Henderson’s Dividend & Income Builder Fund (HDAVX, HDCVX, HDIVX and HDRVX) seeks to provide current income from a portfolio of securities that exceeds the average yield on global stocks, and aims to provide a growing stream of income per share over time. The Fund’s secondary objective is to seek to provide long-term capital appreciation. It has outperformed its Morningstar peer-group benchmark by over 400 basis points since its inception four years ago.
Alex Crooke joined Henderson Global Investors in 1994 as an associate director of investment trusts. He was named Director of UK Investment Trust in 2001 and has managed several funds during his 26-plus years at Henderson. He currently serves as the co-manager of the Henderson Global Equity Income Fund and lead portfolio manager of the Henderson Dividend & Income Builder Fund. In 2013 he was appointed Head of Global Equity Income.
John Pattullo joined Henderson Global Investors in 1997 and is co-head of strategic fixed income. He co-manages the Strategic Income Fund and the fixed-income portion of the Dividend & Income Builder Fund alongside Jenna Barnard.
I spoke with Alex and John on August 8.
As managers of the Dividend & Income Builder Fund (HDAVX), what is the mandate of your fund?
Alex: The mandate for the Fund is to deliver an attractive dividend yield to investors and to grow that over time from investment in both bonds and equities from around the world.
Since its inception on August 1, 2012, your fund has had an annualized return of 7.85%, as compared to 3.53% for its Morningstar peer-group benchmark, the world-group average, earning it a five-star rating. What have been the key contributors to its outperformance over this period?
Alex: One of the keys is we’ve favored equities predominantly over bonds throughout most of that period. Though bonds have done very well, overweighting equities has grown the dividends very strongly. Some of the global equity exposures has done very well as well for us.
We were higher weighted to the U.S. in the front end of that period, which did well. We’ve also had a good exposure to the Pacific region in the early years of the Fund. We reduced that in 2015, which saved us a bit of underperformance.
From the stock picking in the equity portfolio, dividend-paying shares have been attractive to investors in a lot of markets as interest rates have fallen. We’ve been definitely favored some of the more defensive sectors. Utilities have outperformed in most markets. Some property exposures we have also been doing well.
John: The bond section is fairly modest, but essentially we haven’t been short duration. We’ve been longer duration than many in our peer group.
We’ve held a mixture a large-cap, consumer-facing defensive high-yield bonds, specifically double-B and some non-cyclical single-Bs. Double-B and single-B have been a good place to be in high-yield over the years. We have had some triple-Bs, because they tend to be in larger cap and longer duration investment-grade names, which have been a great duration bet over the period. The bond market has been very strong recently as well, and we haven’t been shy of taking duration risk with a mixture of lower-end investment-grade and top-end of high-yield bonds.
In terms of your asset allocation, your portfolio has approximately 84% in equities, 12% in fixed income and the remainder in cash and some other asset classes. How do you decide the allocation between the equities and fixed income?
Alex: There are a couple of indicators we look at that define how we split the asset allocation. The first one is a valuation-based metric where we are looking at the equity risk premium, the value of equities relative to bonds. When we find that equity risk premium is above about 7%, which is its long-term average, then it’s telling us that equities are a good value relative to bonds. We are still in that area with bias toward equities over bonds.
The other thing we view is the change in expectations of economic growth around the world. When you look at previous periods and you compare economic activity and growth with stock market performance, it’s a very poor correlation. Actually, the better correlation is the second derivative of that growth – the change in expectations of economic growth. Over the last 12 months or so, that indicator has been shining a bit red, with economic growth expectations falling. It’s in China, obviously, but also the European markets.
We haven’t quite changed the allocation yet, but new money coming into the Fund is going 20% into fixed interest and 80% into equities. That will over time begin to skew the overall allocation. But until the equity risk premium falls a bit further, then we are likely to keep the allocation where it is now.
Looking at the equity portion, in your most recent quarterly commentary, you stated that you were taking a defensive position given your projections for lower global economic growth. Why are you pessimistic about the prospects for growth?
Alex: It comes down to a few factors in different regions. If you look at Europe, we have worries about the composition of the region and with the U.K. having its recent vote to leave the European Union. Consumer confidence is down and that has a roll-on the effect on the prospect for economic growth. Inflation prospects are very low in the region, and that’s limiting companies’ abilities to increase prices and volumes. That’s hitting sales there.
If you go into Asia, there are more worries about the Chinese economy funded on lots of debt and the marginal improvements in growth coming from increasing levels of debt are fading away. The big engine for incremental growth around the world has been Asia and China in particular, and that is easing. That’s not helping prospects.
In the U.S., we’ve had one hike in interest rates. Whether that was right or wrong won’t be known for a long time. We don’t know if it will have an impact on consumer sentiment and growth prospects, or if rates go up and cut back economic activity.
Adding all those dynamics in different regions makes us more cautious. We think that a lot of companies are well positioned, though. They’re taking market share from their peers or they are in segments or sectors of the market that have incremental growth. In areas like telecom, consumers are more data hungry and want more packages on their mobile phone. They’re using 4G. We are seeing incremental growth coming from there.
Your report stated that you are holding several consumer staples stocks – Johnson and Johnson (JNJ), British American Tobacco (BTI) and Coca-Cola (KO). The P/E ratios of those stocks are 23.08, 20.33 and 25.12, respectively. Why do you believe those stocks are fairly valued?
Alex: I’m going to be honest and say they are expensive. They certainly are against their history and market levels. It shows that I’m not alone in my view in having a cautious outlook, and investors preferred the certainty of the earnings from those premium consumer names.
When we look at the portfolio in the aggregate, we have an average P/E of 15.4, so we must be owning some other stocks which are much lower value than those names which you just quoted.
Those stocks that can continue to deliver growth will support those valuations. We are not putting money into those stocks. If we see a bit more inflation, and therefore a bit more certainty that the economy has grown, we should see cyclicals, industrials and the financial areas of the market become very cheaply valued and improve their prospects. Then maybe investors will sell down some of those premium-growth names. But for the moment, they are worth holding onto, in that we think they will continue to deliver market expectations.
Your report also stated that you were underweight cyclical sectors, such as industrials, technology and basic materials. Do you believe the market has underestimated the probability of a recession in the U.S.?
John: I have a lot of sympathy with Larry Summers’ secular-stagnation thesis, which suggests there is not enough demand in the world. Few people want to borrow money, even if you reduce interest rates. That is particularly pertinent in Europe and Japan, but less so in the states. There are technological problems and productivity and demographics headwinds.
On the back of that, I would argue that the economic cycle is very elongated. The cyclicals have a lot of excess capacity in an economy that is growing at roughly 2% year-to-date, and has grown about 1.3% against an expectation of 2%. The cycle is not the sine wave we were all taught in economics. A lot of the heavy cyclicals have significant excess capacity, which is why they don’t have any pricing power.
I have a lot of sympathy with the view that you want to be safer in the consumer-facing defensive-expensive names Alex mentioned. I accept they are not wildly cheap, but they are not that expensive due to the certainty of their earnings, the certainty of cash flow and the importance of compounding dividends. That is a fancy way of saying cyclicals might be cheaper. They are cheap for good reasons because they are not all going to bounce back. The economy is not going to bounce back very hard. Even if it does, I don’t think the U.S. economy is going to grow at 3% or 4%. It will continue to grow around 2% or lower this year.
All the analysts came in with expectations of 3% in January and, as usual, we will end with a 2% handle. For that reason we are a bit wary of the cyclical sectors, especially in the bond portfolio, and on the equity side as well. If anything, these things could become more expensive because they are so reliable and safe and sensible and consumer facing, unlike some of the notionally optically cheap cyclicals which we are a bit shy of.
Alex: Do we underestimate the probability of a recession? I don’t think we will get a recession in the U.S. The problem is that we see the Fed not able to hike rates up because they don’t see strong growth peeking through. There are plenty of signs and a number of indicators that growth is easing back already and productivity gains are getting really hard to make. But I don’t see a recession nor do I see enough growth to get the cyclical sectors really moving forward unless you can find a couple of names which are taking market share, and therefore, growing in that way.
Your fund invests primarily in dividend-paying equities. How do you respond to the concern that the prices of those securities, especially those with higher dividends, have been bid up because of the lack of yield in the bond market, and that they are overvalued?
Alex: We’ve always been very clear to investors that we don’t believe yield is sufficient to make an attractive investment. By buying the highest yielding stocks, you inherit a lot of issues and problems. The market is often perceptive, and the yield is high because there is a lot of uncertainty in the ability to grow or pay that dividend. We are concerned about some of the high-yielding areas and we prefer to buy stocks with what we say is an attractive dividend yield. That is between 3% and 5%, but with the prospect of very strong or growing growth in that dividend over time. In that area there are plenty of stocks that are attractive to investors wanting yield.
We are concerned about sectors, like property and utilities in the U.S., where investors have gone to find yield. But if we look at property and utilities in Europe and Asia, we find very nice yield, attractive price-to-book, price-to-net-asset value and attractive returns. Being global, that’s the great benefit. We can walk away from some expensive stocks in the U.S. market and find those opportunities elsewhere.
Turning to the bond side, given your forecast for low global growth and low inflation, where are you seeing opportunities in the bond market?
John: The U.S. investment-grade and high-yield markets have been attractive and against the consensus. A lot of people thought high yield was going to have a tough year given the rising default and interest rates, and then the rising oil price. But we have generally favored longer dated investment-grade consumer-facing names in tobacco, telecom and similar sectors to what Alex was mentioning, principally because they got pretty cheap in February and March.
There was quite a lot of supply into investment-grade, driven by lot of M & A activity. Secondly, there was some concern that rates were going back up, which they did a little bit and rallied ever since.
But the big driver has been the overseas buyer. Maybe 40% of all new issuance of U.S. investment-grade is actually taken down by overseas buyers. If you are coming from a Japanese or European perspective, U.S. investment-grade and indeed sovereign bonds are remarkably cheap from an international perspective.
European investment grade yields are all of 0.6% and Japanese yields are about as low. Even British yields have gone remarkably low. What we see as a massive demand from Japan and Asia into U.S. investment-grade. There has not been enough supply, so the spreads have rallied very aggressively and that has resulted in good capital performance for us.
This global grasp for yield is a massive trade. We have had endless U.S. and London brokers tell us about this because Japanese life insurance companies, pension funds and retail investors are all desperate for yield. What really drove this was Japanese taking interest rates negative, coupled with interest rates in Europe going negative. That drove people along the curve in their domestic market.
When those curves flattened out, they then looked internationally and have ended up in the U.S. investment-grade corporate-bond market.
We were buying things such as Walgreens bonds, given it is on every corner in the states. We were buying those 30-year bonds on a yield of about 4.8% and they have gone up more than 12% this year, because of the duration effect of global yields going down coupled with the spread in. The price action has been really great for our investors.
We still quite like that trade but because it has performed quite well. We probably will be thinking about taking some profit out of that and going back to more traditional high-yield names.
I want to ask about one of your holdings. You participated in Dell’s $20 billion debt offering to finance its purchase of EMC. It was rated Baa3/BBB- by Moody’s and S&P. But given that it was priced at a spread of approximately 350 basis points off a comparable Treasury bond and that it was unsecured, isn’t that more typical of a junk-bond issue, which is not what you typically purchase?
John: Yes, it is not typical of our style. If anything, it was a short-term tactical trade that worked fantastically well because it’s gone up 15%.
Generally we wouldn’t favor the sector, but the sector has caught quite a good equity valuation recently. But the main reason why we bought this one was a short-term tactical trade. Dell EMC was the eighth largest LBO ever and needed a massive debt package in secured and unsecured issues, in investment-grade and high-yield bonds to finance that. We’ve noticed that when a deal has to come, it has to come at such a wide premium to get it placed, and nobody is very keen to underwrite such a deal.
On the back of that, jumbo deals, as they’re called, are generally billions worth, and have to be priced remarkably cheap just to make sure the deal gets done, the bonds get placed and everyone is happy. We bought the 20-year bond, which had an 8.1% coupon on it and came at 550 basis points over the underlying Treasury. That spread has come in to 450 basis points over the underlying Treasury. On a duration of 10, it has already gone up 10 points plus the underlying yield has come down, which explains why it has gone up about 15%.
But if anything, it was a short-term tactical trade. It was rated investment-grade, but anything coming at an 8% yield is junk. Subsequently, it has performed very well and Dell EMC has issued unsecured subordinated junk bonds and high-yield bonds underneath it in the structure, so it’s got a bit of in there.
Dell had already preannounced results when it issued those bonds, but it is not a long-term trade for us. But, hey, if you can take 15% out of the bond that’s quite exciting for the bond manager. But we will probably be moving on into some more defensive names in the months to come.
How are advisors typically using your fund in their clients’ asset allocations?
Alex: They are using it in two ways. Advisors like the style bias of dividend-paying stocks and growing income, so it of sits within their equity allocation. They are preferring to own a more dividend-income style than either growth or value, given that value has underperformed. But dividend-paying as a value style has worked quite well.
The bigger market is investors who are using it as a core holding for savers and clients who are still in the accumulation phase, so they are working and saving, or they are into early retirement. They need some income. They want a safer, lower beta style for their equity exposure. They don’t want to be taking a lot of risk. Dividend-paying shares tend to have lower beta over time and they still have a growth dynamic in their portfolio, so hopefully they should have capital growth over time. But they are moving into retirement, and like the income focus of our Fund and the yield of 3%.
The long-term growth in income should be right around 6%, which is the growth of dividends in the MSCI World Index over the last 40 years. If we can lock into that, offer 3% yield with the opportunity of capital growth for our clients’ money, then that fits as a core holding for that client.
What sets your fund apart from its competitors?
Alex: The Fund has a very attractive historic yield of approximately 3%, and a lot of funds in the world allocation sector are 2% and below. We have a growth bias to our investment style in terms of the dividends that we can get for our investments. We focus on cash flow generation in our investments, and that should over time lead to growing dividends.
Our aim is to have a steady, rising dividend off that attractive yield. We also have a very global exposure. Relative to holding a lot of domestic bonds or stocks, we will give you that international flavor. When there are expensive stocks in the U.S., we can find similar themes at lower ratings and valuations in more global markets.
Finally is the strength of the team. Here at Henderson we’ve got deep resources both running equity income and dividend-paying stocks, and running corporate bonds. The global markets are deep and very wide and you need that experience not to fall into traps.
Read more articles by Robert Huebscher
Henderson’s Dividend & Income Builder Fund (HDAVX, HDCVX, HDIVX and HDRVX) seeks to provide current income from a portfolio of securities that exceeds the average yield on global stocks, and aims to provide a growing stream of income per share over time. The Fund’s secondary objective is to seek to provide long-term capital appreciation. It has outperformed its Morningstar peer-group benchmark by over 400 basis points since its inception four years ago.
