The Retirement Income Covenant and the role for Global Quality Value Strategy in portfolios
Global Investment Insights
with Nick Clay, Portfolio Manager - Global Quality Value Strategy, Redwheel (London, UK)
In this exclusive interview with Global Investment Institute (GII), Nick Clay, Portfolio Manager of the Redwheel Global Quality Value Strategy shares his insights on the key areas of focus for him in his dealings with his global client base around the role the Global Quality Value Strategy can play in investors’ portfolios, in times of uncertainty and volatility, and its fit for superannuation fund portfolios, including in the context of the Retirement Income Covenant which came into effect on 1 July 2022.
Q. What are you currently spending most of your time and focus on, in your role as the Portfolio Manager and Head of Team for Redwheel’s Global Quality Value Strategy?
The structure of Redwheel means that all the investment teams have complete autonomy when it comes to their own philosophy and processes, supported by Redwheel’s institutional-quality operational infrastructure. Hence, I spend all my time focused upon the Global Quality Value Strategy. We keep things as simple as possible and run a single, common portfolio across the different vehicles available to our clients.
Our four-person team is structured to play to each team member’s strengths. Robert and Colin are dedicated analysts and almost 100% of their time is spent working on the models for our companies; Andrew is the second portfolio manager, and is my cover when I am seeing clients, but he also spends about 80% of his time on company analysis; and finally, as PM I have day-to-day fiduciary responsibilities such as trading, report writing, risk control etc. and I also bring the macro backdrop into our process.
From a portfolio perspective, the main area I’m focusing upon relates to the sea change in the investment backdrop as markets exit the prolonged period of quantitative easing (QE) and zero interest rates and return to a more normal environment of cycles, inflation and volatility. This return to normality should suit the Global Quality Value Strategy and the way it generates long-term wealth for clients, but it does mean focusing upon the business models of the companies the strategy is invested in. As the backdrop changes many business models will come under pressure. Our investments need to demonstrate an ability to deal with cost inflation, be able to raise prices and to survive without the need to access cheap debt. Further, the strategy’s valuation discipline is becoming important again, and thus the team continues to focus on the asymmetry of potential outcomes for each of our investments i.e. we are invested where we see limited downside under a worst case scenario relative to our base case and best case upside expectations. Finally, the other large structural change is the need for our investments to rise to the challenges of ESG. Thus, the whole team is focused upon, through engagement and monitoring, whether our investments are making the necessary investments and ESG transition progress we expect – the key sustainability challenges for our current portfolio being climate, human rights, rare minerals, fast fashion and palm oil.
Q. How do investors you work with globally use the Global Quality Value Strategy and what objectives does it aim to achieve in their portfolios?
Our clients see us very much as offering an all-weather global equity product and therefore a core holding in both growth and more defensive portfolios. They recognise that the path to wealth creation during normal times requires a more patient, considered and resilient process than the past 14 years of QE-fuelled markets suggests. We focus on companies which we believe are high quality (by which we mean companies which have demonstrated good capital allocation decision-making and who enjoy durable cash flows under a range of adverse scenarios) but which, for one reason or another, are trading cheaply as reflected in a high dividend yield. A key part of our proposition is that, in our view, the compounding of re-invested dividends over the long term ultimately drives a very significant part of our returns. Our focus on dividends, which have much lower volatility than the market, results in a combination of attractive total return and low volatility which is regarded by our clients as eminently suited to both pension fund accumulation and decumulation. Our clients have also seen that our key disciplines of yield, resilience of cashflows and valuation have remained resolutely in place since inception of the strategy in 2005 and have provided diversification from the gravitational pull of growth investing over the past few years.
The following chart illustrates the extent to which dividends and their reinvestment dominate total real equity returns over time. This dominance is consistent across countries.
Source: SG Quantitative Research, total annualised real return in local currency, Q4 2022. No investment strategy or risk management technique can guarantee returns or eliminate risks. Past performance is not a guide to future results.
Our clients appreciate that our process aims to harness this statistical tailwind of dividends. Despite the last decade of QE proving challenging for dividend stock returns relative to growth stocks, the dominant source of our long-term returns comes from reinvesting and compounding a premium dividend yield over time while broadly matching the market’s capital return contribution. Our stock selection process, focusing on quality companies whose share prices we believe are temporarily depressed because the broader market misunderstands the durability of their cash flows, underpins this and makes extensive use of our team’s internal knowledge bank to identify patterns of temporary dislocation that we have analysed and exploited in the past. Since the dividend contribution to total return is naturally less volatile than capital return, the strategy combines an attractive total return (top decile vs the peer group of global equity managers of any style over the preceding 10 years) with lowest quartile volatility (Source: Evestment as at 31 March 2020).
In summary, by applying a disciplined process focusing on high quality companies offering attractive dividend yields we are able to harness the power of compounding an additional, growing, return stream in addition to Earnings Per Share growth and multiple re-rating. Our approach aims to generate attractive total returns with relatively low volatility and excellent downside protection and the process itself produces a portfolio which tends to be a diversifier for institutional accumulation and decumulation portfolios.
Q. What are the effects of the current volatile and uncertain conditions across global equity markets on the Global Quality Value Strategy? (How is the strategy able to assist investors in achieving their desired outcomes under these conditions?)
It’s important to point out just how unusual the post-2008 period has been. Until 2021, quantitative easing and ultra-low interest rates propelled tech stocks (which our strategy is typically unable to hold given that many of these growth stocks do not pay dividends) to extraordinary heights, removed market jeopardy and embedded artificially low market volatility. This had largely made redundant key considerations we hold dear in stock appraisal: valuation, downside protection and the resilience of cashflows. Furthermore, in clear contradiction to centuries of empirical data, these conditions led to capital growth exceeding the return from dividends and their re-investment.
We believe the drivers behind our historic performance are well suited to the current and most likely medium-to-longer term environment in which higher interest rates and the winding down of QE will generate more volatility in equity markets and returns become less concentrated in the small group of market leaders of the last decade, and in which we expect to see dividends regaining their importance as a significant driver of total returns (as they have been over the past 200 years).
The strategy has historically offered material downside protection, as a function of both the low volatility return stream offered by re-investing dividends, and our rather unfashionable focus on downside protection at the stock level. Our sell discipline requires us to sell a holding when a company cuts its dividend (to below the global market yield). This places a natural emphasis on the resilience of a company’s cashflows. Since inception of the strategy, these attributes have underpinned an upside and downside capture of 93% and 79%, respectively (Source: Redwheel, MSCI, UBS Quant Answers, 2022 Q4). This is a combination well suited to a world of heightened volatility.
Q. In Australia, the Retirement Income Covenant came into effect from 1 July 2022, which requires superannuation funds to formulate a retirement income strategy, acting as an important step in broadening the industry focus beyond the accumulation phase and placing greater emphasis on the decumulation phase to improve outcomes for members in retirement.
How does the Global Quality Value Strategy fit into superannuation funds’ portfolios in the context of the Retirement Income Covenant and improving their members’ retirement outcomes?
The Global Quality Value Strategy offers features ideally suited to superannuation members’ needs throughout their whole life.
As the strategy’s historic performance demonstrates, superannuation members of all ages in the pre-retirement, accumulation phase can benefit from a total return which, since inception, has generated strong long-term performance (c.2.5% net annualised alpha vs MSCI World) accompanied by low volatility when compared to global equity strategies of all styles. Since the arithmetic of compounding re-invested dividends works best over the long term, the strategy is naturally aligned to the long-term nature of accumulation and the need to fund rising longevity.
The strategy is also particularly useful for superannuation members approaching or in the retirement phase of their lives. In the first instance, a total return approach which harnesses both capital appreciation plus the power of reinvested dividends can protect purchasing power and ultimately grow retirement portfolios by delivering total returns that may exceed CPI over multi-year horizons, as evidenced by our results. Dividends tend to rise in real terms over the medium-to-long term, so an inflation hedge is built into this investment approach. This can help to reduce the risk of a member outliving her retirement capital.
Secondly, our approach historically delivers lower participation in market drawdowns in particular, which is reassuring for investors and can help them to stay invested in periods of extreme market stress, particularly in the crucial last few years prior to retiring and in retirement when a large drawdown of capital balances cannot easily be recouped through new capital contributions.
As such we believe this strategy could be well suited to address the pressing demands of both pre-and-post retirement superannuation members.
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Nick Clay, Portfolio Manager of the Redwheel Global Quality Value Strategy, Redwheel
Nick joined Redwheel in 2020 and leads the Global Quality Value team. He strives to maintain and build upon a successful, enduring philosophy and process within the team, where all are treated equally. Nick feels that Redwheel’s ownership structure and perpetual partnership are the ideal surroundings to increase the chance of successfully achieving this ambition.
Nick started his career at Sun Alliance in 1991 and has held various senior roles in Fund Management, including Lead of Equity Income at Newton until 2020. His advice to future generations is that one’s many mistakes - which we all invariably make - will be the main driver of education.
Outside of Redwheel, Nick is a budding artist, enjoys drawing and riding his motorbike. Back in his 20’s he successfully sold some of his own art in London’s Covent Garden.
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