This monthly feature is dedicated to a simple proposition. Financial freedom is synonymous with choice. The more you grow your passive income the more choice you have. Let's work on adding a little more freedom to our lives.

Michael Porter may be the preeminent management guru in the world. A professor at Harvard he has authored several books on competition and strategy and is the creator of Porter’s Five Forces. When he talks about strategy people listen.  

Porter said, “Strategy is about making choices, trade-offs; it's about deliberately choosing to be different.” This quote encapsulates the theme of the second edition of Dividend investor monthly which is the seemingly obvious notion that investing – like life – involves trade-offs. 

I think about trade-offs when I ponder what it means to be an income investor. While the world frenetically pursues – and mostly fails to achieve – market beating returns I sit back and collect my dividends. I’m content with this trade-off.

This trade-off was front of mind as I sat perched above a busy Circular Quay in Lazard Asset Management’s Sydney Office. I was there to talk about the Lazard Defensive Australian Equity Fund with Portfolio Manager Aaron Binsted.

The fund is designed to provide regular income that grows over time. I’m trying to accomplish the same thing in my portfolio and jumped at the opportunity to speak with Binsted. The fund was conceived during the GFC with the intention of supporting the goals of retired and pre-retired investors who are searching for high levels of income and lower volatility.

There are trade-offs to pursuing this strategy. Binsted acknowledged that the fund would likely underperform in the heights of a bull market but would fall less than the index in a bear market. This pattern has held up historically. In the first 3 months of 2020 as the market sunk in the face of a rapidly spreading pandemic the fund fell less than 16% while the overall ASX 200 was down close to 25%.

Over the past 5 years the fund has outpaced the ASX 200 with 9.52% annual returns vs an index return of 7.97%. The first step that Binsted and team takes is to narrow down the universe of shares by only considering those with long run dividend yields higher than the RBA cash rate.

Yet this screen on dividend yield is only the first step. The portfolio also aims to invest in enough companies with growing earnings and dividend streams so fund investors can benefit from growing distributions over time. The fund does not just buy companies that have a high spot yield today. This serves two purposes for investors. It protects against dividend traps and provides the opportunity for dividend growth.

Lazard

Source: Lazard

This approach has led to a portfolio that differs from the ASX 200 index. One stark difference is the equal weighted nature of the fund which differs from a top-heavy local market.

There are also sector differences. Compared to the index the fund is overweight consumer defensive and energy shares and underweight financials. Avoiding the big banks undoubtably hurt returns last year. The fund managed only a 1.90% return in the last year compared to an overall 15% return of the ASX 200.

Binsted attributed this to a market where the top 20% of ASX companies have driven overall index returns. Most of the share price appreciation can be attributed to increases in valuation levels with price to earnings on those shares increasing by 50%. Earnings growth has been practically non-existent with market level earnings per share falling in the last year.

The poster children for elevated valuations are the banks. Binsted described banks as trading at 3 standard deviations above their long-term valuations. In laymen speak that means that 99.70% of the time the banks have been at lower price to earnings ratios. Higher valuation levels mean lower dividend yields. This makes it an easy decision to remain underweight financials for a fund focused on income.

The Lazard Defensive Australian Equity Fund receives a Silver Medallist Rating from our analysts. The fund has a total cost ration of 0.78% and a $20,000 initial minimum investment.

Lessons from Lazard's approach

There are several lessons that investors can take from the approach of Binsted and his team.

The first lesson is a reminder that investing is a means to an end. I believe that income investing can be an effective strategy for more than just pre-retirees and retirees. Nevertheless, the Lazard Defensive Australian Equity Fund is designed to solve a specific problem. Spend some time thinking about what problem you are trying to solve and the best way to do it.

The second lesson is that each strategy is going to perform differently depending upon the environment. You can try and switch strategies to always be in the best one for present conditions. Good luck. This is next to impossible to do. I understand that my portfolio won’t perform well in certain environments. I accept that. I have confidence in my long-term strategy and understand when it will do well and when it won’t. Investors in the Lazard Defensive Australian Equity Fund must also accept that there are environments where returns will underperform the market. That is ok. It is the long-run that matters.

The third lesson is one that I make often. Income investing involves more than just buying the shares with the highest yields. A static or falling dividends don’t help any investor achieve their goals. Successful income investing means growing dividends and the only way to do that is to buy companies with growing earnings. That is something that the team at Lazard focuses on and should be a focus of all income investors.

Surge in ASX buybacks

There are two main ways that companies can distribute cash to shareholders. Given the extra boost Australian investors get with franking credits local companies have traditionally preferred dividends. Yet buybacks are steadily gaining in popularity.

According to the AFR a record 47 companies bought back $14 billion of stock in 2024. This is a significant increase from the 13 companies who bought $2.8 billion of stock in 2016.

Buybacks still lag dividends in popularity with CommSec expecting a total of $80 billion in dividends from Australian companies in FY 2024. Globally the dividend / buyback split is much closer with buybacks accounting for 94% of total dividend payments according to Janus Henderson. Buybacks have been gaining on dividends over the years. In 2022 buybacks made up just 52% of total dividend payments.

There is an obvious advantage to buybacks as it is more tax advantageous for investors. A buyback reduces the number of shares outstanding which benefits investors but leaves an investor the choice of when to sell and face capital gains taxes. A dividend forces an investor to pay taxes each time a dividend is paid.  

I certainly understand the argument that buybacks are better. It is all true if – and it is a big if – the shares are doing well when you need to sell them. It is true if the company is buying back shares when they are undervalued.

Apple is a good example. Over the past 10 years Apple has executed the largest share buyback program in US history. The company bought $687 billion of shares over the last 10 years. That is equivalent to 35% of total outstanding shares.

When this 10-year period started in 2015 the shares were trading at a price to earnings ratio of 11.42. If you have a time machine and can go back to 2015 pick up some shares at that valuation level. Get some for me too. In 2024 Apple was trading at a price to earnings ratio of 41.19.

Was the $78 billion spent on buybacks in 2024 worth it? Time will tell. But if the shares were to fall to their 5-year price to earning average of 29.12 the answer is obvious – no. More importantly if the shares drop 30% and you need to sell them to pay for your life the buyback did little good.

The alternative would be using the funds to pay more than 5 times the current dividend of $1 a share. Perhaps that would be enough to pay for an investor’s life instead of selling shares.

For Australians buying Australian shares there is the added benefit of franking credits which depending upon the franking level and your marginal tax rate can more than make up for any taxes owed.

Buybacks are good in theory. For me at least dividends work better in practice.

Income investing insights in February

My colleague James wrote a great article on the power of dividend growth using Buffett’s experience with Coca Cola as an example. The mirrors the lesson that over the long-run dividend growth is far more important than simply buying the highest yields. You can read it here.

I tackled the most unconventional of all my dividend picks for income investors. CSL which currently yields around 1.50% is nobody ideas of an income share. Yet once again in February CSL raised their March dividend with a boost of 15%. Read about my thoughts here.

I would love to hear suggestions to improve Dividend investor monthly. Write me at [email protected] 

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