Henderson Far East Income — Asian income fund with 5.9% dividend yield

Asian markets have been less favoured by investors in recent months because of fears over the likely impact of a trade war between the US and China. However, in absolute terms, returns for sterling investors have been very strong over the past couple of years (Exhibit 2, left-hand chart), with the FTSE Asia-Pacific ex-Japan index up more than 60% in the two years to the end of June 2018. While this has lagged the FTSE All-World index (which is dominated by the US, where performance has been exceptional), it has outstripped the UK FTSE All-Share index over all but the most recent period.

In valuation terms, based on 12-month forward P/E multiples for MSCI indices (right-hand table), Asian markets trade at a less extended level versus their 10-year average than either the UK or the world. This suggests there is potentially better value to be found in these markets, as well as a dividend yield that is higher than the world average, and well above that of the US, where equity yields are now below bond yields. A strategy that focuses on stocks yielding above the broader market average could provide a measure of support for total returns in a period of market weakness.

Henderson Far East Income (HFEL) began life in 2006 as a Jersey-registered company, launched as a successor vehicle to the onshore Henderson Far East Income Trust. It has stock market listings in London and New Zealand, and is a member of the Association of Investment Companies’ Asia Pacific ex-Japan sector, although it is permitted to invest in Japan to a limited extent. HFEL has been managed since 2007 by Mike Kerley at Janus Henderson Investors, who is assisted by Sat Duhra and analyst James Zhang Rui. The main reason to choose a Jersey domicile was to enable HFEL to benefit from a more favourable tax regime on overseas earnings. However, changes in the tax landscape mean HFEL could now access lower tax rates as a UK tax-resident company, and a process is under way whereby the fund intends to migrate its tax residency to the UK, and join the UK investment trust regime.

HFEL aims to achieve a high and growing income and capital growth by investing across the Asia-Pacific region, including Australasia. Equity investments in companies that are either listed in, registered in, or whose principal business is in this region must make up at least 80% of the portfolio. The manager may also invest in debt securities, warrants, and equity-related securities such as unlisted companies that are soon to come to the public markets, and options may be written on stocks in the portfolio as a way of generating additional income. Gearing is permitted up to 30% of gross assets, although the current borrowing facility is equivalent to c 10% of net assets, and in recent times gearing has tended to be much lower (3% at 31 July 2018). Currency hedging is permitted, but has not frequently been used.

The fund has no official benchmark, but for reference purposes measures its performance against the FTSE Asia-Pacific ex-Japan index, and has recently begun including a comparison with the MSCI AC Asia Pacific ex-Japan High Dividend Yield index.

We spoke to Kerley before the recent imposition of trade tariffs between the US and China. He commented that unlike in the US, where technology stocks were still driving the market, Asian market leadership had broadened, with more old-economy stocks receiving earnings upgrades, and a greater number of companies overall outperforming the broad stock market index. Kerley described this as cause for optimism that value stocks (which tend to be concentrated away from new-economy areas) could be the drivers of earnings momentum, and therefore performance. Upside dividend surprises, which have been at a higher level than at any point in the past 10 years, have tended to come from more traditional cyclical sectors such as banks, materials, consumer discretionary and energy. However, the largest individual surprise in the portfolio (more than 50% above expectations) was from Samsung’s January dividend. Kerley comments that while last year the biggest surprises had tended to come from technology stocks (including Samsung), the potential for surprises in the sector were lower this year, because analyst forecasts had been higher. However, in absolute terms, technology companies are growing their dividends and still have potential to catch up further with more traditional dividend-paying sectors.

Kerley has recently reduced exposure to stocks related to computer memory pricing, where fundamentals are less favourable. These include Samsung, previously the largest holding, as well as the Taiwanese stocks Powertech and Quanta Computer. Proceeds from the sales were used to add exposure to old-economy stocks such as BHP Billiton (mining) and Public Bank in Malaysia.

While HFEL benefited from the weakness of sterling following the UK’s vote to leave the European Union, more recently sterling strength has reduced portfolio income, with a c 5% year-on-year fall in revenue in H118 versus a c 6% rise in US dollar or local currency terms. However, Kerley says it would be inappropriate to hedge the currency exposure, as the volatility of sterling given the ongoing Brexit negotiations means it is very hard to forecast the likely path of the currency over the next 12 months.

HFEL’s portfolio of 40–60 stocks is built using a consistent, disciplined approach with the aim of achieving a good balance of high-yielding stocks and those offering high dividend growth potential. While income is a key consideration, the overall objective is to achieve an attractive total return over time. With no official benchmark, HFEL’s managers are unconstrained by index weightings, and can invest in any sector or geography in the Asia Pacific ex-Japan region, with the sole proviso that no more than 10% of the portfolio may be held in a single stock. Stock selection is largely bottom-up, although the managers are cognisant of the potential impact of top-down factors such as macroeconomics and geopolitics. Geographically, the investment team is split between the UK and Asia, with Mike Kerley based in London but travelling frequently to the Far East, while Sat Duhra and James Zhang Rui work out of Janus Henderson’s Singapore office.

The team undertakes many company meetings, both in London and in Asia, which are an important source of idea generation as well as a way of keeping in touch with portfolio holdings. Investment ideas may also come from country visits, industry research and quantitative screens to identify companies with high yields and/or dividend growth. In-depth research and modelling on potential investments aims to identify cash-generative companies that are undervalued in relation to their future prospects. The portfolio is relatively evenly split between companies that have a high current yield and those with the probability of generating significant future dividend growth, with a slight bias in recent years towards the dividend growth segment, partly as a result of stronger total return performance from these holdings.

As shown in Exhibit 3, HFEL’s focus on undervalued companies leads it to have lower average P/E and price/book multiples than the broad FTSE Asia Pacific ex-Japan index, while its income remit means current and forward dividend yields for the portfolio are higher than for the index. Compared with the MSCI AC Asia Pacific ex-Japan High Dividend Yield index, valuations and dividend yields are broadly similar, but HFEL’s preference for cash-generative companies means its portfolio has a higher free cash flow yield than the index. HFEL’s own dividend yield is higher than that of its underlying portfolio, partly because of income from writing options on portfolio holdings (up to a maximum 10% of NAV), and partly because of optimising holding periods to get maximum exposure to dividend payments.

Portfolio holdings are constantly monitored against price targets, risk and style metrics and country fundamentals, and may be sold if they reach their target price or if any of the other measures significantly deteriorates.

At 31 July 2018, there were 55 stocks in HFEL’s portfolio, broadly unchanged on 54 stocks a year earlier. The top 10 holdings accounted for 26.5% of the portfolio, again largely unaltered over 12 months. In geographical terms (Exhibit 4), China is the largest weighting, although it is a slight underweight position versus the FTSE Asia Pacific ex-Japan index. Singapore, Taiwan (where HFEL’s exposure tends to increase in July to gain maximum benefit from dividend payments in Asia’s highest-yielding market) and Thailand were the biggest overweight positions, while India (9.4% of the index but absent from HFEL’s portfolio), Hong Kong and Australia are the biggest underweights. The biggest change in weighting over the 12 months to 31 July was a 2.3pp increase in exposure to Singapore.

One of the most significant changes in sector terms (Exhibit 5) has been a large increase in financials (+7.2pp), which is now a 9.4pp overweight versus the index and accounts for more than 40% of the portfolio. Kerley has added banks in Singapore, China and Malaysia, although he has avoided Australian banks, which have been the subject of an investigation into anti-competitive practices and are also heavily exposed to the overheated domestic property market. Kerley favours banks from a top-down as well as a bottom-up perspective, as they are one of the few high-yielding sectors that are positively rather than negatively affected by rising bond yields. Oil and gas exposure has decreased over the 12 months to 31 July, but has been much higher during the year (c 13% at end-March) as Kerley sought to capitalise on favourable supply and demand dynamics, supported by a period of greater capital discipline during the recent years of low oil prices. The biggest decrease in exposure was to industrials (-7.3pp).

Asian stock markets have been volatile in recent months, partly on fears over the impact of a trade war between the US and China, and this has affected HFEL’s performance to 31 July 2018 (Exhibit 6). Its medium-term record remains solid, with NAV and share price total returns of c 8-13% a year over three, five and 10 years. HFEL has underperformed the broad FTSE Asia Pacific ex-Japan index over most periods of one year and longer (Exhibit 7), but has done better in relative terms more recently, perhaps because of its greater focus on dividend-paying stocks, which may hold up better in periods of generalised market volatility. Over most periods it has performed more closely in line with the MSCI AC Asia Pacific ex-Japan High Dividend Yield index (Exhibit 8), arguably a better comparator given HFEL’s income focus. Key contributors to recent performance include Samsung (formerly the largest holding, now reduced after a strong run), Chinese consumer stocks Anta Sports (sold at the end of May) and Dali Foods, Thai oil companies PTT and Star Petroleum, and top 10 holding Taiwan Semiconductor Manufacturing. Telecom stocks were among the biggest detractors.

HFEL’s very high yield has proved attractive to investors, and over the fund’s 12-year life to date, it has traded at an average premium to cum-income NAV of 0.1%. At 21 August 2018, the shares traded at a 0.7% premium to cum-income NAV, compared with average premiums of 1.5%, 0.3%, 0.7% and 0.9%, respectively, over one, three, five and 10 years. The board manages the premium through regular share issuance to meet demand.

Set up as a Jersey-registered closed-end investment company in 2006, HFEL is currently consulting on moving its tax residency to the UK and becoming an investment trust, in order to access lower rates of withholding tax on overseas income. The fund is listed on the London and New Zealand stock exchanges. It has one class of share, with 122.8m shares in issue, an increase of 5.9m or 5.0% over the past 12 months as a result of regular share issuance (permitted up to 20% a year) to manage a premium to NAV. The fund may also buy back up to 14.99% of shares annually to manage a discount.

Gearing is available via a £45m borrowing facility with Sumitomo Mitsui Banking Corporation, which was arranged in February 2018 and replaces the previous £35m facility with Commonwealth Bank of Australia. If fully drawn, this would equate to c 10% of net assets versus a maximum permitted level of 30% of gross assets. At end-H118 (28 February 2018), £32.7m was drawn, equating to net gearing of 7.4%. HFEL had net gearing of 3.0% at 31 July 2018.

Under a new tiered fee structure in place from 1 September 2017, Henderson Investment Funds is paid a management fee of 0.90% of net assets up to £400m, and 0.75% thereafter (previously the fee was a flat 0.90%). There is no performance fee. Ongoing charges were 1.12% for FY17 (FY16: 1.17%), with scope for this to fall in FY18 given the new 0.75% tier.

HFEL pays dividends quarterly, in February, May, August and November. For FY17, the total dividend was 20.8p and so far in FY18 three dividends have been paid, totalling 16.1p, a 3.9% increase on the first three quarters of FY17. Dividends have increased each year since launch in 2006, growing at a compound annual rate of 5.4% over the past five full financial years, which is well ahead of the rate of UK inflation. HFEL’s dividends have been fully covered by revenue income (which may be boosted by option-writing) each year since launch. At end-H118, HFEL had revenue reserves equivalent to 14.0p per share, equal to 67.3% of the FY17 dividend. Based on the current share price and the last four dividends, HFEL has a dividend yield of 5.9%.

HFEL is a member of the Association of Investment Companies’ Asia Pacific excluding Japan sector. This is a broad peer group without a specific income remit, but there are two funds – Aberdeen Asian Income and Schroder Oriental Income – which, like HFEL, target a high level of income. JPMorgan Asian pays a high dividend but does so partly out of capital and reserves rather than by investing in high-yielding companies. HFEL’s NAV total return performance is below average for the peer group over one, three, five and 10 years, while versus its close peer group it ranks second of three over one, three and five years, and third over 10 years. Ongoing charges are a little above average, and there is no performance fee. Gearing is below average in a sector where none of the funds is highly geared. HFEL has comfortably the highest dividend yield in the peer group, which may be a contributory factor in its being one of three peers currently trading at a premium to ex-income NAV.

HFEL has five independent, non-executive directors. John Russell, the chairman, has been on the board since HFEL’s launch in 2006, and was also a director of its predecessor, Henderson Far East Income Trust. David Mashiter has also served on HFEL’s board since launch. David Staples became a director in 2011, with Julia Chapman appointed in 2015 and the newest director, Nicholas George, joining the board in 2016. The directors’ professional backgrounds are in investment banking, accountancy, asset management and law. The whole board makes an annual trip to the Asia-Pacific region.

Returns for HFEL’s New Zealand-based shareholders have been enhanced over the past 12 months by the relative weakness of the New Zealand dollar versus sterling, which has lifted the NAV total return over 12 months from c 4.5% to c 14.5%, and the share price total return from c 2.0% to 12.0%. The currency effect has also limited losses in the recent sell-off. Over the longer term, however, sterling weakness has dampened performance for New Zealand investors, who have seen annualised NAV and share price total returns of c 5-11% over three, five and 10 years, compared with c 8-13% for sterling investors.