By Mike Kerley

RECENT market volatility has demonstrated once again that investor confidence can be a powerful yet fragile thing, easily eroded and often slow to rebuild. Yet investors in the Asia-Pacific region still have plenty to be confident of in the long term.

The fundamentals in the region are strong, and over the last 5-10 years, Asia has done a good job of turning itself around in terms of corporate governance, sound monetary policies and opening up of economies.

Growth may be slowing, but investors should be able to find some excellent opportunities within Asia, as long as they are willing to look beyond the short-term negative sentiment in favour of a more steady, income-based approach.

Conventional investment wisdom usually divides investors broadly into two main categories - those in pursuit of income or growth. Growth mandates are generally considered more suitable for younger investors who are happy to take greater risks with their investments as long as their capital has the potential to rise healthily over time.

Income-focused funds are deemed to be more suited for mature investors. Global demographics are in favour of income investors. Asia's 60-year-old-plus population is expected to double by 2040, which means that income-focused funds are seriously back in fashion.

Income-generating stocks

Income-generating stocks are most frequently found in industries with well-established cashflows, such as financials, telecoms and utilities. These companies usually have less of a need to spend capital on research and development, or to grow their businesses to maintain a competitive advantage. This means that their cashflow is available for returning to investors in the form of dividends.

The ideal income-generating stock would have a low volatility, a dividend yield higher than 10-year government bond rates, and a respectable level of annual profit growth. Such stocks would also demonstrate a good history of increasing dividends on a regular basis, further ensuring that inflation will not erode the returns to investors.

Income investing in Asia

Market forces tend to dictate that if one asset class is not delivering the required returns, another asset class will step up in its place. The yields available from fixed income asset classes within Asia have fallen significantly over the past six years or so, prompting an expanded search for yield into other areas. At the same time, the earnings of Asian companies have been growing at a considerable pace, and the capital expenditure required to sustain such growth has reached a plateau. This is good news for investors throughout the region, although income stocks are by no means immune from the current market volatility.

Global credit crunch

Despite their recent under-performance, the banking sector in Asia looks far more fundamentally sound than in the rest of the world, albeit with some exceptions. This is because the many liquidity problems associated with the 'credit crunch' are not really issues that Asia has to grapple with.

UK banks lend out far more than their deposit base and rely on credit markets to fund this, which has been shown to be both difficult and costly in the current environment. The Australian market is more closely aligned with the UK banking model, but elsewhere in Asia, the deposit base more than covers the lending, so there are no serious liquidity issues.

On top of that, there has been no credit boom and no massive asset price inflation (property prices in Hong Kong are still below where they were in 1997) which will alleviate the need for higher provisioning. Despite this, the banks have been sold down in line with bad sentiment towards the sector as a whole. Although we have seen earnings downgrades in the region, dividend cuts have been few and far between, which goes a long way to explaining why the performance of income-generating stocks has managed to hold up far better in Asian markets than it has elsewhere in the world. There's a good chance that dividend growth will remain resilient.

Portfolio strategy

Investing for income doesn't restrict your portfolio in terms of the areas in which it can invest. The majority of my fund is made up of companies with high and sustainable cashflows and dividends. A smaller portion of the portfolio is made up of companies which have been identified as having strong cashflows and having dividend growth potential. These holdings may be low-yielding now, but are expected to be high-yielding in the future.

The strategy hasn't changed during the credit crunch with the focus on sustainable cash flow generation, although we have paid more attention to the way dividends are funded. Companies that rely on high levels of debt to fund dividend distributions have been punished by the market and should be avoided.

When it comes to investing for income, total return is still more important than pure dividend yield. Although an income-focused fund could aim to produce a yield far higher than the 5 per cent that we look to pay out, we believe that anything above that would be at the expense of capital return. Many stocks pay high dividends in Asia but if the yield simply isn't sustainable, then the stock price will never get back the dividend after the ex-dividend date. This is something an income investor should try to avoid wherever possible, as robbing capital to pay income is detrimental to shareholder total return.

Income generating funds may not grab the headlines in the same way that their growth counterparts do, but in times of market turbulence, their combination of consistency and long-term conservatism can be quite compelling.

The writer is manager of the Henderson Horizon Asian Dividend Income Fund.

This article was first published in The Business Times on October 08, 2008.