In an environment where bond yields are moving higher, equity investors could turn their attention to income strategies, with Asia presenting a breadth of opportunities, says Newton Asian income portfolio manager Alex Khosla.
According to Khosla, higher interest rates tend to lead to a focus on quality companies whose pricing power can mitigate the effects of inflation.
“As the cost of capital rises, we feel that equity investors focus on income strategies, rather than strategies or businesses whose value arrives further out,” he says.
Khosla notes it is understandable for investors to consider bonds over equities for income. But, he argues, investing in equities has the potential to give an investor not just income but also growth through the compounding of dividends, with Asia offering compelling opportunities.
“Asia is about two-thirds of global growth so you’re further bolstering your ability to grow and compound those dividends,” he adds. “This is possible by focusing on companies with competitive advantages that can compound their earnings and therefore their dividends. Those companies are well placed for inflationary and higher interest rate environments.”
Fertile hunting ground
Khosla thinks Asia is a fruitful region for dividends even without the tailwind of higher interest rates supporting income stocks. He says on a global basis dividends have been a consistent driver of stock returns, with Asia accounting for about US$500bn of the global US$2 trillion of dividends2.
To effectively source these ideas, Khosla argues you need fundamental research capabilities particularly as the business models of companies in the Asian income sector have evolved over recent decades.
He explains: “If you were investing in Asia and emerging markets in the 1990s, business models were less complex. You were looking at telcos, banks, commodities and trying to understand the commodity cycle and the dollar as the main drivers of equity returns.
“But today in emerging markets the industries we engage with are both complex and globally integrated. Semiconductors and insurance companies are such examples, and as a result, it really helps to have global sector analysts who can give you insights into these areas.”
Discipline and quality
It is also integral to have stock selection discipline, adds Khosla. In the Asian income strategy, each stock must meet a strict yield criteria in order to be purchased. This prevents a “barbelling” of the strategy where you have high income paying stocks at one end and growth stocks at the other.
“This gives consistency in terms of the type of business we own,” he says. “Income investing doesn't work passively because you end up owning businesses that might have high yields but they're driving that yield unsustainably, with leverage obviously being the most common way of doing that.”
This approach steers the Newton income team towards quality companies, says Khosla, and there are three key investment pillars it uses to determine quality.
First is identifying strong governance, which involves understanding the incentive of the owners or promoters in a business, and understanding their track record in terms of integrity, competence and capital allocation.
Then there is growth. “You might find it odd that we talk about growth in an income strategy, but we think this is important as it helps us avoid companies in structural decline,” adds Khosla. “Newton’s research platform further allows us to get to grips with where a company is in a thematic journey, be it early, late or towards the declining phase.”
Finally, the quality franchise pillar is about understanding what allows a company to make its returns on capital, what drives its cost advantage and pricing power and whether that is durable, adds Khosla.
As an upshot of this, Khosla says the strategy veers into areas not typically associated with income investing. “Most people think of income strategies as holding utilities and energy companies but because of the global resource we have, we're able to invest in technology in a serious way, so this isn't a dead-industries-printing-cash strategy,” he explains. “This is a strategy that gets exposure to some of the more innovative business models in the world, but at reasonable valuations across Asia.”
Country allocation
The Newton Asian income team does not look to make large bets on countries, but from an allocation perspective, the strategy ends up concentrated in countries that incubate good governance and focus on shareholders. The institutions that do so often provide a backdrop that is supportive of currency strength, too.
India is currently an underweight in the strategy based on a valuations perspective rather than the team having an anti-consensus view on the macro outlook, which it thinks is strong.
China, meanwhile, is also an underweight position. This is largely due to the view that cash payouts often come from business models that the team sees as sustainable are not very high. Conversely, where payouts are high, the business models are not sustainable enough, says Khosla.
On a macro view of China, Khosla highlights there are structural headwinds because of the economy’s imbalances and a debt to GDP ratio that compromises its level of fiscal stimulus, set against some challenging demographic trends. On a short-term basis he says the economic data has been mixed and the housing market remains a concern. This has prompted some incremental easing from authorities, he adds, but not enough to move the needle.
However, Khosla says from a long-term perspective the team isn’t structurally bearish on China. “There do remain selective growth opportunities in China, some of which we are exposed to. One example is the evolution of savings away from property towards other products,” he adds.
But he concludes: “Asia isn't China and there are a huge number of opportunities outside of that market. We think you're starting to see the stars align, not just in the obvious countries like India but in some of the smaller countries as well.”