The Schroder Asian Equity Yield Fund, is a new fund that feeds into the Luxembourg based Schroder ISF Asian Equity Yield Fund. It primarily invests in stocks with high dividend yields in the Asian ex Japan region. The fund targets to pay semi annual distributions, in total 4% return per annum to investors. As at 30 Nov 2004, the motherfund size stands at US$315 million. The fund focuses on capital preservation as well as growth, by selecting high dividend yielding quality companies using a bottom up stock picking approach. The mother fund, since launch, has consistently outperformed its benchmark (Dividend yield of MSCI AC Pacific Free ex Japan + 2%), and it posted a 20.05% 1 year return versus a 5.54% 1 year return from the benchmark (calculated using offer-to-bid prices, with gross income reinvested, in Singapore dollars and as at 31 Dec 2004).

The lead fund manager, Lee King Fuei graduated with First Class Honours in Economics from the London School of Economics and M.Phil Economics from the University of Cambridge. He started his investment career with Schroders in 1999, working within the Global Equity Team in London before transferring to Singapore to join the Asia Pacific ex Japan Investment team in 2001. Currently, the investment team comprises of 8 fund managers and 19 analysts, with an average of 13 years of investment experience and 7 years with Schroders.

Schroders is upbeat on the prospects for Asia ex-Japan equity markets in the long term. It feels that the fund's investment strategy will allow it to tap into the strong economic growth and increasing domestic consumption story in Asia, while playing into the evolving trend of improving corporate governance and increasing dividend payout. The fund's investment strategy categorizes its stocks into three main clusters: dividend surprises, dividend cows and dividend growers. In this interview fund manager Lee King Fuei, talks in detail about the fund.

Rachel Lim: The benchmark for the fund is based on the dividend yield of MSCI AC Pacific ex-Japan (Gross) Index +2%. How did this come about?

Lee King Fuei: When we started this fund 2 years ago, we wanted to target investors who wanted to invest into Asian markets, but felt that the volatility was too high. We decided to provide a product that plays into Asian markets, but with more stable returns than what the market would typically provide.

In essence, total return consists of 2 components: dividend income and capital appreciation. The common approach of most investors is to simply target returns from capital appreciation, but this is usually also the more volatile part of the whole equation. The way we see it, why not target dividend income rather than the capital appreciation? Our initial work already showed that dividend income from equities has historically been a more stable source of return, even compared to cash. As we developed deeper into the concept, we found that there are a lot of other real investment benefits to a strategy targeting dividend income because one ends up investing in good-quality companies. So now not only are you getting the dividend return on a regular basis, in the long run you will have capital appreciation as well, because these are well-managed, fast-growing companies. This makes for a very good formula for investing.

The initial suggestion for the benchmark was that we use a market index. I have always been against using a market benchmark for a few reasons. One, the way I manage this fund is that I do it with the understanding that investors of this fund have a long-term horizon and want minimal volatility. If a market index is being used as my benchmark, my risk will always be taken relative to and managed against the market index. The fund thus ends up with a volatility profile that is very similar to the market.

For our fund who aims to be more stable, a different kind of benchmark that highlights the minimal volatility feature is required. Since we are targeting dividends, we decided to use the dividend yield of our investment universe, which is the MSCI AC Pacific Free ex-Japan index, plus 2%. Some may argue that this is an easy benchmark to beat in periods when the market is up. This is true. But one should also consider that when the market is down, it becomes a very difficult benchmark to beat. In fact, the return profile of our chosen benchmark of dividend yield plus 2% is almost a steep straight line with an upward gradient over time. This positive total return with minimal volatility profile is exactly the characteristic we are trying to capture within the benchmark itself, and we find this to be the most appropriate target to use.

RL: How is the figure 2% derived?

LKF: For a lot of institutional funds, 2% is typically the out performance target expected. That said, our main objective is really to achieve total return with minimal volatility.

RL: What is the fund's investment strategy?

LKF: The essence of our investment strategy is really to buy companies that grow shareholder value. This means that the companies will be growing their dividends. When companies do not payout any dividends, it could actually signal that the management is either not confident of their future prospects and hence their ability to sustain the dividends going forward, or that they are not managing for shareholder value. As such, a strategy focused on dividends would also bias the portfolio towards companies with good corporate governance.

Because dividend is really a function of the payout ratio and the earnings, companies can achieve the objective of growing their dividend streams via two avenues: They can do so by raising their payout, which is a very positive act because it is saying that the company is managing their capital more efficiently, or they can increase their dividends by growing earnings. Ultimately, improved capital management and rising earnings creates the shareholder value we are looking for.

RL:Out of the entire equity investment universe in Asia, what kind of equities typically yield high dividend? Are they mainly large capitalisation stocks?

LKF: Not necessarily. When one looks at our portfolio, there is a mix of good large- and mid-cap names. Smaller companies can have very strong dividend policies.

RL:As you've mentioned investing into high yield Asian stocks have the benefits of lower volatility, capital preservation and also potential capital gains. Some investors may think that this may be too good to be true. Typically strong capital appreciation is accompanied by a commensurate amount of risk.

LKF: Markets are efficient but only to a certain extent. There are always investments out there that can provide higher returns at lower risk. If you look at the graph of the returns of offshore Asian funds in the S&P universe plotted against their respective risk, you will notice that our fund is one of the top-performing funds in its universe, and yet its annualized volatility is also one of the lowest. It is telling you that higher return does not always have to come with higher risk. What you really need to achieve that is a sound investment philosophy, a disciplined process and good resources to back that discipline so that you can find those opportunities. With a team spanning 27 investment professionals in Asia ex-Japan with an average of 13 years of investment experience, we are constantly visiting companies and analyzing stocks to uncover such hidden opportunities.

Source: Standard & Poor’s, USD, bid to bid, net dividends reinvested,SchrodersNote: The Schroder ISF Asian Equity Yield was launched on 11 June 2004, the assets of which are transferred from the Institutional Pooled Fund (IPF) Asian Equity Yield Fund, and it is managed by the same investment team. Any performance history prior to the merger date and data that refers to a “since launch date” (i.e. 12 Dec 2002) refers to that of the Schroder IPF Asian Equity Yield Fund and not that of the Schroder ISF Asian Equity Yield. While the management fee for the Schroder IPF Asian Equity Yield Fund was 0.625% p.a., the management fee for the Schroder ISF Asian Equity Yield is 1.5% p.a.

A sound and strict investment discipline is also critical because it is not useful to just say that you are targeting high dividend yielding stocks. You need to be able to further define the characteristics in a stock that you are looking for besides the yield. By further classifying the high dividend yielding stocks we want to own into the 3 categories of Dividend Cows, Dividend Growers and Dividend Surprise, we are able to look through the market noise and really focus on the stocks we want to hold in the portfolio.

RL: What are the characteristics of the stocks from the three different categories? Are dividend cows mainly big companies with substantial market share?

LKF: The portfolio is currently made up of 10 % in dividend surprises, with the remaining 90% being split equally between dividend cows and dividend growers.

Source: Fundsupermart

Dividend cows do not always have to be big companies. They are characterized by the stability of their earnings and dividends stream. While the fund uses the example of companies that have dominant and stable market shares as characteristics often associated with dividend cows, this is not always the case. The size of a company's market capitalization, by no means, precludes its ability to deliver stable earnings and dividends.

Likewise in a market oligopoly, where the competitive landscape is stable and consists of only a few companies, one might not be the most dominant player in the market but can still enjoy a stable market share and earnings. These can be dividend cows as well.

RL: Dividend surprises take up about 10% of the portfolio. But isn't it difficult to pick up stocks in this category?

LKF: That is why it only makes up for about 10% of the portfolio. One needs to be out there meeting companies and doing good bottom-up research to get these ideas.

RL: What are the key things that you look out for in the process of picking out dividend surprises?

LKF: We typically get these ideas by going out and meeting the management. You will check with the management, if they are holding a big cash pile, whether there are any alternative uses to the cash. By talking to the management you can get a good feel for how keen they are in paying out the cash. This helps in determining whether you will be surprised on the dividend front.

It is not always true though that companies should pay out the cash they have. If they have a big project that is very lucrative and requires funding but they chose to pay out the cash while borrowing to fund the project instead, then obviously it is not necessarily the optimal thing to do as the funding costs and the interest costs are actually higher than that of cash.

RL: Close to half of the fund is invested into telecommunications and financials. What are the reasons for being overweight in these two sectors? Are these regarded as dividend cows because the business is cash and income generative?

LKF: It is important to note that this portfolio is pretty much being built bottom up. We look at each of the stock and determine their merit. We do not try to take either sector or country bets explicitly. If the final allocation appears to be biased towards certain sectors or countries, these are almost entirely a default result from our bottom up picking and not something that we specifically target.

For example when the original fund first started two years ago, much of the exposure is actually in utilities, with very little exposure in telecommunication. But now, two years later, situation has changed and a lot of the exposure is in financials and telecoms instead.

It is not necessarily true that these sectors, being typically more cash generative, are dividend cows. For example, one of our telecom plays, Telecom New Zealand, goes into the portfolio not as a dividend cow but as a dividend surprise. Telecom NZ had been using their cash flow to pay down their debt over the last few years. Sometime last year, we identified that with the company having already de-leveraged its balance sheet to a comfortably low gearing ratio and the core business continuing to be very cash generative, the scope for the company to increase its dividend payout is actually quite high as its capex plans are also fairly static. This increases the likelihood of the market being surprised on the dividend side. Of course, to get stock ideas like that, you will need people out there visiting companies and doing good bottom-up research. Having the proper resources to do that is very important.

RL: Doesn't it mean that the company is not using its capital to grow and build the business?

LKF:No. Telecom NZ is already the dominant player in the market and there is only so much capital one needs to sensibly fund one's growth options. By returning the excess cash to shareholders, the management is actually managing the company for shareholder value.

RL: What are the main risks that face these two sectors face, as large components of the fund?

LKF:For telecommunications, the biggest risks are always the regulatory and competitive risks. . For financials, besides competitive risks, the bad debt experience, the interest rate cycle and the loan growth cycle are also very important.

RL: Since the fund's largest country allocation is in Taiwan, is the fund invested into other companies besides telecoms and financials?

LKF: Yes. We do hold some technology stocks within Taiwan. With share prices having come down so much, some of the yields of these companies are actually looking very attractive. In addition, in Taiwan, there is an ongoing trend of companies paying out more of their dividends in the form of cash than stocks. This is a very positive development.

RL: REITS has been popular with local investors. Does the fund hold any such stocks and what is your view on this?

LKF: Yes, the fund is holding REITS. Investments like REITS and dividend funds are not rarities in more developed markets like the US or Australia, but are only starting to take off now in Asia as the market's investment understanding evolves and becomes more sophisticated. Investors are recognizing that a profitable total return strategy can be achieved by simply investing for good dividends. It is not just a flavour of the month.

RL:What's your outlook for the US dollar? Since the fund is denominated in USD, is there currency risk for the fund?

LKF: I typically run the cash in the portfolio to less then 1%, thus exposure is very limited. In fact investors are going to benefit from any USD depreciation as the underlying investment is denominated in Asian currencies which are appreciating against the fund currency. In addition, for this particular SGD denominated fund, any currency exposure in the portfolio will be passively hedged.

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