Ask a Fund Manager
The Motley Fool chats with fund managers so you can get an insight into how the professionals think. In this edition we pick the brains of Michael Maughan and Malcolm Whitten – portfolio managers at Tyndall AM for the Nikko AM Australian Share Income Fund – for their insights into ASX dividend shares.
(Note, the Nikko AM Australian Share Income fund was acquired by Yarra Capital Management in April 2021. It will be rebranded as Tyndall AM in due course.)
Can you give us an idea of the Nikko Australia Share Income fund’s investment philosophy and background?
Malcolm: The fund was launched in November 2008 to meet investor needs for regular income and long-term capital growth. The fund provides exposure to equities which are expected to grow and thereby address longevity.
Our primary objective is to exceed the grossed-up dividend yield of the S&P/ASX 200 by 2% per year over a rolling
5-year period. We’re proud to have met that objective over the life of the fund.
The current market expectation for the grossed-up yield is approximately 4.0% which means we’re aiming to generate a 6.0% yield. I should stress that the objective may not be met every year. However, in the 12 months to May 2021 the grossed-up yield was 6.1% despite the challenges of COVID-19.
What boxes does a share need to tick before you’ll consider investing in it?
Michael: We’re an income fund. So, the ideal stock has a good sustainable yield and valuation upside according to our intrinsic value process.
In reality, portfolios are living things. We look at our stock ranking, ranking them from cheapest to most expensive. And we look to how things move within that live ranking. That might be the share price driving those moves or it might be a reassessment of value on our behalf.
When stocks that we own move down that ranking we look to recycle that capital into stocks that are towards the top of that ranking. Keeping in mind that we’re always looking to enhance the overall risk-return of the portfolio.
Malcolm: We’re an active portfolio service. Mike mentioned the recycling of positions. There’s a constant review of value and of where the positions of the portfolio sit on that rank. We watch that every day, and as the positions shift, the relative value gap closes, that’s an opportunity to sell one and buy into something else.
Broadly speaking, our position sizes are a function of that perceived valuation gap. It’s not binary, buy-sell all the time.
Are you happy to invest on the smaller end of the market as well as large-cap shares?
Michael: We don’t deliberately target the market cap segment. Our research universe starts at (ASX) 200. Cap-wise the distribution of our market bias is towards the bigger end. But we’ve found historically a sweet spot (of) opportunity exists in the mid-cap space. So in the (ASX) 50 and (ASX) 100.
As an income fund, how do rank a share’s dividend yield?
Michael: Dividends are the fund’s primary objective. But there are various building blocks of yield for the fund.
The keystone is for franked dividends. But there are other forms of yield. That might be a return of distribution, a return of capital or a circumstance where a company sells a division and returns that surplus capital. That could be by a buyback, it could be by paying down debt. And that increases the future return to shareholders.
What’s your outlook for ASX dividend shares?
Malcolm: We think we’re in a sweet spot for dividends at the moment. There are really 3 tailwinds there.
The first is the dearth in alternative income sources, with bonds sitting at that 1-2% band. [Aussie] equities continue to deliver in the 4-5% band. Those dividends should be growing because we’ve got the recovery in earnings and the normalisation in payout ratios. And then thirdly, markets are at all-time highs. We expect that dividends are going to make up a bigger part of total returns into 2022.
What types of risk management do you employ?
Michael: We don’t necessarily have stop losses in place. What we use is our fundamental valuation process to assess what could go wrong with a company. And that gives us a margin of comfort in the positions that we own.
Malcolm: We look at 3 layers of risk. We have a team of 11 people doing bottom-up analysis and then interrogating that analysis. That’s the first line of defence in terms of risk. Knowing the risks of the individual stocks, the risks to the earnings.
Secondly, we go through analysis of the aggregate risks in the portfolio. We use numerous tools to understand what owning that portfolio of stocks adds up to in terms of total risk.
The last one is we put limits on ourselves in terms of stocks and sectors. That makes sure we get a diversified portfolio, which is really important. Especially in an income fund, which are prone to falling into the trap of concentration risk, with everyone gravitating towards (classic) yield type stocks.
The ASX 200 banks are historically strong income shares. Are there any that look particularly strong to you?
Michael: We have been served well by our investments in the banks over the last year.
At the commencement of COVID, when it broadened from just being a China issue to affecting the rest of the world and perhaps broader equity damage and financial risk to the economy, we went underweight. And then in the early stage of optimism on vaccines we started to close that underweight on the perception that eventually there would be a cure, either through herd immunity or a vaccine. Today we’re overweight in the sector.
We still see good value in the banks. And indeed ANZ [Australia and New Zealand Banking Group Ltd (ASX: ANZ)] and CBA [Commonwealth Bank of Australia (ASX: CBA)] stand out particularly because they have capital surplus to their needs.
Like many funds, your portfolio took a big hit during the viral meltdown in early 2020, and it’s enjoyed a big lift since. What went wrong in early 2020 and what then went right to deliver the past year’s run of big gains?
Michael: The markets went crazy in terms of the impact of the sudden stop and the isolation measures that were put in place. That was an unanticipated risk. The distinction between stay-at-home and out-and-about sectors hurt the fund badly.
Part of our narrative is to be patient and not panic. So, in those months of February and March (2020) the fund was actually relatively quiet in terms of activity. Because the risk was that you act rashly, without looking at the longer-term valuation.
That really is key. We’re an active portfolio service with a valuation process that’s looking at a 3-year horizon. The turnaround in the fund since then is the benefit of riding out that storm.
What were your best-performing investments over the past 12 months?
Michael: The contributors to our outperformance have included our position in ANZ. It’s one of the banks that we still see as an attractive opportunity with higher prospects for return on capital.
Then there’s Oz Minerals [Oz Minerals Ltd (ASX: OZL)]. Despite the shutdown more broadly in the economy, they carried on with commissioning their new copper mine in South Australia. They even hosted a virtual site tour. They adapted readily to the confines of social distancing and managed to deliver on the commissioning of their mine. With the running copper price and the delivery of what they had promised, Oz Minerals have been very good to the fund.
Riding Virgin Money UK, [Virgin Money UK PLC (ASX: VUK)] out of the depths of what was arguably one of the worst COVID-hit economies also served us well.
And Downer [Downer EDI Ltd (ASX: DOW)]. It really had its own missteps prior to COVID. Their engineering division had cost overruns. That business has recovered, and the rest of their portfolio has improved in the reopening trade.
Iluka [Iluka Resources Ltd (ASX: ILU)], a mineral sands producer, is tied to the fortune of the housing markets in China. It’s performed very well also.
Malcolm: Iluka is one of those stocks where the demand for its product is late cycle. Supply is constrained. And we see that contributing for us.
You have a fairly significant position in the resource sector then.
Michael: Indeed, we do. We have a consideration of who is generating strong free cash flow. The iron ore price has exceeded our expectations at about US$200. And with very low gearing they’re well placed to distribute their higher-than-expected earnings to shareholders.
Malcolm: This is where we differentiate ourselves from some other income funds. We are a diversified portfolio across all parts of the market. We’ve got the broad research team covering all parts of the market. A team that includes former geologists and engineers being able to take a view and invest beyond the typical income sectors.
Is there a particular sector you think will offer good ASX income opportunities?
Michael: To varying extents we’ve found good value in insurance names. They’ve been burnt by exposure to business interruptions globally and locally. They’ve raised new capital. That’s spread across IAG [Insurance Australia Group Ltd (ASX: IAG)], QBE [QBE Insurance Group Ltd (ASX: QBE)], and Suncorp [Suncorp Group Ltd (ASX: SUN)].
Income for today and capital growth for tomorrow — that’s our mantra; it’s how we think of our job.