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The big opportunity from dividend adversity

2016 will be a time to hunt harders and cleverer for income, and the rewards could well prove worth the effort.
January 15, 2016

What’s the one bit of advice I would give investors for 2016? This was the question posed to me, Algy Hall, by FT Money editor Claer Barrett for a piece featured in last Saturday’s paper containing a wide range of views from a number of commentators.

The issue that stands out for me in 2016 is dividend sustainability, hence my urge in that piece that investors become ‘dividend detectives’. The cause for concern is illustrated by the bar chart to the right that shows the deterioration of dividend cover on higher-yielding shares among current FTSE 350 constituents. Those FTSE 350 shares offering a more than twice covered yield of over 3.5 per cent are listed in the table on this page.

 

 

FTSE 350 stocks with DY over 3.5% and cover over 2 times

NameDYDivi Cover
PHOENIX GROUP HDG.5.9%2.3
PETROFAC5.4%2.4
OLD MUTUAL5.3%2.2
HICL INFRASTRUCTURE4.9%2.5
DEBENHAMS4.8%2.2
WEIR GROUP4.7%2.7
STANDARD LIFE4.7%3.8
F&C COML.PROPERTY TRUST4.5%3.7
INTERSERVE4.5%2.6
MORGAN ADVANCED MATERIAL4.5%2.2
LONDONMETRIC PROPERTY4.5%3.4
3I INFRASTRUCTURE4.5%4.0
INTERNATIONAL PSNL.FIN.4.4%3.0
UK COMMERCIAL PR.TST.4.4%2.8
MAN GROUP4.3%2.8
3I GROUP4.2%3.7
TRITAX BIG BOX REIT4.1%2.8
HANSTEEN HOLDINGS4.0%3.7
CLOSE BROTHERS GROUP4.0%2.3
NORTHGATE3.9%3.2
COUNTRYWIDE3.8%2.3
MEGGITT3.8%2.4
BOVIS HOMES GROUP3.7%2.2
STAGECOACH GROUP3.7%2.6

Source: Thomson Datastream

 

What first may come to mind from this chart is that the current environment presents huge risk for income investors. True enough, and there is every reason to focus on whether the dividends paid by shares in a portfolio are as secure as they have been in the past. But I think there is also an opportunity to be grabbed from this situation for investors who are prepared to be adventurous and innovative in their hunt for equity income.

An example of where such opportunities are to be found came from Standard Life’s Harry Nimmo in my recent “Investment Essentials” feature, which reveals the favourite stock-picking secrets of three star small cap fund managers. . Mr Nimmo thinks small-caps that demonstrate an ability to pay sustainable and growing dividends will soon be in increased demand due to the increasingly shonky fundamentals of classic income favourites – from the likes of GlaxoSmithKline to SSE.

Our tips of the year for 2016 (IC, 8 January 2016) also pick up on this theme. As well as looking to smaller companies, we looked to companies where we think the market is being too pessimistic about yield prospects by basing expectations on past trading trends rather than signs of improved trends developing. Indeed, the current uncertain outlook for dividend mainstays means there should be a lot to gain in share-price terms for companies that have the potential to take the mantle of being a dividend-stalwart, as well as a lot to lose from dividend stalwarts that disappoint. Our Tips of the Year with an income angle are NewRiver Retail (NRR), BAE (BA.), J Sainsbury (SBRY) and Lloyds (LLOY).

With interest rate rises looking likely to be modest and slow, equity income can be expected to stay popular. That being the case, the message from the deterioration in the fundamentals of income stocks should not be to give up the hunt but should rather be to hunt harder and hunt cleverer. AH

 

Good yields and well covered

Closed-life insurance consolidator Phoenix (PHNX) and South Africa-based financial services group Old Mutual (OMG) provide two quite different stories for the income-focused investor.

Phoenix has been a long-standing buy tip, with its robust dividend yield supported by a high level of cash generation from the closed life business that it has acquired. The company remains on track to generate £2.8bn of cash between 2014 and 2019.

It has received sign-off from domestic regulators for its internal model for Solvency II, a European-wide reform that includes capital requirements. But not everything is straightforward. Assuming the market is not disappointed by its new capital position, to be revealed in March, the challenge remains for Phoenix to make further acquisitions to support its asset base – it missed out on the purchase of Guardian Financial Services last year.

As for Old Mutual, its dividend yield has been encouraged by the fall in its share price over the 2015 financial year, as the emerging markets downturn meant a serious decline in the rand, the currency of its Nedbank and emerging markets operation, against the sterling in which it reports and pays dividends.

Add to that the unpredictability of South African president Jacob Zuma, whose sacking of finance minister Nhlanhla Nene in December, and subsequent appointment of little-known David van Rooyen was severely punished by the markets, giving a big further downward shove to the rand. Although Mr Zuma quickly replaced Mr van Rooyen with Pravin Gordhan, who had previously served for five years in the post from 2009, the damage had been done. The wider commodity-led emerging markets slowdown, the political mismanagement and the related currency risk all hang over the stock.

Another dividend yield that has improved with a falling share price is that of life insurer Standard Life (SL.). In its sector, Standard Life is very much exposed to equity market movements. This is because the growth of its asset management arm, Standard Life Investments, and other regular fee-earning products such as drawdown, has led investors to view it as more of an ‘asset gatherer’ than a traditional life insurance company. So a downturn in equity markets, and with it Standard Life’s funds under management, is hurting the company. As analysts at Canaccord Genuity have argued, Standard Life’s healthy position in the retirement savings industry through its income drawdown product and multi-asset funds “will only drive the bottom line in the long term”.

Plummeting commodity prices have inspired a growing number of income investors to capitalise on depressed sentiment towards high-yielding companies maintaining robust balance sheets.

One example is Glasgow-based industrial valve and pump maker Weir (WEIR). The engineer’s valuation has contracted by more than half this past year as capital expenditure cuts in key oil and mining markets sent group order intake tumbling. But that scenario has also seen the dividend yield balloon to 4.7 per cent, with decent cover to match it.

A rampant cost-cutting programme, including axing North American energy headcount by a third, has played a key role in boosting free cash flow. The question looking forward is whether these savings will be enough to offset further declines of more profitable aftermarket work, a risk that looks increasingly probable as difficult trading conditions show little sign of easing.

Having fallen 30 per cent since we last rated them a sell, the shares (at 832p) now trade at a steep discount to industrial peers on 10 times forecast earnings. We suspect another tough year ahead may put them under further pressure. But in light of the big fall, cost savings and subsequent dividend strength, we’d advise against dumping more. Hold.

Of course, Weir’s products have applications beyond oil and gas markets, which is just as well with Brent crude currently bumping along at $35 a barrel. However, there are some well-covered income options to consider. The shares of oil services group Petrofac (PFC) have performed abysmally over the past five years, but they’ve easily outstripped the oil services sector over the past 12 months.

Despite this relative resilience, an improved earnings outlook doesn’t yet appear to have been priced in by the market, as Petrofac is trading at a much deeper discount to rivals across a range of historic earnings multiples – on EV/Ebitda the implied upside comes in at 24 per cent, while on a simple price-earnings multiple the figure comes in at 48 per cent. Of course, it’s generally held that historic premium/discount rates are less illuminating during periods of high volatility, but they can still be indicative of price anomaly.

Petrofac currently yields more than 5 per cent from a dividend that’s due to be covered 2.4 times by forecast profit in the current year. As such, it’s relatively secure – assuming assumptions hold true – and even has headroom to grow over the medium term. Shareholders can also take heart from a strengthening order backlog, which increased 11 per cent to $21.6bn at the end of November.

Clearly, the energy industry is experiencing a highly challenging period, and while Petrofac comes with a relatively high degree of risk, its valuation and income prospects appear to tip the balance in the investor’s favour – at least for those who can stomach a degree of volatility.

For anyone else, the retail sector provides a more predictable theatre of operations. With a 4.8 per cent dividend yield, which is covered by more than two times earnings, it’s clear high-street retailer Debenhams (DEB) deserves its status as an income stock. However, investors wanting to buy Debenhams’ shares should be made well aware of the challenges facing the company.

Chief executive Michael Sharp announced his departure alongside the group’s last set of numbers in October. Although the exact timing of his exit isn’t decided, the news followed widespread reports of shareholder discontent at Debenhams given the lack of profit growth or share price momentum under Mr Sharp’s tenure.

But it seems Mr Sharp has one last surprise left in the bag. The group’s share price leapt nearly 16 per cent following better-than-expected Christmas trading. Like-for-like sales rose 3.5 per cent while online sales grew by 12 per cent. Trading on just 10 times forward earnings, there’s still room for a further re-rating. IS, MR, DL, HR