Where to find income in a Corona Virus world?
2020 will go down as one the most unusual and ultimately unique years of our lives. While it appears, at least for now, the worst of the Corona virus pandemic has past Australian shores with our health care system largely intact with both deaths and total cases being significantly below some of the alarming estimates we saw earlier in the year.
While, I for one, will not miss the daily alerts of significant policy upheaval and the seemingly ever increasing restrictions on our daily freedoms, the heavy social distancing measures that are still somewhat in force have allowed me the opportunity to deeply consider where is next for financial markets.
In this current environment it is incredibly difficult to remain calm when markets are experiencing swings of in excess of 5% daily swings and in many cases life savings are disappearing in mere hours.
However, in an environment when the returns on cash are so minimal with many savings accounts paying less than one 1% and some paying as little as 0.05% investors are now faced with the incredibly tough decision as to where and how they should invest.
Unfortunately, the low interest rates we have experienced over the past decade has forced many investors to increase the level of risk taken within their portfolios in to maintain the levels of income they require.
A million dollars invested in a 1% term deposit only provides an annual income of $10,000 before taxes. With most individuals and families requiring significantly more than this to maintain their quality of lifestyle, this is an unacceptable return.
Until the recent pandemic, Australian investors were blessed with some of the highest yielding equities in the world (as any Big 4 Bank or big miner investor can attest) which many have seen owning the equity of a bank as an alternative to owning a term deposit within the bank.
This was due to the Australian banks benefiting from what has been an abnormally long good credit cycle, rising house prices and the ongoing resilience of the Australian economy. However, it is evident that our banks will start to return to closer to a global average pay out ratio, so in my opinion it is an almost certainty that the double digit fully franked returns that were available from the Big 4 are behind us.
In a situation like this where should investors turn for income?
For the more conservative investor, there are still pockets of the fixed income market that do offer a reasonable yield, with the added security of being senior debt. While this is not the 8% p.a. that term deposits would offer a decade ago, these investments can offer a reasonable level of income whilst providing a higher level of capital security than equity investments.
Property and Real Estate Investment Trusts (REITS’s), have been a favoured investment of Australian investors since before I was born. Many of the larger REIT’s on the Australian market are heavily exposed to either commercial offices or retail sectors.
For these sectors, corona virus has effectively bought forward 10 years of technological advancement. During the early stages of social distancing, many families starting truly experiencing the convenience and benefits of online shopping. This does not bode well for the traditional retailer and the almost weekly collapse of formally large retail chains provides clear evidence that the traditional bricks and mortar retailer is on struggle street. Struggling retailers should result in lower rents and therefore lower valuations/yields for these assets.
While, I am more optimistic regarding the office market, I truly believe that the rapid adoption of video conferencing and work from home will make a significant and permanent difference to the longer term demand for these spaces. I don’t believe that the office will disappear in its entirety but it appears that a downsizing is inevitable with the increased use of these technologies.
Residential property valuations across our capitals are reasonably stretched by most measures and as a result of this true yields are relatively low. With the additional burden of maintenance, on going costs and relatively illiquidity (you can’t sell a bedroom or bathroom), this effectively becomes a poor income generating asset for many investors.
Of the main stream asset classes, this only leaves equities left to generate that income that older investors not only covet but require. This has lead to the create of the apt abbreviation TINA, standing for “There Is No Alternative”.
Looking over the local equity market, expected dividends for the next 12 months are incredibly difficult to predict but it would not be an outlandish assumption to state that over the short term it is highly like that dividends will reduce on a broad basis.
For the income seeking investor, there has arguably never been such a need to focus on the quality of the investments they hold but also the strength of the balance sheet. It is my belief that there will be an increased appeal for three types of businesses within the ASX 200 over the following 18 months.
The first is businesses that have a rock solid balance sheet and are industries that have not been as deeply affected by covid19 as the broad market. In effect, there are actually blue chip names like Coles and Amcor that have experienced a short term boost in revenues and profits, as unlikely as that sounds.
The second is businesses that exhibit as capital light nature and defensive earnings streams. While no business has guaranteed earnings, it is likely that for businesses like Computershare the core of the business will be able to achieve strong returns on capital and maintain dividends.
The last businesses are the GARY stocks. GARY being an acronym for “Growth And Reasonable Yield”. These businesses may not be paying the highest yields today but offer investors the potential to have exposure to growing dividends, potential for capital growth but more importantly a high yield on investment in future years. A classic example of this would be CSL. While the dividend has grown steadily over time, the share price has grown as rate the yield today is unimpressive yet for investors even 5 years ago it is an appealing proposition.
In the current environment it has never been more crucial or prudent to ensure that you have a solid understanding of how your capital is allowed and how you are going to generate income whilst preserving your capital over the long term.
*The information contained in this newsletter has been provided as general advice only. The contents have been prepared without taking account of your personal objectives, financial situation or needs. You should, before you make any decision regarding any information, strategies or products mentioned on this website, consult your own financial advisor to consider whether that is appropriate having regard to your own objectives, financial situation and needs.