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A different approach to equity income investing

Rudi Minbatiwala has managed the Equity Income Fund at First Sentier Investors since its inception in 2005. With his team, Rudi has developed a novel way to generate income from Australian equities.

Graham Hand (GH): You've spent a couple of decades developing your Equity Income strategy. How would you describe it?

Rudi Minbatiwala (RM): We use the label ‘objectives-based’ to address the needs and challenges of income-seeking investors. This group is the typical pre-retirees or retirees, and their objectives are not only maximising returns. They're thinking about a mix of good returns, with lower volatility and of course, income. There are multiple objectives and a conflict between objectives.

Our belief is that maximising income from Australian shares requires investing in companies that can grow earnings and dividends over the long term. But income is not viewed with a long-term lens, it's a here-and-now problem. So we need to address the income and lower volatility needs as well. And our approach is selectively using call options to generate a greater proportion of the return as income. This equity income approach is called a ‘buy-write’ or a ‘covered call’ strategy.

GH: Can you explain how your approach differs from other equity income funds?

RM: The traditional approach tilts to buying high-yield, dividend-paying stocks. But I come from a fundamental analysis background which requires a broad range of inputs as part of comprehensive stock research. I struggled with investing based on one factor which throws out all the value from the research effort. And in the last 18 or so years, equity income and the better ways of doing it have become my life.

GH: Let’s make sure everyone understands ‘buy-write’ or ‘covered call’, which I describe as selling call options over an existing portfolio. And a call option is giving someone the right to buy a stock at a set price and your fund sells call options to generate income.

RM: So the starting point is building the underlying stock portfolio, but in all the years of our Equity Income Fund, there's only been one month where our portfolio's dividend yield - ignoring the options premiums received - has been higher than the market. Think about that for an equity income fund.

GH: Yeah, that's unusual.

RM: It's about building the best ideas portfolio. We think the usual approach is misleading. The dividend yield is a short-term metric. It compares the current dividend to the current share price without thinking about how they change over time. We want exposure to future earnings growth of the best companies.

GH: Not just the highest-yielding companies.

RM: And the benefits come back to us over time in the form of (hopefully) growing dividends and some eventual reflection in a growing share price. The percentage yield can look low for years, but the dollar value of income can be growing really healthily. It requires a long-term perspective to income. And this is where the buy-write strategy comes in. We can't just say to our investors, think about income with a long-term lens. They need the income here and now. And so, the role of the options is to provide a bridge that allows us to focus on the best stock ideas. If it's got yield, great. If it doesn't, it doesn't matter either. The options provide the additional level of income and a downside cushion of lower volatility. And that's how we go back to achieving that mix of objectives mentioned at the start.

GH: I want to make sure that people understand the selling call options part. Can you give a stock example?

RM: Here’s a recent one. James Hardie (ASX:JHX) is a stock with attractive investment opportunities but it's decided to keep capital and reinvest it in the business. So, now it's a non-dividend paying stock. Typical equity income investors would just push that one to the side, but we like the upside potential. When its results came out recently, the stock responded, and then we thought the stock was more fully valued. We still like James Hardie, so we want to keep a position in that stock, but there's an opportunity to cap some of the potential upside in return for income.

Let me bring this example to life with some numbers. James Hardie was trading at $46.57 on 8 August when we agreed to sell a JHX Call Option with a strike price of $51.22 and expiry date of 11 October on a proportion of our JHX shares (at this time, 26% of our holding). In our assessment, capping the potential share price upside to 10% over the next 64 days was attractive given we were compensated with a certain upfront option premium income of 56 cents per share (annualised yield 6.9%pa). And that income is generated if the share price stays flat, goes up a little bit or even goes down. That's the balancing act.

GH: Whether that example plays out remains to be seen. Have you got an example of something that you did maybe 10 years ago, which was a low-yielding stock, not traditionally held by equity income funds, but you liked the capital gain potential of it?

RM: A great example is Realestate.com. Again, it's a stock that has been ignored by most equity income investors because it's only ever had a yield in the 1% to 2% range for a 14-year period. But it offered a 2% yield 14 years ago on a share price of $10 or $15, and then it became a 2% yield on a stock trading at $20 to $40, and now it's a 2% yield trading on a price of $140.

Along the way, like any active manager, we'll take some profits to reflect our fundamental views. Perhaps we sell an option to cap some of the future potential upside as we go along, convert that into income, and our job is to change the degree to which we use options on each stock.

GH: You've also said that your equity income fund can replicate the market risk characteristics of a traditional 70-30 portfolio. Now that's a big call for an equity income fund. How do you justify that?

RM: The 70-30 concept, 70% equities-30% cash, is often used to de-risk away from 100% allocation to equities. But the problem is that the de-risking also delivers a similar reduction in expected returns. It potentially addresses a risk objective but at the expense of achieving the other two objectives of long-term returns and income. We use the options to reduce the short-term exposure to the market by around 30%. It hovers over time at 20% to 40%, but on average, it's in that ballpark of around 30%. So our Equity Income Fund lags in rising markets and cushions a falling markets, similar to a 70-30 portfolio.

GH: That’s because you sold call options. If the market runs strongly, the counterparty exercises the call option, their right to buy, and your fund loses something off the top.

RM: Yes. But in other times, if the markets were weak, flat, or just going up a little bit, we've earned that premium. The big difference is our equity income approach remains fully invested in shares, like a long-only portfolio, which means that over the full market cycle, we expect full capture of what is called the equity return. What comes off in a strong market is made back on the other side. The value add is delivering similar returns to the market but with less risk. And that’s what pre-retirees and retirees want, rather than just higher fund returns than the benchmark, which is more of an accumulation-centric mindset.

GH: Why does the more traditional approach of chasing high-yielding stocks dominate equity income investing?

RM: I can understand why individual investors do the high-yield concept themselves. The strategy I'm talking about is a lot more challenging to implement. Individual investors don't receive the same over-the-counter pricing benefits that we do as a large investor. And the media is attracted to simple stories. We acknowledge our approach is more complex, but that's only because the things that retirees are looking to achieve, a balance of different objectives, different timeframes, conflict between objectives, that's more complex too.

GH: Another way we tend to talk about market performance for simplicity reasons is before-tax returns without factoring in tax benefits, such as franking credits.

RM: We think about after-tax returns with the combination of capital growth, dividends, as well as the franking credit benefits. Franking credits are valuable, but they need to be considered as just one of the components towards maximising after-tax returns. After-tax returns are not simply about maximising franking credits. We value franking credits, we capture them, but they don't become the sole basis upon which we buy stocks.

Let me come back to selling an option above the current share price. It reflects our view on a value of the stock. And if it goes up, well, that's where we are comfortable to reduce some of our positioning at that price. So it's no different to any other active investor thinking about managing their sell discipline. And we also avoid those companies who keep paying a dividend even if they raise new capital to afford it.

GH: Are your investors puzzled by an equity income fund holding stocks with a yield lower than the overall market?

RM: We own Realestate.com, James Hardie, Xero, Wisetech - all the names not usually in an equity income fund, but the combination of stock and options delivers a lower volatility with the aim of delivering a higher income yield after the addition of the option premium income. I'm not telling a 65-year-old to change their ways, to take on more risk. It goes back to the start of our discussion. How do we best balance a combination of needs? It's not just to de-risk to manage more conservative needs. It's not just to throw everything into generating income. Most investors still need to think about longevity and inflation risk, or estate planning considerations that make an investment time horizon longer. Equities should remain a part of that thought process.

 

Graham Hand is Editor-At-Large for Firstlinks. Rudi Minbatiwala is Head of Equity Income at First Sentier Investors, a sponsor of Firstlinks. This article is intended for general information only and does not consider the circumstances of any investor. It is an edited transcript of a full discussion on the Wealth of Experience podcast published soon.

For more articles and papers from First Sentier Investors, please click here.

 

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