For Long-term Portfolio Resilience to Market Volatility, Ingredients Matter
Portfolios comprised of top-notch equities and bonds coming into the economic and market crises should do even better coming out of it.
Among the coronavirus’ growing ranks of market victims are dividends and especially share buybacks, which many politicians on the left and even some on the right have long targeted for eradication. While some companies can maintain dividend payouts near-term, many can’t, given the hit to cash flows from stay-at-home and business shut-down orders.
Income investors, including many retirees, are understandably worried about their dividend income ebbing. Just how much it does will depend largely on the duration of the public health policies meant to slow the virus’ spread, the pace at which people with immunity to it get back to work and the development of therapeutics and vaccines to manage and counter it. In the meantime, the individual companies that populate income-focused portfolios matter more than ever.
Companies with the ability and willingness to cover their dividend payments, at least in the near term, may well benefit in the long run if their competitive position improves once the pandemic passes. Much depends on how they were allocating capital heading into the crisis. The vulnerable may have over-leveraged their balance sheets, drifted from their core competence or simply failed to think hard enough about their current and future business strategy.
As the global economy falls into recession, the differences between those who survive and those who thrive coming out of it will become apparent across sectors and geographies. The market, though, may not be particularly adept at identifying them early on, especially when broad market swings sweep companies of varying quality across sectors higher or lower in tandem. Take telecoms, which were among the hardest hit during the mid-March selloff.
Can You Hear Me Now? Telcos Benefit from Higher Call, Data Volumes
“If there’s one business that’s not seeing their revenues dented, it’s telecoms,” says Brian McMahon, Thornburg’s chief investment strategist and fund manager on the firm’s hybrid stock/bond income strategies. Indeed, U.S. telcos have been reporting massive increases in messaging as well as in time people spend on calls, along with surging smartphone mobile hotspot usage and video game traffic.
Below are extended comments from McMahon on select telecoms and two energy supermajors, which also weren’t spared in the market downdraft. A key business health metric among telcos is “churn,” or the percentage of subscribers who drop their service provider.
- For the guys we own, one of the things that matters is churn. To jump from one operator to another you have to go into an outlet, which are closed with the lockdowns. So, companies aren’t now making bargain offers to try and swipe subscribers from other operators. COVID-19 should be good for their profitability, not bad. It’s not easy to find those kinds of businesses that actually might benefit from the crisis, and I think communications can actually benefit.
- Quality telcos have invested substantially in their networks; they’ve had to because the wireless networks didn’t exist 30 years ago, and they’re super important now. The wirelines have also had to be upgraded. In a few more years, so much money will be invested in these networks they will be somewhat future proof; at that point, they will turn into cash cows.
- Once you’ve laid fiber and attached homes to it, and built a network of towers and small cells, you don’t have to do it over and over again. So, it’s not like three guys in hoodies working out of a garage can come along and challenge you in replicating that network. These are core infrastructure assets.
In terms of valuation, telcos are cheap relative to the quality of the businesses, McMahon points out. For example, the enterprise value (EV, which includes a company’s debt and cash on the balance sheet) to earnings before interest depreciation and amortization (EBITDA) of Orange SA, France’s dominant telco, recently stood at just 4.7, and, at 2.1, its net debt/EBITDA, a ratio reflecting the amount of income available to pay down debt, is highly manageable. China Telecom, the world’s largest telco by numbers of subscribers, is net cash positive, and sells at an EV/EBITDA of 2.4. Both have also been good dividend payers. China Mobile now sports a dividend yield of 6.2%, with Orange’s running at 6.4%.
Of course, it’s critical to distinguish between those focusing on their core competency and pricing strategy and those that aren’t. Are major U.S. telecos, for example, moving to compete in the media business sufficiently focused on their network infrastructure and pricing strategy? Perhaps not, if they’ve effectively created a “pricing umbrella” that could allow an up-and-coming competitor to undercut them both on pricing and wireless network quality, McMahon notes.
In Energy and Financials, Pick Your Shots Carefully
The same is true in energy, where Total SA and Royal Dutch Shell have diversified their business lines in complementary ways, with Total in particular having pursued opportunistic acquisitions of high-quality assets at exceedingly attractive prices. Shell, for its part, has moved into the cleaner-burning, low cost natural gas segment, and delivers one out of every four shipments globally of liquefied natural gas.
Both companies are paring back their capex and have canceled their share buybacks to preserve their dividends; and they could well benefit from coming distressed asset sales in the energy space. Orange and China Mobile, likewise, have confirmed their near-term dividend payments, no doubt thanks to growing subscriber network usage, and revenues.
Financials, which are among the more attractive dividend payers, are coming under political pressure to not return capital to shareholders. On March 27, for example, the European Central Bank recommended that banks suspend dividends at least until October and refrain from engaging in share buybacks. Sweden, Russia, Norway and Hungary have also pushed banks not to pay dividends.
Bank of America Merrill Lynch in a research note pointed out that mandating dividend cancellations at a system-wide, rather than at the individual bank level is counter-productive because the savings “will be more than offset by the deteriorated incentives (for capital providers) and higher funding costs – and lead to less capital in the banking system after a couple years.”
The mammoth $2 trillion U.S. fiscal stimulus package restricts corporate aid recipients from paying out dividends or repurchasing shares, although many companies likely to receive help had already cancelled their capital return programs or were moving in that direction anyway, particularly U.S. airliners and leisure industries.
Outside those segments, though, highly select companies exhibiting sound business strategy, strong balance sheets and free cash flow going into the crisis should weather the current storm better than their less prepared peers, and improve their competitive positions coming out of it. They are the ingredients–the top companies across sectors in key markets around the world–that should best serve shareholders in equity income portfolios until both the pandemic and the political pressure on capital returns to shareholders abate. “Over time, these are the kinds of businesses that you want to own,” McMahon says.
|% OF PORTFOLIO|
|Taiwan Semiconductor Manufacturing Co.||4.0%|
|China Mobile Ltd.||3.5%|
|Electricite de France S.A.||2.9%|
|JPMorgan Chase & Co.||2.7%|
|Deutsche Telekom AG||2.7%|
|CME Group, Inc.||2.7%|
|The Home Depot, Inc.||2.5%|