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Income stocks still a smart defensive play, but look beyond miners and banks

Dividend investing can be a good source of defensive income in volatile times, but changing fundamentals mean resources companies and banks may be the weaker play in 2023, with opportunities emerging beyond these traditional Australian dividend payers - although valuation will be key.

Despite the increasing volatility in sharemarkets, dividend investing is still a strong proposition for investors looking to generate income with defensive posturing, according to market observers – although shifting fundamentals mean investors looking beyond the usual domestic suspects will likely find the best opportunities.

Dividends are coming off a massive 2022: payouts rose 8.4 per cent to deliver a record US$1.56 trillion to shareholders, according to the Janus Henderson Global Dividend Index, released March 1. In Australia, declines in the mining sector held back growth, but payouts still hit a new record in Australian-dollar terms of about A$98 billion.

Banks and mining companies accounted for more than three-quarters of that amount, but lower commodity prices and higher interest rates represent substantial headwinds for these traditionally reliable income stocks in 2023. Pressure on valuations should enable investors to identify attractively priced, sustainable dividend opportunities amid the disruption, said Scott Kelly, portfolio manager of DNR Capital’s Australian Equities Income Fund.

  • “Historically, people were inclined to buy banks and resources companies or buy Telstra and sit and hold,” Kelly told The Inside Investor. “That was a pretty good strategy 10 years ago, but there has been a shift over time. You need to be more active and more opportunistic rather than just sit and hold.”

    Kelly said despite the strong dividend performance in 2022, he is more cautious about the outlook going forward, given the market has been overly optimistic about the inflation picture and China’s reopening.

    “The market has been putting the highest probability on the least likely outcome, which is a soft landing, inflation contained at 2 per cent and central banks soon pausing and cutting rates without causing major damage to the economy,” he said. And while Australia is well positioned relative to its peer economies, it is not immune to inflation issues, labour constraints and housing shortages.

    “If the likelihood is a recession, then we want to own quality, defensive businesses that should be able to grow no matter the economic cycle. On the other side of the coin, if inflation is stickier for longer, we want to own companies that can pass inflation through to customers.”

    Shifting dynamics in 2023

    Australia was one of 13 countries that saw record dividend payouts in 2022, according to Janus Henderson. Globally, 88 per cent of companies raised dividends or held them steady last year, returning to trend following reductions during the pandemic. Asia-Pacific was one of the major beneficiary regions, along with emerging markets and Europe; all saw dividends rise by about one-fifth on an underlying basis.

    But with banks and energy companies driving much of that outperformance, growth is unlikely to continue on the same level as the conditions that have made it possible are shifting to create a less favourable environment for traditional dividend leaders.

    “The mining sector in Australia and around the world paid record dividends in 2021, but the price of many commodities is now lower, with the notable exception of coal,” Janus Henderson said in its report, noting that sector trends are currently more dominant than geographic ones in the global picture.

    In this shifting landscape, DNR Capital has a “double-digit underweight” position on banks and is underweight resources, Kelly revealed. It is overweight industrials and defensive, quality companies, including in telco, health care and insurance – “defensive up-and-comers like Lottery Corp. and Endeavor, the drinks business”.

    He also named Reliance Worldwide as a “reasonably defensive option” that he called “a combination of misunderstood and mis-forecast”. This is a big part of what DNR is looking for: “companies unfairly derated by the market, misunderstood businesses, businesses that have recently got a new management team in, or the competitive environment has changed in their favour.”

    Sustainability also matters, Kelly said, so seek out sector leaders that grow above market through economic cycles and “might demand a higher valuation in three to five years than what the market is prepared to pay today”.

    And while it can be difficult to find sustainable, quality businesses at the right price, Kelly said, opportunities are emerging with derated businesses in the cyclical space, such as Reliant and James Hardie.

    With the changing economic backdrop, the dividend picture in 2023 may look different from last year’s bonanza, but equities sill provide a good alternative to fixed income, especially in Australia with the “free lunch” represented by the franking system, Kelly said.

    “The key message is that the dividends from the market year after year are usually very stable and predictable,” he said. “There were exceptions with COVID and the GFC, but they bounce back – it’s the share prices that are volatile. And Australian market dividends on average have franking of 70-80 per cent, which is the cream on top.”

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