Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 366

Income investing during COVID-19 demands a dual technique

Covid-19 has created one of the biggest market falls (or drawdown) in Australian equity earnings in history, even bigger than during the GFC. Income investors are understandably concerned about the impact the shutdowns and ongoing social distancing will have on the ability of Australian equities to pay dividends.

This article discusses our forecast of the near-term dividend outlook and examines how active managers can help investors navigate this unique moment with the objective of creating a sustainable income stream.

Equity income and Australian dividend outlook

The near-term outlook for dividends remains challenging. At the time of writing, based on broker consensus estimated for next 12 months dividends, the dollar dividend stream from the February (pre-COVID-19) peak for the broad market (S&P/ASX 200) will be down more than 32% (and down 24% for the stocks in our Equity Income strategy).

We expect the income stream to come down further as dividend forecasts published by stockbroking analysts have yet to fully account for the effect that the reduced company earnings will have on dividends.

Our own 2020 COVID-19 dividend profile work suggests that the full extent of downgrades to the income stream for the broader Australian market will be in the order of approximately 40% down on February estimates (and for our Equity Income strategy, down ~30%) as shown below. See notes at end of the article for more details on Next 12 months (NTM) calculations.

A crisis and an opportunity

We recognise that the fall in income is a critical issue for investors such as retirees who rely on that income for their living expenses. However, without minimising the seriousness of that issue, we believe this crisis is an opportunity for active managers like ourselves to build a diversified portfolio of businesses with the ability to generate sustainable dividends at once-in-a-lifetime valuations.

For an income-oriented strategy, successfully navigating these market conditions requires a balancing act that entails a nuanced approach satisfying both of the following two conditions:

  1. Ensure that the long-term income potential of the portfolio remains robust, i.e. focus on the long-term business outlook and dividend potential of the portfolio companies.
  2. Deliver the best possible income stream over the course of the near-term business disruptions caused by the pandemic, i.e. ensure that there is a reasonable level of income in the coming 12 to 24 months to support income requirements.

The need to optimise across these two parameters illustrates an important benefit of active management over passive or ‘smart beta’ strategies at this critical juncture.

For example, a passive manager who indiscriminately sells stocks where the dividend is cut to $0 will likely be selling uniquely profitable and monopolistic businesses at historically low valuations. Similarly, buying stocks in sectors where dividends haven’t been reduced to chase higher short-term income will entail paying a significant valuation premium and must be done with a discriminating eye towards long-term dividend sustainability. The combined effect of such a robotic approach to income investing is likely to result in a significant impairment of the long-term income potential for investors in these passive, yield-chasing strategies.

What’s called for at this moment of market dislocation is a case-by-case assessment of each company’s prospects by a seasoned team of sector specialists to parse the likely winners from losers. We use a dual track framework that examines both the short- and long-term income potential of each portfolio company.

Deep fundamental analysis of short-term impact

Since the start of the covid-19 crisis, each stock in our portfolios and investible universe has undergone a '2020 COVID-19 Dividend Profile' to accompany the 'Sustainable Dividend' analysis. This analysis more precisely calibrates each stock's downside income risk, and understands which stocks should see dividends recover relatively quickly versus those that are likely permanently impaired.

Our recent focus has been on the following market segments:

  • Companies that 'make money while you sleep' rather than those that have a more 'transactional' nature
  • Exiting positions that are most vulnerable to the adverse outcomes from social restrictions, and
  • Purchasing undervalued companies that have not acted as defensive as they genuinely are.

Quantifying dividend sustainability and long-term income potential

Portfolios are constructed from stocks based on their ability to pay a forward looking 'Sustainable Dividend' rather than a current or consensus dividend. We judge each company’s dividend paying power by assessing their free cash flow generation through different stages of the economic cycle. The analysts then model a two-year bear-case scenario, i.e. can a dividend be paid in eight out of the next 10 years? The 8/10 approach considers a significant downside scenario for each company and what level of dividend they can pay post a crisis.

The unprecedented impacts from covid-19 mean that for a number of companies, short-term expectations for dividends have fallen below the sustainable dividend forecast. Critically, though, where the long-term sustainable dividend potential remains robust, we continue to hold them.

"We continue to think that it is usually foolish to part with an interest in a business that is both understandable and durably wonderful. Business interests of that kind are simply too hard to replace." - Warren Buffett

Using this dual track analytical framework balances long-term dividend potential and short-term income protection. The aim is to re-position income strategies to remain well positioned to provide investors with portfolios built on a foundation of sustainable dividends for the long-term.

 

Will Baylis is a Portfolio Manager for the Legg Mason Martin Currie Equity Income Fund. Legg Mason is a sponsor of Firstlinks. The information provided should not be considered a recommendation to purchase or sell any particular security. Please consider the appropriateness of this information, in light of your own objectives, financial situation or needs before making any decision.

For more articles and papers from Legg Mason, please click here.

 

Source: Martin Currie as of 29/05/2020, Next 12 Months (NTM) Income yield is calculated using the weighted average of broker consensus forecasts of each portfolio holding –because of this, the returns quoted are estimated figures and are therefore not guaranteed. Assumes zero percent tax rate and full franking benefits realised in tax return for Martin Currie Equity Income.

  •   15 July 2020
  • 1
  •      
  •   

RELATED ARTICLES

Higher yields are creating opportunities in global bonds

The diversification illusion: why 'balanced' portfolios may be exposed

Bonds are copping a bad rap

banner

Most viewed in recent weeks

It’s time for LICs to die

A high-profile dividend cut and a prominent fund manager’s apology have reignited a long-running debate. If investors can access similar exposures more cheaply and efficiently elsewhere, what exactly is keeping LICs alive?

Division 296: the initial moves to make before the windows close

What if the best superannuation strategy isn't about earning more, but acting before your options disappear? Several overlooked planning windows are narrowing, with consequences that can last for decades.

The retirement scorecard: how many of these questions can you answer?

From the maths of retirement, estimating spending and picking the right asset allocation to survive a poor decade, here are the questions every retiree – current or future – should be able to answer for themselves.

Testamentary trusts: Treasury has picked the wrong reading

A decades-old estate planning tool has survived one tax crackdown only to be caught by another. The surprise isn't who the reform is targeting, but who could end up paying the price for drafting choices made years ago.

Higher yields are creating opportunities in global bonds

Bond markets are adjusting to a new reality, but not in the ways investors expect. With markets repricing and capital competing for attention, investors may need to rethink where resilience and opportunity lie. 

Avoid unnecessary CGT with this estate planning clause

A simple estate plan can create a ticking time bomb. One overlooked clause can pit spouses against children, delay inheritances, and potentially leave a family facing an unexpected tax bill worth hundreds of thousands of dollars.

Latest Updates

Superannuation

Superannuation’s structural failings

Politicians are fighting over access to super, but they may be arguing about the wrong thing. The system’s three fundamental flaws have been hiding in plain sight for decades, costing Australians far more than they realise.

Planning

The great wealth transfer myth

Why do some families preserve wealth for generations while others struggle to? As the great wealth transfer unfolds, the determining factor is often not the structure of the estate, but the preparation of those who will inherit it.

Investment strategies

What comes after bank hybrids?

For years, bank hybrids have been a cornerstone of portfolio income. With tens of billions of dollars now disappearing from the market, investors face a critical question: what comes next, and are the obvious replacements enough?

Investment insights from the US

What happens when knowledge becomes a commodity? The latest themes emerging from the US tech sector suggest AI could reshape company moats, disrupt incumbents and create winners and losers in unexpected places.

Investing

Can Berkshire thrive without Buffett?

Warren Buffett's departure marks the end of an era. But the more important question for investors is whether Berkshire's culture, discipline and capital allocation framework can survive without the man who built them.

Retirement

The Bengen 4% Rule: Lost in translation

For years, retirees have been told to focus on withdrawal rates. But the real question is far simpler: how many dollars can you safely spend? The answer may be very different from what conventional retirement wisdom suggests.

Interest rates

Super low interest rates came with side effects

For more than a decade, investors lived through an era of near-zero interest rates. With bond yields now surging, it's worth asking whether cheap money solved economic problems, or introduced a much larger set of risks.

Sponsors

Alliances

  • ASA-Logo-RGB-ActiveGreen-web.png

© 2026 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.