Episode 14: Calling on Income

In the first of a two-part series, Thornburg Chief Investment Strategist Brian McMahon discusses the current income landscape as well as telecommunications companies in Thornburg Investment Income Builder Fund.


Calling on Income

Michael Ordonez: It seems fitting that on February 14, 1876, Valentine’s Day, Alexander Graham Bell filed the patent for the telephone. We’ve had a love affair with the device ever since, and in the time since Steve Jobs unveiled the iPhone in 2007, our love, reliance, and addiction to telecommunication services has only intensified. I’m Michael Ordonez, Director of Client Portfolio Management at Thornburg, and today I’ll be speaking with Thornburg Chief Investment Strategist and Portfolio Manager, Brian McMahon, about telecommunication companies on Away from the Noise.

You’ve heard it all a million times by now. The Coronavirus pandemic is unprecedented. We’re working from home. We’re on video calls. We’re learning how the mute button works. And none of us will take the reliability of home Internet for granted again. These services, and in particular our smart phones, are keeping us connected and more productive than ever. In the world of investing, we’ve experienced record highs and record falls. In the wake of that volatility, there is opportunity. For someone like Brian McMahon, who has spent over 40 years in finance, and has been at Thornburg since 1984, there is a reason why we use the word unprecedented. It’s even new to him. As a portfolio manager on Thornburg’s Investment Income Builder Fund, let’s first consider the income landscape. Here is Brian.

Brian McMahon: I guess I would start with the economy, and the economy – global economy – is marked this year by the COVID-19 pandemic which led to stay-at-home for more than 2/3 of the global population in countries that account for more than 3/4 of global GDP. And these orders lasted form months depending on location, but national GDPs declined 10 plus percent in many countries year over year in the June quarter. And as we speak today, new disease outbreaks are necessitating sporadic new orders that restrict activity in some geographies. So, government bodies around the world have taken really unusual steps to A) control the disease, B) mitigate the consequences of the severe economic disruption, so that the basic structure of the global economy can remain in place. And there are two big visibility issues today, that impact all investments, including income investments, and those are when will these economies return to normal, and what is the ongoing willingness and ability of various national governments to continue to finance these mitigation measures, and you see those political debates happening around the world, including here in the US.

Michael Ordonez: So, how do you take the Coronavirus and economic backdrop into consideration in the Thornburg Investment Income Builder?

Brian McMahon: What we have tried to do in Thornburg Investment Income Builder is increase our resilience of the portfolio and of the assets in the portfolio to carry on in this uncertain economy, and to continue to produce income, and to continue to produce the cashflows that can support our dividends and the interest payments to the extent that we own bonds. Financial asset prices have been really volatile. I would just wrap up because it influences all financial assets, and that is that various therapies for treating Coronavirus, and vaccines to prevent it, are being tested, and on any given day we get news of successes, or failures, or delays, but there are so many efforts and so much cooperation by scientists around the world, that I fully expect positive news in the months to come on both therapies to treat people who get the disease, and also vaccines to prevent it. So, a lot going on, but to come back to Thornburg Investment Income Builder, what we’ve tried to do in various ways is enhance the resilience of our portfolio.

Michael Ordonez: Over its nearly 18-year history, Thornburg Investment Income Builder Fund has focused on providing an attractive yield to investors, mostly through dividend-paying stocks. The team, including Brian, Jason Brady, Thornburg’s President and CEO, Ben Kirby, Co-Head of Investments, and Matt Burdett, Portfolio Manager, have collaborated to accomplish just that in the fund for clients. Brian, I want to come back to something you mentioned which is resilience. Thornburg Investment Income Builder’s flexibility allows us to rotate where the team sees value. Is resilience bonds?

Brian McMahon: Well, in some cases, yes, it is. So we’ve increased our bond weighting by a few percentage points in Thornburg Investment Income Builder. Most of that increase, back in the spring. Central Bank bond buying has been augmented by material private investor demand for bonds. So, bond yields have gone down a lot, and bond prices have gone up a lot, even as the issuance of new bonds, both by governments and by private companies, private borrowers, is at record levels, all-time record levels. So you have a huge supply, a huge demand for bonds, some of it artificial created by these by these central banks.

Michael Ordonez: One such bond that illustrates the path of price and yield over the past few months is one we’ve owned for several years. Issued in 2014 by the Williams Companies, a gas, pipeline, energy and infrastructure company based on Tulsa, Oklahoma. The company issued a $1.25 billion bond that pays a 4.55% coupon through June of 2024. Here is Brian again.

Brian McMahon: We have a significant position in this bond, and have held it for a number of years. Back in March – March 5 – so, before the big news hit on Covid here in the US, our Williams 455s were priced at 110 percent of par to yield 1.96 percent. By March 23, 18 days later, that bond was priced just shy of 77 percent of par. So, it dropped 33 percent in 18 days, and at that point had a market yield of 11.57 percent, and these were the last trades prior to the Fed announcing its big bond purchase program. So if I fast-forward to today, that bond is back up to $112.00 price to yield only 1.03 percent. So, it’s barely exceeding a 1 percent yield.

Michael Ordonez: How do bond yields like that compare to dividend yields in stocks?

Brian McMahon: If I look across our portfolio, and I look at stock yields, dividend yields versus current market debt yields for the same companies so I can give you an example or two, but let’s take, say a Deutsche Telecom which is a significant holding, and which I’d like to talk more about, but they have a 2 percent bond, denominated in Euros, due in December of 2029, and that has a current market yield of just over 60 basis points. Meanwhile the dividend yield for Deutsche Telecom is 4 percent, would round to 4 percent. So, if I take a 10-year forward view, what’s 10 times 4 percent? It’s 40 percent. And what’s 10 times 60 basis points? Right? It’s 6 percent, and what’s the difference between 6 percent and 40 percent? It’s 34 percent. So, I’ve got some room there on a forward-looking basis. I’ve got a lot of room to endure some stock price volatility, and frankly, I think, Deutsche Telecom for reasons I would love to discuss, will have an increasing dividend over the next 10 years. So, at this point we’re finding better fishing in dividend-paying equities, and particularly maybe so-called value dividend-paying equities with resilient businesses that we think can carry on, support their current dividends, and grow new dividends. So, that’s kind of my view of stocks versus bonds.

Michael Ordonez: At the start of the year, Communication Services weighting in Thornburg Investment Income Builder Fund was about 15 percent. Today it’s closer to 23 percent. The near 7.5 percent increase is substantial, especially considering that it’s a relatively small sector in the overall economy. Clearly, the popular so-called work-from-home trade has to be a part of this, but there’s more. Back to Brian.

Brian McMahon: If I would look back a few years where people talked about defensive equities things that come to mind are consumer staples, utilities, all businesses and sectors that we have owned over the years in Thornburg Investment Income Builder, and so I think what’s illustrative is I’ve looked at the top consumer staple stocks in the Russell 100 Index, and the top 15 are all companies that any listener will recognize. So they are kind of in order, I just read off the top five. Procter & Gamble, Coca-Cola, Pepsi, Philip Morris, Altria. I’ll go down a little more, Mondelez, Colgate, Estee Lauder, Kimberly Clark, Keurig, Dr. Pepper, Kraft Heinz, General Mills, etc. So, if I scrunch all of those together and I look back 5 years, the weighted average revenue per share growth for those companies is negative 30 basis points, negative three tenths of 1 percent. So, these businesses, we know them, and we love them, and we respect them, but they actually aren’t growing.

Michael Ordonez: Brian, what about the valuations? Consumer staple stocks are valued at 24.5 times earnings, and telcos are at 12.8 times. So their earnings multiple is half that of the staples. What are you getting at here?

Brian McMahon: Well, I get actually a 5.2 percent dividend for my telco stocks, versus 3 percent weighted average dividend for the staple stocks, and the dividend for the staple stocks is pulled upwards basically by the cigarette companies, Philip Morris and Altria, which have high single digit dividends. Most of them are below 3 percent dividend. And, and what I find striking, is the trailing 5-year total return for these staple stocks, for these top 15 staple stocks is plus 65.8 percent. So, a nice double digit average annual return for these staple stocks, and the trailing 5-year total return for the telco stocks is negative 12 percent. So, a 78 percent total return gap, looking backwards, but I need to look forward, and I think most of the people listening to this call need to think about looking forward. So, at 24.5 times earnings with almost no revenue growth, and by the way expected earnings growth for the staple stocks for this year, for 2020 is negative 80 basis points. Whereas expected earnings for our telcos for this year is a positive number, positive 80 base points. So, a 1.6 percent gap there on expected earnings growth for this year. Looking forward, I see a lot more need for communications, both wireless and wireline, and digital communications. We all see that day in and day out. So, I’m pretty excited about the set up that we here for future performance in our telecom stocks, and by the way, I’ve got a great dividend and frankly, I would expect these dividends to grow over the years. So, that’s why we’re heavily weighted in telcos. It’s a combination of resilience, great value, and great income.

Michael Ordonez: Brian, I know how much you like talking about the ingredients of the portfolio, and the Investment Income Builder Fund, so let’s dive in.

Brian McMahon: Great. I love to talk about our holdings, because I’m excited about the investment portfolio for the Thornburg Investment Income Builder.

Michael Ordonez: Let’s start with China Mobile, a substantial weighting in the portfolio.

Brian McMahon: This is the largest telecom company in the world. They have some 950 million mobile subscribers, and about 200 million digital broadband subscribers. China Mobile has a trailing 5-year revenue, and EBITDA growth of 2.7 percent, and 4 percent per year, respectively. It has a dividend yield of 5.4 percent, and has net cash equal to 30 percent of its market cap. So, here, the share price declined by some 31 percent between mid-February and mid-March and it’s gotten back about half of that today. But we think it has a lot more to go, and here, the EV/EBITDA multiple is barely more than 2 times. So China Mobile is a favorite of ours, big business, an important business, very cheaply valued and with good income production, more than a 5 percent yield.

Michael Ordonez: For comparison’s sake, let’s go back to 1876 when Bell patented the telephone. There were about 1.5 billion people in the entire world. As Brian noted, China Mobile has 950 million subscribers. Another holding in our portfolio is French telecom company, Orange, which has over 207 million mobile subscribers across 27 countries in Europe, the Middle East and Africa. Add to that 184 million Deutsche Telecom subscribers and Vodafone which has 300 million mobile subscribers, and we exceed the entire population of the planet 144 years ago. Okay, enough useless trivia, let’s hear about Orange next.

Brian McMahon: Orange’s share price went down 37 percent between mid-February and mid-March, and it has recovered a bit from that, but not much. The dividend yield is over 5 percent on this year’s dividend and, on what we expect for 2021, it would be over 7 percent. So, why do we like Orange? Well resilience in the first half of this year, Orange’s revenue was up 30 basis points. EBITDA was down less than 1 percent. They have great assets. They own what I call digital bricks and mortar, and that is some 40,000 wireless broadcast towers, and terrestrial fiber, fiberoptic cable that passes more than 42 million homes in Europe. That’s a lot. I think over time they may spin out some of those assets into a separate business.

Michael Ordonez: Let’s turn to Deutsche Telecom.

Brian McMahon: Deutsche Telecom is an interesting company in part because it’s the largest incumbent telecom company in a number of European countries, most notably Germany, but also Austria, Greece, Hungary and a few other countries in Eastern Europe, but famously, they are the control shareholder for US-based T-Mobile. They own 540 million shares of T-Mobile, and today, as we speak, that’s worth more than 50 billion Euros. So for a company with a market cap of 71 billion Euros, that’s a very high percentage of their market cap despite TMUS contributing really less than half of their operating income. It has a 4 percent yield, which we like. That share price declined by some 35 percent between mid-February and mid-March. Deutsche Telecom has very significant digital real estate. They own 35,000 cell towers in Germany, and the Netherlands, and they own another more than 15,000 cell towers in other European countries, and they also own a significant fiber infrastructure. So, we like the combination of great assets, great income important business, resilient business, and a business with probably more demand tomorrow than they had last year.

Michael Ordonez: Let’s round out the discussion with Vodafone, the British telecommunications company.

Brian McMahon: Vodafone is quite interesting because it has a 35 billion Euro market cap just over 40 billion in net debt. So, 77 billion economic value of the firm. They have almost 15 billion in EBITDA and a 6.7 percent dividend yield. So, a very attractive dividend yield. Imbedded within Vodafone they’ve set up a separate tower company that they call Vantage, and Vantage owns some 60,000 telco towers in Europe. In early 2021, Vodafone expects to spin out Vantage and IPO Vantage. They will retain a controlling interest in Vantage, but if Vantage is valued at anywhere close to where other listed publicly traded tower companies are traded, and I give you a couple of examples we own in Thornburg Investment Income Builder and have owned for a number of years, Crown Castle International which now trades at a multiple of more than 25 times EPITDA, and Cellmax, a European comparable company trades at 25 times EV/EBITDA. So Vantage, Vodafone’s at this point, captive tower sub, if it gets anywhere near that kind of valuation, that would leave the stub telco business at a very, very cheap valuation with a more than 6 percent dividend yield. So, we like the assets. We like the digital real estate. We like the dividend yield, and we like the capital appreciation potential for Vodafone.

Michael Ordonez: That will do it for today’s episode because, clearly, I have to make a phone call. My thanks to Brian for telling us so much about these telecom companies. Join me next time when we talk to Brian about financials, technology companies, and one big box retailer that since working from home many of us have visited more than usual, on the next episode on Away from the Noise. Today’s episode was produced by Michael Corrao. Check out other episodes on Thornburg.com/podcasts, as well as on Apple, Google Play, and Spotify. See you next time.

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