Income strength and sustainability

Income has taken a hit. John Stopford and Jason Borbora-Sheen offer a way forward through a focus on strong and sustainable income.

May 26, 2020

16 minutes

Income has taken a hit. John Stopford and Jason Borbora-Sheen offer a way forward through a focus on strong and sustainable income.

The fast view

  • Unprecedented policy and fiscal stimulus have helped to stabilise markets
  • But investors should acknowledge the uncertainty about the future and avoid complacency
  • They should rather focus on securities offering both strong and sustainable income
  • This approach has helped us to limit losses in the sell-off and now gives us dry powder as we aim to exploit the resulting market dislocations

The path forward is very uncertain; we offer a four-step approach capable of delivering returns underpinned by sustainable income.

Stimulus support

Income investors have taken a severe hit thanks to COVID-19. The March sell-off saw higher-yielding assets – across stocks, bonds and alternatives – underperform as the longstanding ‘hunt for yield’ was replaced by a ‘hunt for safety’.

To make matters worse, many companies cutting dividend payments to preserve cash has left income investors with fewer options.

However, the unprecedented stimulus from policymakers1 around the world to keep businesses and households afloat during the Great Shutdown2 seems to be working so far. We think this gives investors the potential to not only recover losses, but also to benefit from price dislocations in financial markets.

Investors should still be wary of the extraordinary level of uncertainty about how the future may unfold. Now is not the time for taking big bets. Rather, we think a cautious approach focused on income strength and sustainability is the best way forward.

We believe four elements can help us navigate the coming challenges.

  1. It helps if you can start from a position of strength

    The Fund’s performance capture to the upside versus the downside is a good measure of comparative strength. Limiting the drawdown in returns, in absolute terms and relative to many of our peers3, leaves us well placed to recover, especially when you consider that many asset classes and individual securities still have room to rebound after the price dislocations seen in March.

    Figure 1: GMAI upside/downside capture since inception

    GMAI upside/downside capture since inception

    Ninety One Global Multi-Asset Income Strategy average monthly gain and loss as a proportion of Global Equities average gain and loss. Source: Ninety One, in USD gross of fees and taxes with income reinvested, Global Equity returns are for MSCI AC World Index NDR, from 01 June 2013 to 31 March 2020.

    Capturing more upside than downside means less time is needed to recover back to positive territory after a period of drawdown. What’s more, our performance profile in this recent episode is broadly in line with our longer-term numbers, giving us confidence in our ability to recover this time as we have done after previous major risk-off periods.

    A key design difference in our portfolio

    How were we able to capture more upside than downside during COVID-19? We think it’s down to a key design difference in our portfolio compared with other income strategies, which has to do with our bottom-up security selection process4. In equities, for example, income investors often go for the highest dividend stocks (naturally). We don’t do this because we think very high yields are often a risk indicator as they can imply unsustainable dividend payments. Through a bottom-up process based on fundamental research conducted by our analysts, we instead seek to find companies that pay sustainably high dividends, but not the highest. Please refer to this piece for more detail on the difference of our process versus other equity income strategies.

    ‘Our research-led process interrogates the profitability and capital allocation decisions of a company to see if its income stream is based on resilient characteristics’

    Table 1: Our yield sweet spot is high, but not the highest

    Our yield sweet spot is high, but not the highest

    The yield of the underlying securities is not guaranteed, there is no assurance of its stability and sustainability and it does not represent the yield of the Fund. A positive yield does not imply a positive return.

    Our research-led process interrogates the profitability and capital allocation decisions of a company to see if its income stream is based on resilient characteristics, and is not just reliant on riskier drivers, such as leverage. This in turn has created more robust income from the overall portfolio.

    This combination of better COVID-related upside versus downside capture due to our bottom-up focus on resilient income securities is why we believe we are starting the rest of the year from a position of strength as we now seek to take advantage of some meaningful opportunities.

  2. Taking advantage of pricing dislocations

    To be clear, we were not immune from the sell-off in markets. The Fund’s equity exposure lost value, with higher-yielding equities generally underperforming the broader market. Our property holdings also sold off.

    That said, the considerable falls created opportunities where prices dislocated from fundamentals. Despite the considerable recovery in asset prices since the sell-off, persistent price dislocations resulting from the prior indiscriminate selling can provide ammunition for future returns. This is particularly true from a bottom-up security selection perspective, but also from a top-down asset allocation perspective.

    One example is the pricing of long-dated high-quality corporate bonds, where the market stress and drying up of liquidity in March led to irrationally sharp falls amongst some very robust household names. Figure 2 puts this into perspective.

    Figure 2: High-quality companies underperform US Treasuries significantly

    High-quality companies underperform US Treasuries significantly

    No representation is being made that any investment will or is likely to achieve profits or losses similar to those achieved in the past, or that significant losses will be avoided. This is not a buy, sell or hold recommendation for any particular security. For further information on specific portfolio names, please see the Important information section. For illustrative purposes only. Source: Bloomberg, 18 May 2020. The chart above shows the price of the corporate bond divided by the price of a US Treasury with a similar maturity. This shows the corporate bonds trading at a discount relative to similar-dated Treasuries.

    These moves reflected market panic but created an opportunity to benefit from a return to more rational pricing, which has now begun to happen. We added significantly to these bonds and those of other similar issuers during the period of maximum distress in late March.

    Significantly, our ability to look across asset classes means that we are well placed to spot apparent pricing inconsistencies between the bonds and the shares of a company such as Amazon or Microsoft. Identifying these opportunities requires a holistic analysis of markets and we are encouraged by what our cross-asset collaborative research specialists have uncovered in recent weeks. We provide a summary in Table 2.

    Table 2: Pricing dislocations and income opportunities across our investible universe

    Credit
    • Following the considerable dislocation in credit markets, high yield spreads have only been wider during the GFC and the tech-bust recession of 2001-2003. On a risk-adjusted basis, the dislocation was even greater within investment grade, with implied default rates in high quality bonds trading in excess of anything that has been seen in even short periods during the worst recessionary episodes historically.
    • This extreme dislocation provides attractive future return opportunities assuming spreads normalise as they have done in prior periods of widening and they look particularly compelling when compared to ‘safe haven’ assets like Treasuries from an income perspective, not least the bonds of those companies which the equity market sees as potential winners from this shock.
    Listed infrastructure
    • The rush for liquidity by investors during the market sell-off impacted listed infrastructure and saw these names move to trade at a discount, enabling us to increase our exposure at attractive entry points.
    Emerging market debt
    • Emerging market bonds repriced significantly in March increasing the yields available. Reward looks attractive in a range of local currency bonds in countries such as Indonesia and South Africa, which offer a high yield for limited duration risk. These can be fully currency hedged, benefitting recently from the slightly lower cost of hedging.

    In short, we believe the path forward provides a rich landscape of good opportunities to take advantage of. We believe doing so selectively and in a measured way, based on our bottom-up research-led process and informed by top-down awareness of the shifting macro picture, will be key./p>

  3. Identifying resilient sources of income

    Even though stimulus should limit the damage done by lockdowns, the economy’s recovery will likely be messy and uneven. The rebound in markets so far has seen many assets recoup a large portion of the losses suffered year-to-date, but it seems hopeful to assume that we are completely out of the woods just yet. This makes it critical to carefully analyse potential opportunities for those which are best placed to withstand continuing instabilities and shocks in markets.

    Resilient returns from bottom-up stock picking

    Though spotting pricing inconsistencies from cross-checking different markets is exciting, we believe our primary edge lies in bottom-up security selection to build resilient returns. This means focusing on the quality of each, individual holding within our portfolios and keeping our carefully chosen selections to a concentrated number. On average, we hold only 40-50 stocks5 in our equity portfolio, while a fund of funds portfolio with exposure to global equities will have look-through exposure to thousands of companies. The portfolio invests in a relatively small number of individual holdings. This may mean wider fluctuations in value than more broadly invested portfolios. A similar approach is adopted for other asset classes, such as corporate and government bonds, listed property and infrastructure.

    This research-led process, and the difference in design as mentioned above, we think, results in a differentiated set of positions if we compare the characteristics of the securities we own to those of the market. We believe this is helpful for our investors as it means they avoid repeating the same investments they might hold elsewhere.

    Table 3 shows our top ten equity holdings. We believe they each have the resilient characteristics we look for to create a portfolio that seeks to generate returns through sustainable income, and this in turn helps to deliver robustness exemplified by the positive performance skew we aim to deliver.

    Table 3: Top ten equity holdings

    Company name Weight in fund (NaV)
    Partners Group Holding Ag 1.15%
    Watsco Inc 1.10%
    Roche Holding Ag 1.02%
    Tokio Marine Holdings Inc 1.00%
    Vinci Sa 0.98%
    GlaxoSmithKline Plc 0.92%
    Pepsico Inc 0.91%
    Abbvie Inc 0.88%
    Unilever Plc 0.84%
    Sanofi 0.84%

    No representation is being made that any investment will or is likely to achieve profits or losses similar to those achieved in the past, or that significant losses will be avoided. This is not a buy, sell or hold recommendation for any particular security. For further information on specific portfolio names, please see the Important information section. The portfolio may change significantly over a short space of time. Source: Ninety One, 30 April 2020.

    Deeper dive

    Partners Group Ag / Weight: 1.15% / Yield: 3.1%

    • Very strong record of investment performance
    • High and stable management fees
    • Industry highest returns of capital
    • No company level debt and significantly less leverage than peers
    • High degree of ownership from the founders
    • Progressive with dividend growth over long term

    Watsco Inc / Weight: 1.10% / Yield: 4.3%

    • Leading market share in a highly fragmented industry
    • Return on capital are attractive and the balance sheet has little debt
    • A large proportion of sales are recurring in nature because they come from maintenance and repair driven demand
    • No company level debt and significantly less leverage than peers
    • The company has very strong management with a unique incentivisation structure that encourages long term decision making

    Roche Holding Ag / Weight: 1.02% / Yield: 2.8%

    • Roche is a European pharmaceutical company and is the undisputed leader in Oncology
    • It has a deep pipeline of drugs in development and has displayed impressive R&D efficiency historically which has enabled the company to drive growth organically. As a result, their historical capital allocation has been amongst the best in the industry, being one of the only pharma stocks to not engage in large scale M&A which has in turn underpinned high profitability levels
    • Source: Ninety One, May 2020.

    By showing this, we hope to demonstrate the level of detail required to build a sustainable income portfolio. There are many factsheets that will be showing high yields right now after the market turmoil. The key question investors should ask is how sustainable that yield is? What are the building blocks and what are the underlying risks to those income streams?

    The current yield of our Fund is 4.8% (3.2%)6. With our research-led bottom-up approach, we believe we have a portfolio of attractively-valued securities with resilient yieldgenerating characteristics that are well placed as a result to deliver more persistent levels of yield and performance.

  4. Proceed with caution

    Our central risk case assumes a sharp economic recovery as lockdowns ease and many businesses come back online, followed by a slower rebound in some parts of the economy which take longer to normalise. In this scenario, we believe, our approach gives us a head start in making back recent losses and then participate in the recovery in the prices of the resilient yielding securities we hold.

    Significant risks remain, however, such as a second wave of the virus or a slower recovery in companies requiring social distancing, leading to more lasting damage to jobs and income, and to a more protracted recession.

    While our security selection is expected to do the heavy lifting in terms of future return generation, diversification and risk management will be used to navigate through what are expected to be volatile markets. Given the uncertainty we mention above, we are still positioned fairly cautiously.

    We are excited about our ability to participate in opportunities across a very broad range of global markets, and importantly we are not reliant purely on equity gains from here.

    For example, and to add colour, our addition to corporate bond exposure has been not only focused on higher quality names; we are yet to add meaningfully to the emerging markets in either the sovereign or the corporate bond space, where we are continuing to gather insight through our ongoing research and collaboration with the relevant firmwide investment teams. Though there are many price dislocations across the equity and debt sphere in emerging markets, the virus path in each market is uneven and multifaceted. The hit to tourism, sensitivity to the decline in oil prices, factors determining the potential severity of the virus, and the extent to which policy can respond, are some of a vast array of considerations that need to be mapped before adequately assessing the investment potential. Security selection once again is likely to be key. Given our more defensive approach that looks to build returns through sustainable income, we think we are positioned appropriately and do not believe now is the time to go all in.

A way forward

That said, we are long-term investors and we are mapping not only the short-term impacts of the COVID-19 crisis, but the medium and long-term ones too7 . As we learn more and more each day, we believe an incremental approach that regularly considers and acts on the rapidly changing investment environment is the right way for us to proceed.

Ultimately, it is through a single-minded focus on our defensive return objective driven by the search for resilient income at the security level across different asset classes that will give us the best potential to achieve positive returns sustainably as we continue forward on this unprecedented path.

 

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1. Silberston, R., "Fast and furious: policymakers respond to COVID-19," Ninety One, April 2020.
2. Mahtani, S., Morgan, D., Saunders, P., Silberston, R, The Great Shutdown and its medium-term effects - a series from the Ninety One Investment Institute, May 2020.
3. Source: Morningstar. 30 April 2020. *Peer group comprises all UCITS multi asset and absolute return funds that have a yield >4%. GMAI I Acc YTD performance: -4.0% (-10.2). Five calendar year performance: 2019: 6.9%, 2018: 1.2%, 2017: 6.6%, 2016: 5.0%, 2015: 1.6%. Performance is net of fees (NAV-based, including ongoing charges, excluding initial charges), gross income reinvested, in USD.
4. Borbora-Sheen, J., Stopford, J., "Dividend risk and our income strategies," Ninety One, May 2020.
5. The portfolio invests in a relatively small number of individual holdings. This may mean wider fluctuations in value than more broadly invested portfolios.
6. Charges are taken from capital and may constrain future growth. The amount of income may rise or fall. Source: Ninety One, 31 March 2020. A Inc-2 Yield = 4.8% (3.2%). The bracketed number shows the level of yield had charges been deducted from income. For further information on yields and the figure in brackets, please see the Important information section.
7. Mahtani, S., Morgan, D., Saunders, P., Silberston, R, The Great Shutdown and its medium-term effects — a series from the Ninety One Investment Institute, May 2020.

 

Specific risk(s) Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income. Default: There is a risk that the issuers of fixed income investments (e.g. bonds) may not be able to meet interest payments nor repay the money they have borrowed. The worse the credit quality of the issuer, the greater the risk of default and therefore investment loss. Derivatives: The use of derivatives may increase overall risk by magnifying the effect of both gains and losses leading to large changes in value and potentially large financial loss. A counterparty to a derivative transaction may fail to meet its obligations which may also lead to a financial loss. Emerging market (inc. China): These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems. Equity investment: The value of equities (e.g. shares) and equity-related investments may vary according to company profits and future prospects as well as more general market factors. In the event of a company default (e.g. insolvency), the owners of their equity rank last in terms of any financial payment from that company. Government securities exposure: The Fund may invest more than 35% of its assets in securities issued or guaranteed by a permitted sovereign entity, as defined in the definitions section of the Fund’s prospectus. Interest rate: The value of fixed income investments (e.g. bonds) tends to decrease when interest rates rise.

Authored by

John Stopford

Co-portfolio manager

Jason Borbora-Sheen

Co-portfolio manager

Important Information

This communication is provided for general information only should not be construed as advice.

All the information in is believed to be reliable but may be inaccurate or incomplete. The views are those of the contributor at the time of publication and do not necessary reflect those of Ninety One.

Any opinions stated are honestly held but are not guaranteed and should not be relied upon.

All rights reserved. Issued by Ninety One.