Henderson Far East Income — Update 4 May 2016

2016 got off to a difficult start in markets around the world, with Asia proving no exception. Fears over economic growth, currency devaluation and ill-judged government intervention in the stock market in China have had ramifications for the whole region. Lower oil and resource prices have hit producer nations such as Australia, Indonesia and Malaysia, while arguably providing less than the expected benefits for the net importing countries that make up most of the Asia Pacific area.

As seen in the right-hand chart in Exhibit 2, the continued development of the Asia Pacific region (including Australasia) is an important element in expected world economic growth, even though annual growth expectations for the next five years are – in contrast to the G7 developed economies – lower than in the previous 10 years. Many countries in Asia have large and young populations that share aspirations with those in the West, although in many cases the path to achieving these differs, for example with development of mobile internet largely bypassing fixed-line networks.

Although investors may see Asian markets as more growth-orientated, dividends are an increasing component of total returns and may prove more sustainable than those in markets such as the UK, where a large proportion of total dividends comes from hard-pressed energy and commodity stocks. Despite this, high-yield stocks have slightly underperformed the market as a whole in recent months (left-hand chart), suggesting potential for recovery in an environment of lower economic growth and continued low interest rates, where income may come to be seen as more important.

Henderson Far East Income (HFEL) was set up in 2006 as a rollover vehicle for Henderson Far East Income Trust. It is incorporated in Jersey and listed on the London and New Zealand stock exchanges. The fund aims to provide investors with a high income and capital growth from a portfolio of companies in the Asia Pacific region, including India, Australasia and to some extent Japan (the latter is not expected to make up a significant part of the portfolio). HFEL does not have a formal benchmark, but measures its performance against the FTSE AW Asia ex-Japan index and is a member of the Association of Investment Companies’ Asia Pacific excluding Japan sector. The lead manager is Henderson Global Investors’ London-based, pan-Asian equities director Mike Kerley, working alongside fund manager Sat Duhra and a team of analysts in Singapore. HFEL is one of a small group of income-seeking Asian investment companies and has substantially the highest yield of this peer group, achieved principally through focusing on companies with above-average dividend growth, as well as those with above-average yields, but also through the use of efficient portfolio management techniques.

HFEL’s manager Michael Kerley is cautious on the outlook for markets at present, with the recovery in March and April that followed a sell-off at the start of the year being focused more on highly cyclical areas like commodities than on the more dependable, income-generating stocks that make up the fund’s portfolio. He notes that dividend growth in the first half of HFEL’s financial year (to 29 February) was very strong; portfolio income rose by 31% compared with the same period in 2015 and the majority of this came from dividend growth rather than other methods of income generation such as option writing.

While there may be some weakness in the outlook for Asian dividends, this is concentrated in cyclical areas such as energy, resources and semiconductors, while more domestically focused areas have seen some upgrades to dividend forecasts. Free cash flow (FCF) generation by Asian companies has been rising steadily, and the ratio of FCF to sales is at highs not seen for more than a decade. However, dividend payout ratios are still among the lowest in the world, suggesting significant scope for dividend growth. While Kerley aims to hold a balance of high-yielding companies and those with high dividend growth potential, he says that in Asia it is often possible to find both characteristics in the same company.

Fears over the slowing of economic growth in China have been blamed for much of the recent global market volatility, and Kerley has reduced the fund’s weighting there (see Current portfolio positioning below), explaining that he is trying to keep to interesting underlying structural stories in China, not policy-driven ones. The manager has also become less positive on the outlook for India, noting that while the market had become excited about the opportunities for reform-driven growth, he believes that in the short to medium term India will deliver less than had been hoped. Korea, on the other hand, offers significant dividend growth potential, albeit from a low base, as a result of government pressure on companies to increase returns to shareholders.

Kerley notes the widening in HFEL’s discount to NAV and those of its income-focused peers, but counsels that the recent investor focus on highly cyclical areas is likely to be short-lived. In a world where growth is slow and interest rates remain low, the manager feels that attention will return to the total return potential of income funds in due course. While the fund’s dividend yield (6.9% at 2 May) is higher than those of its Asian income peers, Kerley views it as sustainable because of the strong valuation focus in selecting investments. The fund’s steady record of year-on-year dividend increases, fully covered by income, in a variety of market conditions gives weight to his view.

HFEL does not hedge its currency exposure and Kerley says this is unlikely to change, given that effective currency hedging is expensive and difficult and achieves little in the long term.

HFEL is managed by Mike Kerley, Henderson’s London-based director of pan-Asian equities, and Singapore-based Sat Duhra, supported by a team of Asia equity specialists mainly based in Singapore. The managers follow a consistent, disciplined approach with the aim of achieving attractive total returns, not just a high income, from a portfolio of 40-60 stocks.

Investment ideas come from management meetings and country visits, industry research and the use of quantitative screens. In-house research and modelling focuses on identifying cash-generative companies with high yields and/or growing dividends, where current share prices do not accurately reflect the value of the business. HFEL’s portfolio is broadly balanced between ‘dividend yield’ and ‘dividend growth’ stocks, although recently there has been a bias to dividend growth because of better expected total returns.

Once in the portfolio, stocks are monitored against price targets, risk and style metrics and country fundamentals. Although the portfolio is built largely from the bottom up, top-down factors such as the macroeconomic environment can affect returns, so the managers are cognisant of these.

HFEL’s portfolio has a higher yield than the overall market (Exhibit 3) as well as a higher level of dividend growth. The fund’s average P/E ratio is generally lower than the regional average because of the focus on finding good-value investments. A higher weighting in India and Australia versus history had increased the fund’s average P/E because companies in these markets tend to trade on higher ratings. The above-average return on equity underlines the fund’s focus on good-quality companies. HFEL’s own dividend yield is higher still (currently 6.9%) than its portfolio yield, with further income generated by writing options and by ensuring that holding periods maximise the available dividend stream. Kerley notes that portfolio turnover tends to be higher in periods of market volatility; for the five financial years from 2010-14 turnover averaged 64.5%, but in the year ended 31 August 2015 it was 121%.

At 31 March 2016 HFEL had 54 holdings, which is towards the higher end of the 40-60 stock range, but a little lower than the 57 stocks held six months previously. Just over a quarter of the portfolio (26.9%) was invested in the top 10 holdings, reflecting the fact that HFEL tends to hold broadly equal weightings in most of its stocks. While only five of the top 10 holdings at 31 March were in the top 10 six months previously, this is again a function of many positions being of roughly equal size, rather than an indication of wholesale portfolio changes.

The past six months have, however, seen some notable changes to portfolio weightings. The allocation to China has fallen by 4.6 percentage points since the end of September (Exhibit 4), with Kerley having sold out of HFEL’s Chinese bank and insurance stocks after all the large Chinese banks cut their dividend payout ratios. He remains happy with the rest of his Chinese holdings (which include internet firm NetEase, electric vehicle maker Zhengzhou Yutong Bus Company and air conditioning firm Gree Electric Appliance), and says that some of the biggest positive dividend surprises in the portfolio over the past six months have come from China.

A trip to South Korea in November 2015 has prompted an increased weighting, as the effects of government intervention to encourage more shareholder-friendly behaviour from companies are beginning to be seen. New Korean holdings include SK Innovation (the second-largest position at 31 March), an oil refining and petrochemical company, and KB Financial Group, a banking stock that Kerley feels is overcapitalised and as such likely to raise its dividend significantly.

A more recent trip to India has left the manager feeling less positive about the world’s second most populous nation, with little sign of the political reform investors had hoped for following Narendra Modi’s election as Prime Minister in 2014. Kerley has sold HFEL’s holding in Rural Electrification Company, whose fortunes he felt were too dependent on reform occurring, but retains positions in IT outsourcing firm Infosys, mobile phone mast company Bharti Infratel, and Coal India, which he says are broadly non-cyclical and remain on reasonable valuations, unlike Indian banks and consumer stocks.

Australia is the largest country weighting, with stocks there held mainly as a source of yield rather than for their dividend growth prospects; payout ratios in Australia are already quite high at c 70% and, against a dull economic backdrop (with the exception of a housing market bubble inflated by money from China), earnings growth will be hard to come by.

At a sector level (Exhibit 5), the largest exposures are to financials, telecoms and technology, although financials (which includes real estate) is below the index weight. Telecoms is the largest overweight, at more than 11 percentage points above the index. Exposure to the sector is diversified across the region, with companies including SK Telecom in Korea, HKT Trust & HKT in Hong Kong, Spark New Zealand and Telekomunikasi Indonesia Persero all among the top 10 holdings.

The biggest increase in terms of sector weighting over the past six months has been in oil and gas, where two new holdings have taken HFEL from zero to only a small underweight versus the index. Kerley remains negative on the prospects for oil exploration and production stocks, but feels that those operating in the ‘downstream’ areas of refining and petrochemicals can benefit from reduced input costs and higher demand because of the low oil price, as well as a lack of capacity because the oil majors have retreated ‘upstream’ to contain costs. As well as new Korean holding SK Innovation, Kerley has added Star Petroleum in Thailand.

Option premium income in the half year to 29 February 2016 was 13% lower than in H115, reflecting a lack of option writing in the last quarter of calendar 2015 amid uncertainty over the pace and timing of US interest rate rises. Option writing has picked up again since the beginning of 2016, with volatile markets and divergences in performance between stocks and sectors (where some have sold off along with the market, while others remain close to all-time highs) allowing the manager to write both put and call options, to take advantage of falling and rising share prices.

Since launch in 2006 HFEL’s shares have traded at an average premium to cum-income net asset value of 0.6%, having spent much of the post-financial crisis period trading above NAV. The recent market volatility and worries about growth in China have seen the shares move to a discount, which reached a five-year widest point of 5.9% in mid-February 2016. At 2 May this had narrowed to 2.5%. In the past five years 15.3m new shares have been issued to meet demand and manage the premium. While the pace of issue has slowed, with 4.2m new shares allotted in 2015 compared with 5.4m in 2014, and no new shares issued so far in 2016, there have as yet been no buybacks and HFEL’s discount to NAV remains substantially smaller than the peer group average, suggesting that the fund’s high yield is supporting demand for the shares in spite of market falls.

HFEL is a closed-ended investment company incorporated in Jersey and listed on the London and New Zealand stock exchanges. At 2 May 2016 it had 114.54m shares in issue. HFEL has expanded its capital base significantly by issuing shares to meet demand: in 2015 4.2m shares were issued, raising £13.3m. It may allot up to 10% and buy back up to 14.99% of shares annually.

The fund is permitted to gear up to 15% of gross assets. Its current borrowing facility of up to £45m would represent c 12% gearing if fully drawn. At 31 March 2016 net gearing stood at 3.0% versus a 12-month range of 2-6%. The manager uses gearing on a stock-specific basis (when there are more ‘buys’ than ‘sells’) rather than as a way of expressing a view on market direction. The current borrowing facility is priced at Libor + 40bp and is due to expire in 2018.

Henderson Investment Funds, HFEL’s Alternative Investment Fund Manager (AIFM) under the AIFM Directive, delegates portfolio management to Henderson Global Investors. Henderson is paid an annual management fee of 0.9% of net assets, reduced from 1.0% at the start of FY14. There is no performance fee and ongoing charges at the 31 August 2015 year-end stood at 1.06%.

HFEL pays dividends quarterly, in February, May, August and November. Dividends have risen each year since the fund’s incorporation in Jersey in 2006, achieving a compound annual growth rate of 7.2%, well ahead of inflation. While the fund aims to pay out substantially all its income as dividends, it has also built a revenue reserve of 13.1p per share (at 29 February 2016), equivalent to 68% of the FY15 dividend. The total dividend for FY15 (year to 31 August) was 19.2p, a 5.5% increase on FY14. Dividends were fully covered by income, although the board has indicated it may be willing to take a more flexible approach to future dividend cover, allowing the fund to dip into reserves where pursuing a covered dividend might affect total returns. So far, two interim dividends of 4.9p have been declared for FY16; if the remaining two are paid at the same level or higher (as has been the case each year since HFEL’s inception), this suggests a FY16 dividend of at least 19.6p. Based on the 2 May 2016 share price of 284.8p and the last four dividends, HFEL currently yields 6.9%.

HFEL is a member of the AIC’s Asia Pacific ex-Japan sector (Exhibit 10). These 15 funds follow a range of investment approaches, with some including and some excluding Australasia. HFEL is one of three (alongside Aberdeen Asian Income and Schroder Oriental Income) with a specific income objective. Its NAV total return is somewhat below the weighted average for the sector over one, three and five years. In a difficult period for Asian equities, none of the funds has produced a positive return over one year, with almost half in negative territory over three years as well. Risk-adjusted performance is broadly in line with the average over one and three years. Ongoing charges are average and HFEL does not charge a performance fee. Gearing is below average for the sector and HFEL has the highest dividend yield by some margin. Having historically traded at a premium, it currently stands at the smallest discount in the peer group.

HFEL has five non-executive directors. Chairman John Russell became a director of HFEL on its incorporation in Jersey in December 2006 and had previously served on the board of predecessor company Henderson Far East Income Trust. David Mashiter has also been a director of HFEL since inception. David Staples joined the board in 2011 and Julia Chapman was appointed in January 2015. As part of a continuing board succession plan, two of the original HFEL directors, Richard Povey and Simon Meredith Hardy, have recently retired, and the appointment of Nicholas George was announced on 20 April 2016. The directors have backgrounds in banking, asset management, accountancy and law. The whole board travels annually to the region.

The New Zealand dollar weakened versus sterling over the first half of 2015 but sterling has been weaker more recently owing to concerns over the possibility of the UK voting to leave the European Union. The weaker NZ$ has increased returns from HFEL for New Zealand-based investors over one and three years, but more recently the weaker pound has seen broadly positive returns for sterling investors reduce once translated into the New Zealand currency.