The hidden risk in dividend investing

Our first speaker tonight is Tim Richardson, investment specialist from Pangana Capital Group.

His presentation topic is the hidden risk in dividend investing.

Pangana offers a range of listed and unlisted international and Australian products.

The active strategy with non-benchmark mandate, which means they can invest in the best idea they can.

Tim is an investment specialist at Pangana.

He's a CFA charter holder with 25 years of financial services experience.

Welcome to the presentation, Tim.

Thanks ever so much.

It's great to be with you.

His talk a little bit about dividend investing and in particular, there's some hidden risks out there that Australian income investors should perhaps be aware of and some ideas of how those can be well managed.

The reason that I'm so particularly interested in this subject is we run the Pingana International Equity Limited.

That's PIA on the ASX ticker.

That's the largest ethical international equity lick on the on the ASX with with over 300 million of assets under management.

The LIC aims to deliver regular, reliable and fully franked dividends.

We've established a track record of paying these quarterly, increasing them over time.

And currently now the yield when grossed up for franking credits is seven percent.

Australian equities have had a pretty good decade, all in all, generated a return of 8.2 per cent per annum over the last 10 years.

Now, this chart shows that it's been a bit of a rocky ride.

There's been a lot of volatility.

But over the long term, it's been a good asset class for investors to have put their long term wealth.

And now, if it's been

a good decade for equity investors.

It's really been a great period of time for income investors who have invested in the share market.

At the present time, the dividend yield is 4.5%.

Franklin credits, courtesy of the ATO, adds another 1.6% to return.

So that gives the grossed up income yield of 6.1%.

With a bit of capital growth over time, the Australian share market has been good for Aussie income investors.

But there are some risks that are evolving that income investors should be mindful of.

Inflation's obviously come down quite a bit over the last year or so, but it still seems to be quite persistent and getting it back to the targets range is tricky.

That means interest rates clearly high and they're likely to stay high for longer.

And that is having an impact on the,

on the economy and particularly those businesses that tend to move in line with the economic cycle.

The other issue that should concern Australian equity investors is the breakdown of the Australian share market.

This chart shows the relative size of the different sectors of the global share market in the light blue and the Australian share market in the dark blue.

Now what we see on this is the two big thick dark lines for materials, that's the mining stocks and financials, particularly the banks, together account for 50% of the Australian share market, about 25% each.

And those numbers are clearly way higher than the equivalent totals for the global share market.

Now, this issue is even more acute for income investors who depend on dividends.

This chart shows you the breakdown of dividend payments within the Australian share market.

Now, if you look at the red shaded parts of this pie chart, you'll see materials is 40% and financials is 24% of the dividends that are paid out in Australia.

So two thirds of the dividends coming from the Australian share market come from just these two sectors.

Now, if you add in real estate energy, which are obviously big parts of the Aussie investment market, something like 80 percent of dividends are paid by just these four sectors, which tend to be very sensitive to the economic cycle.

Moreover, some of these sectors represent some pretty significant sustainability challenges.

Now, generally, all investors tend to be mindful of managing ESG risks now to some extent, but to those investors who are particularly concerned that their portfolios are sustainable and their investments align with their values, focusing on just the Australian equity market presents a challenge.

This chart shows you the size of the Australian share market compared to the global market.

It's a bit of a sliver, 2.3%.

So if investors get all their exposure to the share markets through Australian equities, they'll be missing out on something like 97.7% of the equity opportunities.

That meant missing out on some pretty interesting investments in 2023 when global share market returns have been pretty good, but they've been quite concentrated in a limited number of stocks.

In particular, there are some secular growth themes which are much more challenging to access in Australia than through a global equity portfolio.

The obvious one is artificial intelligence, which has done very well.

Companies like Nvidia, Taiwan, semiconductors and businesses like Adobe that are creating the solutions that people use.

As manufacturing moves onshore in the US and Europe and Japan, companies such as Schneider Electric and Rockwell Automation that can automate and optimise plants have got a great opportunity.

There's a growing focus on health care.

Businesses like

like Vertex Pharmaceuticals or those first dollar out of the wallet businesses that are closer to the consumer.

Businesses like L'Oreal with a strong global brand, which is quite resilient to the fortunes of the consumer spending cycle.

There have been some great businesses this year.

What does it mean for investors?

Well, interest rates have clearly risen quite steeply.

Consumers are now under pressure and that creates some investment challenges.

But innovation is bringing some great opportunities for global investors.

Returns so far this year, past performance clearly not a particularly good guide to future returns, but this is interesting.

Year's date of September, the S&P ASX all ordinaries has returned 4% by investing in global shares but hedging your currency exposure that goes up to 10%.

And for those investors that didn't hedge their currency exposure, they they've returned fifteen point six percent so far.

Again, this is not necessarily particularly strong guide to future returns, but it does illustrate there's there are there's some great opportunities overseas.

So what are we looking at for for next year, 2024?

Interest rates may well stay higher for longer to get control of inflation.

Consumer spending is likely to remain under pressure.

We think it's good to focus on the structural growth themes I've just talked about.

Cautious exposures to the consumer look for strong balance sheets.

There's a problem with investing in global equities.

Franklin credits.

International companies don't offer franking credits.

So the solution is the side I'd like to talk about is international listed investment companies.

These can smooth dividend payments to investors.

LICs don't have to pay all their income out in a single year, so dividends are smoothed.

Australia based LICs can distribute franking credits, which is a big part of the income of Aussie income investors, greater diversification by region and sector, which I've touched on, and the ASX listing provides continuous liquidity.

So in summary,

Australian equity investors, they've had a great run, but share prices and dividends bring some challenges now.

Investing in Australian shares for income investors brings pretty high level of concentration, that adds to risk, which they're perhaps not getting paid for.

and international licks provide a unique strategy which is able to access frank dividend credits and it diversifies investments to a broader global opportunity set.

Thank you very much.

Thank you, Tim.

Just touch on a few things you mentioned in your presentation and you did mention these.

My first question for you is, isn't this a bad time to invest in global equity given that the high interest rate is slowing down the economy?

I think that's a good point.

There are certainly some significant headwinds out there that investors need to be mindful of.

Inflation is sticky, interest rates are likely to stay higher for longer.

This is likely to slow the economy as household balance sheets become weaker.

And there's the ongoing macroeconomic geopolitical challenges, particularly the relationship between China and the US, which is likely to over time decouple the global trading system.

And of course, more recently, the problems in the Middle East, which

which pose a risk to the oil price.

I think probably having said that, most companies do look at more attractively price after the price adjustment over the last couple of months.

And earnings for most companies look okay.

But what I think we're going to see is a greater dispersion in company earnings between those that are exposed to the secular growth trends, AI,

automation, green energy, health care and so on.

And those companies whose fortunes are very much more dependent on the consumer spending cycle as that closes.

And I think that's likely to be reflected in share prices over time.

And in your opinion, what are the key risks that you have identified to the global outlook, especially for the income investors?

Sure.

I think the

you know, the most the most obvious risk that investors face is is inflation.

And if central banks are unable to bring that back down to target within an acceptable timeframe, you're going to see eventually further interest rate rises, which clearly poses a risk of bringing bringing about a hard landing, which, you know, which will be detrimental to to equity investors.

The second is the geopolitical tensions, the risk to oil prices, the risk to trade.

And the third risk that's perhaps worth mentioning is that we're seeing the growth in non-bank lending as banks pull away from much of their traditional corporate lending.

And that's been picked up by the non-bank lenders, particularly private credit funds.

If that capacity doesn't build up in a way that

many very high quality lenders are able to access finance, that would perhaps pose a risk to the global economy and global returns.

Thank you, Tim, for the presentation and the answers to my questions.

Take care of yourself.

Thanks very much.