Property crash, royal commission are key for income investors

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Glenn Freeman: Aaron, thanks very much for your time today.

Aaron Binsted: Pleasure.

Freeman: One of the areas that you cover specifically is defensive equity strategy within the Australian team. What do you define as a defensive sector, or indeed, a defensive company, in terms of the way that you think about them?

Binsted: It's a really good question, because we think that in terms of a sector, you cannot always assume a sector is going to be defensive. For example, one sector can be defensive in one market environment and not defensive in another. A great example there is REITs, which if you look during the GFC, they clearly weren't defensive, too much debt, aggressive payouts. In the years subsequent, they had to cut their dividend payouts, raise equity. We actually think for the next maybe sort of four to five years after that, they were good defensive stocks, they had sensible balance sheets, were sensible with their dividends. But from maybe late 2015 to early 2016, some of those bad habits started to creep in again. Acquisitions at high valuations, gearing rising and payouts getting a bit aggressive. So, while not as bad as pre the GFC, we though that they had started to lose some of that defensive characteristics as we like to define them.

So, a few key things we look for; quality of balance sheet, certainty of cash flow and predictability of that cash flow coming to the investor in dividends. They are three of the things that we really want to focus on.

Freeman: We've heard – now, this year, we've probably seen the best of the dividend payouts from Australian companies. It's kind of reached the peak and as expected to sort of taper off. So, how do you maintain that income yield if the companies themselves aren't paying out as much?

Binsted: It's a very good question. And we actually would agree in the sense that dividends in and of themselves are more favorable and less favorable at different times. And one distinctive feature of the defensive Australian equity fund is that we will not risk capital for the sake of a dividend stream. So, we will not risk losing your money to chase a good income yield. That means that we will accept maybe a slightly lower starting yield that we think can protect your capital grow. Or indeed, if there aren't enough good-quality income opportunities, we'll invest some of the portfolio in cash which does have lower yield, but we think it's much more important to not risk valuations, not risk capital and then deploy that in other income opportunities when those do arise.

Freeman: And within the Australian market, what are some of the sectors that you are more constructive on at the moment or perhaps less constructive on that you are trying to veer away from?

Binsted: Yeah. So, look, I mentioned REITs before. So, while they have come down a bit, as a general comment, that's an area that we are not invested in. We still think that valuations are a bit too aggressive and dividend payouts across some of those names may need to come back. Banks is an area where we are very cautious on. On traditional metrics like headline dividend yields and so on, they look very attractive relative to history. But we have the 10-ton gorilla in the room being Australian housing. And while we don't know exactly how that's going to play out, if it gets bad, that's a big risk to the dividends and capital. And it's not a risk we are prepared to take for our investors at the moment.

Freeman: And within that financials space, have you changed your allocation to some of the specific banking stocks in Australia? Probably another elephant in the room is the Royal Commission and the big four banks that have taken a little bit of a hit, though the companies themselves have arguably held up okay in terms of financials. But have you changed your exposure to the big four banks at all?

Binsted: It has been low, but it's reduced. We've taken the opportunity when it presented itself to lower some of those weights and put that capital into other areas, we think, is more attractive. Some of the revelations into the quality of mortgage underwriting, I think, left a lot to be desired and indeed, the regulator and the banks have themselves said that publicly. Going back a few years ago, I don't think anyone would have expected that that was the reality if in fact what was going on.

Freeman: And just finally, in the past your team, I think, probably on one of the other funds that you also touch on, you've been somewhat contrarian in selecting some companies that were a bit against consensus. You had companies in there like, Computershare, Woodside, Origin. How often does that sort of thing happen where you do find yourself in a contrarian to the viewpoint?

Binsted: Typically, – so, this is for our Select Australian Equity Fund – it typically happens at extreme points, either for a sector or a stock. You mentioned Woodside, which I think is a great example to kind of bring that out. We were very bearish on resources from, say, 2006 to 2014. Commodity prices were too high. We thought they were going to come back, and they eventually did, and it was quite painful. So, we were very contrarian in not owning any of them in the Select Fund or very light holding. Through 2015 when those commodity prices fell a lot and their equities fell to a very large extent also, we actually built very large positions. Woodside is the one you mentioned. There were some other names we bought too; Rio Tinto and Alumina.

So, at that stage when – at the start of 2016, we were very excited about those names. I think if people told you that that was in their portfolio they have put across the street, they probably wouldn't have wanted to be there. That turned out to be a very good move. So, the thing we like to say is we are valuation-focused. We are absolutely focused on the valuation. There's no point being different for the sake of being different, but we have conviction in the work we do. And if we believe in a valuation that's different to the market, we will back it.

This report appeared on www.morningstar.com.au 2022 Morningstar Australasia Pty Limited

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