Atlas Funds Management: A dividend focus

This week’s fund manager interview is with Hugh Dive, the Chief Investment Officer of Atlas Funds Management. They run two funds, one which is a high income property fund and the other is a concentrated Australian equity portfolio. As Hugh explains to me, the funds both focus on delivering consistent dividends for investors. Having been in the industry for over 20 years, Hugh’s also got some interesting things to say about the outlook for 2021, which based on his forecasts is going to be an average year for the market. He also runs through some of the specific stocks and sectors he likes going forward.

Here’s Hugh Dive, the Chief Investment Officer of Atlas Funds Management.

Table of contents:
Investment philosophy on importance of dividends
Investing approach during 2020
Filter model when analysing stocks
High income property fund
High income property fund holdings
Australian equity portfolio
Australian equity portfolio performance & fees
What to do with the big banks
Outlook for 2021

Hugh, I wanted to begin with your investment philosophy, which is centred around the importance of consistent distributions in the short-term rather than those large returns in the future which are a bit riskier. How’s that impacted your investing during 2020 given a lot of companies reduced or cut dividends and that search for high yield and low risk assets has become a bit harder?

In 2020, whilst we have seen some dividend cuts, ultimately a lot of the cuts were a lot less than expected during the dark days of April and March, a range of companies were expecting to pay zero dividends and they ended up paying us a lot more than expected. I think dividends, despite the fact that we have seen cuts and moves around, they’re more important than ever, especially during these times where the cash rates are close to zero. We like investing in companies paying certain dividends today which can be distributed to investors, rather than putting our money and investors capital in companies with more variable returns in the future. Being a professional investor for over 20 years, a portion of these future returns never materialise due to a range of unforeseen circumstances.

What we always see and even see today, is that investors consistently overpay for these blue sky and higher future expected returns. Having observed the ‘tech-wreck’ up close in North America in 2001, there’s a lot of parallels to the ASX today where investors are not providing much of a discount to the blue sky promise and a lot of these Aussie tech companies. It’s a bit unfashionable to want distributions, but we very much take the view that a bird in the hand is worth more than two in the bush in the future.

Can you shed some light then on how you have approached investing over the past few months given what’s happening in Australia with the rolling lockdowns and then what’s been happening in the macroenvironment around the world with the US elections and COVID cases surging around the world?

2020’s been one of the more volatile and one of the more difficult investing years in my career, far more difficult than the Asian crisis in ’98, the ‘tech-wreck’ in 2000 and also the GFC. It was very sort of violent and was quite different to the previous thing. What was different was both the speed and the uniformity of the falls in 2020, which I think what we saw is that index funds are far greater in 2020 than they were in 2008 and 2000. A lot of also what we’ve seen is levered index funds. In most previous market falls, the company’s most exposed to – the factor that was out of favour was falling over either tech or credit crunch companies not being able to refinance their debt, they fell the most.

However, in 2020 with the impact of levered index funds, we saw the whole market move down almost in lockstep, because when an index fund obviously gets redemption, they sell whatever – 9 per cent of CSL, 1 per cent of Afterpay, 1 per cent of JB Hi-Fi. So we saw in March, big falls in companies like Afterpay and JB Hi-Fi, companies that have had record years.

Looking in terms of my things, during the dark days, having seen heavy falls in the portfolios in the past, I think portfolios populated with companies that pay dividends from stable recurring earnings such as TransCanada Pipeline or Amcor, and with no exposure to companies that are reliant on frothy market conditions such as Nortel, Babcock & Brown, what I’ve learnt from these is having a portfolio which is constructed in a conservative manner with companies paying dividends and potentially growing dividends with low gearings will bounce back from even the blackest of nights and doom and gloom.

Your website talks about a quality filter model you use in your investment process. Could you explain what sort of filters you do use when determining whether a stock is appealing?

One of the first things we’d look to do is, what are the characteristics of companies that have blown up in the past? There’s a range of quality filters, so we look to try and knock out companies first. For example, things that have high leverage, whilst that looks great in markets going up and down, in dark times that hurts. Also, we saw companies with high leverage were the ones who were forced to raise equity in 2020 at obviously quite dilutive raisings and that’s not very good for shareholders. Also, we look at company’s governance. What we’re looking at there is the independence of the board and a range of other things, and try to knock out companies that have poor governance, poor ESG… Because ultimately those companies tend to have more problems than others.

The third factor we look at is, is there any sort of risks on the future in terms of technological or operate technological risk? For example, I look at Fairfax and a range of other companies like that – there’s strong technological risk that the business model is going to be impacted. Finally, we look at operating risks and score companies based on that, and that’s – is there a chance that something could go wrong in a company’s business that could disrupt earnings. For example, you score a company like Orica quite high, higher in that if you’re making explosives there’s more chance of something going wrong than in something more basic such as Amcor, where you’re producing packaging where it’s a very repetitive process and the plants unlikely to blow up. That’s how we look at that.

The final thing we look at, earnings quality. How good are the earnings, are they being bolstered by non-cash items, is there any sort of accounting trickery in there? Because ultimately, that causes problems over time.

And you run two funds, but let’s start with the high income property fund, explain a bit about that?

What it is, is we have a range of rent collecting, high yielding listed property trust funds in the fund. What we do is, over the top of that we sell short-dated call options for additional income, generally about 3 to 4 per cent, but depending on where the market’s out of the money. That’s based on the view that a range of these future gains don’t materialise and you’re converting uncertain future capital gains into certain income today. That’s sort of, through the cycle, we believe the market tends to overestimate the gains of that and particularly at the moment with all the volatility we’ve seen in the last year or so. The premiums were getting very attractive, so that’s generating anywhere from 2 to 4 per cent per quarter additional premiums. On top of that, we look to buy a certain amount of put options to protect the downside protection. Ultimately, having run this sort of portfolio for a number of years both at Atlas and at previous funds with previous fund managers, it’s ultimately has been very consistent, being able to provide that consistent 7-ish per cent annualised income. Indeed, in this year we’ve had no issues with providing that income despite the fact we have seen some cuts amongst some of the rent collecting trusts, but that’s been outweighed by the big significant boost in premiums. Also, a range of property trusts end up not cutting their dividends and keeping them relatively stable. Ultimately, on the income side, whilst it’s been a dreadful year for a listed property, we’ve been able to maintain distributions.

What fees are associated with that fund?

0.9, and that includes GST.

Could you run us through some of the other holdings in that fund that you’re seeing as presenting value going forward?

Looking there, we have a lot of other similar sort of non-discretionary things. Another big holding there is Charter Hall Retail, we own that, very similar dynamics to SCA Property. We also hold Arena REIT, which was sold down very heavily in March, I think it was off close to 45 per cent. But this is a collection of medical centres and childcare centres. Ultimately, this trust collected close to 100 per cent of their rent over 2020, but it was viewed as a particularly sort of poisonous and particularly difficult thing. Another big holding in the portfolio is APN Industrial, a trust which owns a range of industrial sheds around Sydney, Melbourne and Brisbane and some outer-suburban offices. That was similarly sold down very heavily in March and April but ultimately ended up collecting close to 100 per cent of their rent. Speaking to the CEO, going through this, he was saying, “Everything’s fine – a range of our tenants have asked for rent reductions or rent abatements…” and when he asked those tenants, “Can you please show us how your business has been affected?” Virtually every one of those tenants did not come back, so ultimately that proved to be a very stable trust and maintained their distribution even through these difficult times.

You’ve also got your Australian equity portfolio, what sort of companies are you looking for in this fund?

On the Australian equity portfolio, it’s a concentrated Australian portfolio, so we generally have around 20 to 25 large-cap securities, that’s a managed discretionary account on Hub24 and Netwealth. What we’re looking for there is companies that are looking to try and maximise after-tax returns for investors. It’s low turnover and a focus on favouring stocks that pay a high franked dividend yield and trying to keep the turnover to a minimum, just looking to be invested in companies that are doing capital tax effective returns.

For example, a big holding in the company is Ampol, they’re doing off-market buyback at the moment and that’s a good way to return some of the excess franking credits off their balance sheet and into the hands of investors. We use franking and dividends as an earnings quality signal, so the whole thought process isn’t just purely chasing tax credits, because we see that companies have incentives to manipulate profits but not overpay taxes. Franking credits are only generated through tax payments and no CFO is going to pay more tax than they want to. However, what we viewed over the long-term, we’ve seen companies having to restate earnings due to some impressive accounting, whereas no one can ever restate a dividend once it’s sitting in your bank account.

We see that franking credits are systematically undervalued in Australia and that’s a result of around about 50 per cent of the ownership of the ASX are offshore investors. That’s our focus, very much quality/value bent. Where we have suffered in 2020 is not owning enough tech stocks, in that, that doesn’t really fit what we’re trying to do in that focus on delivering income for retirement phase investors, but we’ll see how that works in 2021.

Were you actively avoiding those tech stocks or has there been a temptation to dip into those or have you tried to steer clear completely?

I started my career in Canada working for a big Canadian fund manager and unfortunately, that coincided with the ‘tech-wreck’ which was very sort of volatile and a bigger part of the Canadian index at that stage, we saw Nortel was 30 per cent of the index, a range of other companies – JDS Uniphase, Research In Motion that owned BlackBerry were going to take over the world. And so, as a bit of a formative experience, I’m naturally predisposed to being quite sceptical towards claims that a lot of these tech companies without much earnings are all going to take over the world because 20 years ago these range of companies were very powerful and were going to dominate the index. Virtually all of them have fallen by the wayside.

When I look at the Australian tech sector, I think we saw Altium came out with a revenue fall this morning, so they probably won’t do well when they open this morning. Not every one of these companies are going to be successful. If you look at the buy now pay later sector, there are seven different companies in that sector. From my experience, they’re not all likely to succeed. Additionally, with the fund where we have a big focus on dividends and earnings, it’s very hard to put a company in the portfolio which doesn’t have dividends at all and there’s a fair bit of risk on the earnings going forward. We have not played that, that has hurt us last year. There’s always a temptation when you’re underperforming, but I think when you have to look at – if the investors know what they’re getting and they’re getting a stable core portfolio of dividend-paying stocks, it would be a big surprise and departure from the investment process to start buying companies with no earnings and no dividends. There’s no temptation but we’re very aware of it.

How did the Australian equity portfolio perform last year?

We ended up slightly underperforming. We had a few wins that offset that. We had some big positions in JB Hi-Fi and Sonic Healthcare which has benefitted quite well, but we did end up trailing as a result of not only not owning the tech stocks, but also being a bit more cautious towards the miners. Counterbalancing that, we ended up having a very big year in 2019. Given the structure of the portfolio with value and a focus on dividends, we underperformed in 2020 and that would be expected.

What are the fees on the Australian equity, is that the same as your other fund?

No, it’s quite a lot less, it’s 0.4, so 40 basis points, given that the costs of doing this are a lot easier to manage as MDA, we don’t have the significant costs of running a unit trust because with the property fund it’s listed on the ASX through M-funds, there’s a range of other costs, so it’s quite a bit cheaper at 40 basis points.

In the top 10 holdings for that Australian equity portfolio, you’ve got three of the four big banks except for NAB. Are they a holding just with less weighting or have you actively avoided NAB?

We’ve actively avoided NAB. Looking over the years, NAB’s generally a bit more entrepreneurial, they tend to have a few more issues. We owned it about two and a half years ago but then saw that, going into 2018-2019, they were likely to have a few more troubles coming out of the Royal Commission. Also unlike, for example, ANZ and CBA, NAB had still owned MLC. Whereas, ANZ and CBA went into 2020 very highly cashed up as a result of selling a lot of their wealth management divisions and getting very good prices for them. NAB had not done that. We just viewed that there were just too many issues as a fixer-upper and when you’re running a concentrated portfolio, you want to have the better quality names and owning all four especially when you view one of them as lower quality/with more issues than the others, it doesn’t make sense to own that.

What is your view on the position the banks are going to hold or should be holding in an investor’s portfolio going forward? Are you of the view that these are going to be central to that fund going forward?

I think it’s one of the biggest questions that investors have, one of the bigger questions, what to do with the banks? They took very heavy provisions in April/May, last year, around about $2 billion dollars apiece in provisions relating to COVID, and that was based on the assumptions that unemployment was going to be somewhere near 10 to 15 per cent, we were going to see a 10 to 15 per cent fall in Australian house prices… That hasn’t really happened. The question about what the unemployment rate is still up for discussion. JobKeeper doesn’t roll off until the end of March, but certainly, we haven’t seen a massive fall in house prices which would be concerning for banks.

One of the advantages the banks have now, when you look at previous big downturns, let’s say ’91 and 2009, is the interest rate that a lot of the borrowers are paying. For example, Matt Comyn, the CEO of CBA, talked about this in their August results, in that he said their average loan is around about $400-450,000 dollars and at current interest rates it’s only about 2-2.5 per cent, that equates to roughly about $200-300 bucks a week if a customer who’s in financial difficulty moves from principal to interest-only, and that’s roughly cheaper than rent. What they haven’t seen is the range of defaults that happened in ’91, ’92 and then also 2009 – the rates are so much lower. Because it’s advantageous to still keep paying, people in difficulty can still keep paying their things. Looking in 2021, I think the question is, what does the next couple of years look like? Does it look like the slow grind out of the 90s, or a bit of a fast return out as we saw out of the GFC? Our view, it’s probably likely to be a quicker recovery post the GFC. I think the banks could actually surprise on the upside.

We’re not going to see any capital returns in 2021, but what we could see is sharper than expected earnings per share gains, as well as some of these heavy provisions taken in last year being written back. That’s our view there. I think banks are probably quite well placed in 2021 to surprise on the upside.

Just more broadly, how are you feeling about things going forward in ’21, Hugh? You sent through some forecasts based on those three key building blocks about why you’re anticipating an average year ahead. Could you elaborate on that for us?

When you try and build a bit of a forecast for any following year, what you look at is what is the earnings per share growth in the underlying index. Currently, consensus is around about 13 per cent, doing a bit of a bottom-up you can get the number closer to 8 per cent, so not as strong as that. What you look at then is, what’s the PE multiple? The current PE multiple is about 18.6 times, so that’s a fair bit above the long-term average of close to 15 times. But then the PE is elevated with risk-free rates so low and also a bit of earnings recovery. We see a PE of around about 18 times which is high but it’s probably right given the environment. Then, a dividend yield of – it’s currently close to 4 per cent, 3.8.

Building all those things together, it comes up at about an 8-ish per cent which is a rough average return for the year. Though, I have to say I have a far lower level of confidence forecasting next year than I think I’ve ever had in the last 25 years of investing, in that there’s just a lot more uncertainty over the next year. As mentioned before, the bank’s bad debts look much better than the provisions taken in 2020. This number looked conservative, but then if we see further outbreaks – we’re seeing obviously small lockdowns at the moment, but if we see a quite substantial outbreak in Australia that could change.

If China moves to restrict Australian iron ore sales and that could impact on the downside and also, when we see JobKeeper rolling off in March and we see the unemployment spike, this 9 per cent return could prove to be a bit optimistic. One can have a forecast, but I think this is one of the harder ones to forecast the upcoming 12 months.

Which particular sectors are you liking in 2021? Are you investing in themes as you go forward, or are you judging each holding on its specific merits?

We pick stocks on a bottom-up basis. How’s this company going to do…? We have liked the companies that are doing well out of coronavirus and will continue to do well in that. They’re companies like JB Hi-Fi, Sonic Healthcare. We quite like the infrastructure space, I think we’d see a fair bit of spending towards that. A particularly unloved holding in the portfolio is CIMIC, I think that will do quite well, they’ve sold 50 per cent of their mining business. A big issue that we also face is we do have a large exposure in the portfolio to offshore earners and the rising Aussie Dollar is putting a bit of an issue on that and putting a brake on the economy.

What we’re also seeing over the last three to four months is a bit of a search for yield. I’m seeing this in the property fund and also in the equity fund, is new money flowing into industrial companies that can provide relatively steady yields and these are former investors in term deposits, rolling them over and being very dismayed at the 30 or 40 points they’re getting, so they’re virtually getting a negative real return and then these term deposit investors being forced into equities and also more risky structured products. That’s fuelled the rise of the likes of Mayfair 101 and also some biotech offering term deposit like terms. That’s some of the themes we’ve seen in ’21.

Thanks very much for your time, Hugh.

Thanks very much.

That was Hugh Dive, the Chief Investment Officer of Atlas Funds Management.