward large-capitalisation stocks is a result of its focus on high-quality companies that offer attractive dividend yields.

"This ability to compound returns while paying out a large part of earnings as dividends is perfectly suited for the income portfolio, and is more commonly found in larger companies," Bloomer says.

"Having said that, we love finding medium- and smaller-sized companies where our analysis suggests they are building an economic moat around their businesses and offering worthwhile dividends along the way."

The investment process

Morningstar generates several effective qualitative and quantitative ratings, and data points to support its security analysis and portfolio construction processes--in addition to a global capital markets team that conducts ongoing return and risk forecasts on asset classes and sectors around the world.

While this international strength is utilised in maintaining the fund, the locally-based expertise of its Sydney-based equity research team and portfolio managers are paramount.

The ratings generated by this team of around 20 equity and credit analysts and strategists--part of the 100-strong global equity team--are central to Morningstar's identification of investment opportunities for the income portfolio.

"We have minimum required allocations to companies with attractive moat ratings and lower uncertainty. These are essential elements in our aim to limit downside risk, so they are very important factors in our screening and portfolio construction processes," Bloomer says.

"By biasing towards quality companies, we expect to generally outperform markets during periods of negative returns."

Individual company uncertainty ratings--which range between low, medium, high, very high, and extreme--are also part of this process.

In the valuation assessment phase, the price attractiveness of companies is considered. While these are currently based on a continuum ranging between "Buy", "Hold" and "Sell", this process will be shifting to a star-rating process later this year--in line with our Morningstar US and global funds rating methodology.

The income assessment is the next step in the process, which combines quality, value and income considerations.

"This approach helps us find companies that have high net yields, gross yields, and dividend-per-share growth. The process also finds companies that might have modest or even low dividend yields today but offer attractive dividend growth potential," Bloomer says.

The final assessment combines Morningstar's quality, valuation, and income measurements. Importantly, Bloomer and his team take a longer-term view on dividend payments, rather than simply looking to the next year's dividend projections.

"This helps us in many ways, such as identifying payout ratios that might be unsustainable, companies that could be paying much more in dividends but aren't for some reason, among a host of other important dividend-relevant characteristics," Bloomer says.

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