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Income tricks of the trade

In the third in our Investment Essentials series, Algy Hall looks at three successful income fund managers’ differing approaches to achieving yield
October 14, 2016

With central banks resorting to ever more extreme forms of monetary stimulus, the search for yield has become an obsession of our times. Equities have much to offer investors hunting for income. Not only do shares offer higher payouts than most bonds and many other types of income-producing assets, but with good stock-picking there is also the potential for growth based on the rising profits of companies invested in and the compounding effects of dividend reinvestment.

However, finding companies paying reliable dividends is no easy task. This especially seems the case in our current low-growth, low-inflation and low-interest rate environment which has seen a number of former income stalwarts, such as Tesco (TSCO), Centrica (CNA) and Rolls-Royce (RR.) cut or pull their payouts.

Income is the subject of this piece: the third in our occasional series of ‘Investment Essentials’ features, where we ask top investors what financial ratios and metrics they rate most when attempting to identify winning stocks. Wary that the subject of dividend-hunting could produce a narrow range of key criteria, we’ve purposely sought out three successful income fund managers that have distinct approaches. Even so, some common themes have emerged, especially around the importance of cash-flow analysis, balance sheet strength and dividend cover. Without further ado, here are their investment essentials.

For more on this feature, listen in to this week's free IC Companies & Markets podcast in which editor John Hughman talks with Algy Hall on income investing.

The small-cap dividend evangelist

Gervais Williams

Diverse Income Investment Trust (DIVI)

Small-cap fund manager Gervais Williams is a vocal champion of investing in smaller companies for income. In a low-growth, post credit-crunch investment world, Mr Williams believes the growth and dividend-paying potential of smaller companies is more relevant than ever. What’s more, growth can be a cash-sapping activity for some smaller companies, Mr Williams believes there are plenty of small caps that are very capable of sustaining and growing dividends in line or ahead of earnings. What’s more, the presence of a dividend against which a valuation can be pegged can be an important safeguard against the kind of share price volatility equity investors have had to endure over recent years.

Mr Williams says: “The market is volatile and bond yields suggest capital returns are expected to be low. One of the ways a company can give confidence to its customers and investors is with the dividend and a dividend that is rising over time; it demonstrates the underlying quality of your investment is strong. A high yield means you get more share price stability and if you’re going for yield the dividend will pull the share price up over time as the dividend rises.”

Diverse Income performance

Price: 89p

Discount to NAV: -1.7%

Mkt cap: £341m

Yield: 3.2%

Ongoing charges: 1.2%

Top 10 holdings

Charles Taylor2.40%
Stobart2.00%
Burford Capital1.90%
4Imprint1.80%
Safestyle1.70%
IG Design1.60%
Powerflute1.40%
Lok’N Store1.40%
Conviviality Retail1.40%
Amino1.40%
Top 10 total17.00%
Total holdings140
As at 31 Aug 2016Source: Trust, Winterflood Securities

 

Mr Williams puts a lot of emphasis on face-to-face contact with companies, and the fundamentals he highlights as his Investment Essentials are best regarded as factors that support his stock-pricking process rather than what leads it. He describes his choice of Investment Essentials as “leftfield”, reflecting his desire to highlight some under-utilised analysis techniques. That said, he also looks at more conventional indicators of dividend sustainability, such as companies’ cash positions and dividend cover.

Sales-to-market-cap is a classic ratio for assessing the potential of recovery stocks and has been championed by famous US investors James O’Shaungnessy – in his seminal book What Works on Wall Street – and Ken Fisher, although these investors look at the valuation metric as a price-to-sales ratio. Mr Williams looks at sales compared with enterprise value (EV) as well as market cap.

Price-to-sales (P/S) ratio = sales per share/share price,

or sales/market cap

Sales/EV can be used to help take account of a company’s net debt or cash position

Mr Williams says: “When it comes to us buying income stocks, it’s often the case that they’re recovery stocks because they’re the ones with really high yields. We look at things that allow us to see companies on the turn rather than wait for them to have turned. Clearly, though, they will need to be in a position to invest in their own business. The dividend should never obscure the attention management is paying to running the business well. You should not distribute cash to shareholders if the business is being starved of investment.”

The reason recovery investors tend to be so keen on buying companies that allow them to pay a small price for sales is based on the belief that the market’s obsession with earnings numbers makes it overly sensitive to temporary falls in profitability This can cause sharp upward share price movements when a recovery kicks in, pushing up both earnings and the earnings multiple shares trade at.

Indeed, Mr Williams’ other two Investment Essentials are both innovative ways of assessing management action that could potentially drive margins up, thus unleashing the earnings upside potential suggested by a low P/S ratio.

Mr Williams says: “If we are going to get a recovery from a stock we like to see high sales to market cap. If it does come right, then there are a lot of sales there and you just need a slight pick-up in margin to get a huge growth in profit. If I’m looking at recovery I am not so interested in seeing sales growth but sales do need to be rising rather than falling.”

Mr Williams highlights a good example of this dynamic as IG Design (IGR), formerly International Greetings. Over recent years the company has sparked a profit recovery through internal investment with relatively little assistance from sales growth. It should be noted, IG can hardly be regarded as an income stock as dividends have only just been reinstated. However, the table below (charting the effect of margin recovery on EPS) certainly offers a great illustration of a dramatic earnings recovery with little movement in sales.

 

IG Design's earnings recovery

to 31-Mar201420152016
Sales225.2224.5229
Ebit margin4.64.95.2
to 31-Mar201420152016Fwd 2017Fwd 2018
EPS5.1p9.3p12.0p14.3p16.0p
DPS0.0p1.0p2.5p3.4p4.2p
Source: Ionic Information

 

Capex payback

Mr Williams’s uses capital expenditure (capex) payback to assess the likely returns from individual projects based on the targets set by management. This kind of analysis means each investment plan needs to be seen on its own merits. For broad measures of how effectively companies deploy capital, investors can look at the returns generated from all balance sheet assets (see Hugh Yarrow’s Investment Essentials). However, wide-ranging measures such as this don’t quite capture Mr Williams’ approach.

Mr Williams says: “We look at all types of capex. It can be research and development, hiring extra sales force, whatever. What we are interested in is the cash payback on new capex. How quickly do you get the investment paid back? IG Design was investing about £10m and cash payback was about two and a half to three years. We’re crazy about that kind of thing.

“Companies may not make their capex payback target or they may do better. But once they get cash payback the rest of the return can be used to reduce debt and fund dividends.”

Service levels

If capex payback as used by Mr Williams is hard to measure with a one-size-fits-all financial ratio, then his final Investment Essential, service levels, is pretty much impossible to apply a broad-based approach to. Mr Williams sees services levels as an increasingly important determinant of competitive advantage. Despite this, he finds few investors are paying attention to this aspect of the businesses they invest in and that the attention of management teams to this detail of their operations is very variable. But Mr Williams is in no doubt that improving service levels can drive margins higher.

Mr Williams says: “We want to know if companies measure their service levels. For example, do they check their deliveries are made on time and in full? If service is poor people pay less and don’t come back. High service levels lead to high profitability.

“This is an area that doesn’t get the attention it should and companies are surprised when we ask them about it. But it’s one of the best ways of defending margin, an outstanding level of service makes a big difference. We invested in Fulcrum Utility Services (FCRM), for example, because we talked to management and were impressed by how they were planning on improving service levels and they’ve done very well; they haven’t even had that much sales growth.”

 

The dividend growth guru

Hugh Yarrow

Evenlode Income (GB00B405MR25)

Hugh Yarrow’s investment approach puts particular emphasis on identifying companies with qualities that are likely to produce dividend sustainabwility and growth, and he is prepared to accept a lower yield when he first invests if it will get him access to a business with the right characteristics. Indeed, in his Investment Essentials he highlights free-cash-flow yield over dividend yield as a valuation metric based on his view that dividends are the cart behind the free-cash-flow horse. His approach can be described as high-conviction, reflected in the fact that 20 shares make up about 70 per cent of his Evenlode Income fund’s near-40 stock portfolio.

Mr Yarrow says: “We do believe quantitative analysis needs to be combined with qualitative analysis. We’re a dividend and dividend growth fund. The aim is to deliver an attractive initial dividend yield but crucially a dividend stream that can grow above the rate of inflation. It’s about getting that balance between dividend today and dividend in the future.”

Return on tangible assets = earnings before interest and tax (Ebit)/(net working capital + net fixed assets)*

Return on total capital: Ebit/total assets*

*Mr Yarrow looks at the average capital employed over the year rather than just the year-end figure

Mr Yarrow’s strategy of focusing on income growth put him at odds with his trade body earlier this year when his fund was reclassified an IA UK All Companies fund because it fell marginally short of producing a yield equivalent to 110 per cent or more of the FTSE All-Share, which is the requirement to be classified as a IA UK Equity Income fund. Whether this can be regarded as arbitrary and narrow thinking, or a necessary evil of having a classification systems, there can be little argument that Mr Yarrow’s investment approach is very much focused on dividends and has been very profitable for investors in Evenlode Income (see graph).

 

Evenlode Income performance

Unit price: 256p

Mkt cap: £1.0bn

Yield: 3.4%

Ongoing charges: 1.0%

Top 10 holdings

Diageo6.80%
Unilever6.20%
Sage4.70%
Microsoft4.60%
AstraZeneca4.50%
GlaxoSmithKline4.10%
Johnson & Johnson4.00%
Procter & Gamble3.60%
Smiths3.50%
Compass2.90%
Top 10 total44.90%
Total holdings39
As at 30 Sep 2016Source: Fund, Morningstar

 

When analysing companies, Mr Yarrow uses some of the rawer numbers from companies’ results statements, such as reported “statutory” earnings and free cash flows. From year to year, these numbers tend to be far less consistent than the carefully crafted “adjusted” and “underlying” earnings numbers that companies carefully craft to tell stories of smooth progress, which investors find easier to digest. The strength of reported earnings and cash flows, though, is that they are far harder to manipulate. Mr Yarrow gets around the year-to-year consistency issue by looking at long-term trends. He breaks his investment essentials into metrics used to identify growth potential, defensiveness and valuation.

Mr Yarrow says: “We like to look at reported profit numbers but we look at the average over time. We look back at 10 to 15 years to get a fair picture of earnings. For example, pharmaceutical companies often face litigation costs, however, these are large and lumpy. We also look at return on capital measures over time.”

High return on capital (growth)

There are many measures of return on capital that investors can use, but the common thread between the various ratios is that they provide an insight into how much profit or cash a company is making from the money it has invested in the past. As such, return on capital is a measure of the quality of a business. Mr Yarrow focuses on two different types of returns:

Mr Yarrow says: “Return on tangible assets tells us whether a good franchise exists. Return on total capital includes goodwill which means it includes money that has been used to make acquisitions. The first one is a good operational indicator and the second looks at management’s capital allocation abilities too. Spectris (SXS) and Halma (HLMA) are examples of companies that rate well on both measures. Management is being sensible with spending money on acquisitions as well as spending on organic growth.

“We like companies that are generating a high level of profit relative to assets. Put simply, if you held a business from when it started out, how much more is it going to pay you back than you put in? High returns on capital are a virtuous circle of investment. You get a compounding of profits over time as the company reinvests its profits back into the business. We call this a quality compounder.”

“A good return on capital tells us a good business has existed in the past. What quantitative analysis can’t tell you is whether a good business will exist in the future. We’re very keen on Warren Buffett’s idea of economic moats [to assess future prospects]. We ask ourselves – could you build this business if you had limitless capital? We tend to like businesses that have customers who focused primarily not on price but on value. We like to see customer embeddedness and loyalty, thanks to software subscriptions or consumer healthcare brands, for example. These are often companies with businesses built on providing value to customers, not low pricing.”

High free-cash-flow cover (defensiveness)

“It sounds so simple, but we like businesses that finish the year with more cash than they started. If cash is falling or debt is rising, then that business is not self-financing, and we really like self-financed growth.”

“We’re looking for businesses that can consistently convert earnings into free cash flow. We look at free cash flow adjusted for maintenance spending, which Mr Buffett calls the owner-earnings yield. You need to use a bit of judgement to assess maintenance spending. Depreciation is not always what maintenance would be. For example, we often find true maintenance capex for software companies is lower than depreciation. If we think growth capex is going into sensible projects then we like that.”

“We like to see free cash flow healthily higher than the dividend. If you have nice cover, we see that as a safety buffer. All companies go through difficult periods of trading, so you need some safety. Cash flow is volatile so we look at cover over several years, but cover of 1.5 times or more is preferred.”

“A problem with Free Cash Conversion is that while it is often right for a business to invest organically today, it will result in lower free cash flow. Ironically, if it makes an acquisition, even a quite bad one, this will improve free cash flow [given how low interest costs on debt are currently]. And in the current acquisition environment, in which valuations are often elevated, buying another business is likely to generate lower returns on capital than organic investment.”

Strong balance sheet

Mr Yarrow looks at three different measures of a company’s debt burden which ask three different questions:

■ How high is debt relative to profits?

= Net debt/cash profit (Ebitda).

■ How easy is it for the company to cover finance costs?

= Interest cover = Ebit/interest expense.

■ How geared up is the company’s balance sheet?

= Leverage ratio = total assets/equity

Mr Yarrow says, “We like a low level of net debt. We have 14 out of 40 companies in our portfolio with no net debt at all. We look at debt on both a non-adjusted basis and adjusted for pensions and lease liabilities.”

“A lot of the companies we own are repeat-purchase businesses, such as makers of shampoo or subscription-software developers. We’re more comfortable for those businesses to have a higher level of debt. But for more economically sensitive businesses we’re more cautious.

For example, we made a recent investment in recruiter Page (PAGE) following the referendum. Page’s management accepts the business is cyclical and runs the balance sheet very conservatively with that in mind. That’s why it did not need to cut the dividend during 2008-09.”

Valuation

Mr Yarrow says: “We look both at what the FCF yield is today and how it will develop over time. We like all stocks to contribute from a dividend yield perspective, but we want dividends with the potential for growth. FCF is really the key, though, and the most important metric. Dividends should be the cart behind the horse. FCF is the horse. It’s needed to sustain the dividend in the long term. We estimate long-term FCF and apply a discount rate to get a forward cash return that is comparable to the redemption yield on a bond.

“The sustainability of dividends is a particular issue at the moment. It has been hard for companies to achieve organic sales growth but debt is very cheap, which leads to the temptation for companies to increase dividends at a rate that isn’t sustainable. Many companies have wanted to carry on with dividend growth at pre-2008-09 levels, but the economic growth has been lower than many expected. This has meant many companies have had to revisit dividend growth.”

Free-cash-flow yield

Mr Yarrow looks at the FCF yield calculated using a both company’s market cap as the denominator and its enterprise value (EV). The is mainly interested in the EV version of the ratio though because it “looks at valuation on an unleveraged basis”. The formula for FCF yield is:

FCF/EV x 100

FCF/market cap x 100

The Income Veteran

Job Curtis – City of London

Investment Trust (CTY)

The City of London Investment Trust sounds more like a venerable and august institution than a UK equity income fund. But perhaps that’s fitting given the dependable role the fund plays in the portfolios of many income-hungry investors. Indeed, City of London boasts a staggering record of 50 years of dividend growth. For nearly two decades, Job Curtis, Henderson’s head of Value and Income, has been the person charged with preserving this formidable track record. He took the helm having already amassed over a decade’s fund management experience. The consistent dividend growth achieved by the fund is built on spreading the risks associated with dividend cuts, and the fund has holdings in over 100 companies. The fund also has a blue-chip focus, with FTSE 100 stocks accounting for about 70 per cent of the portfolio.

While Mr Curtis is keen on locking in good dividend growth with his investments, he is also focused on shares with high initial payouts. While this contrasts with the more dividend-growth centric approach of Mr Yarrow, many of Mr Curtis’s Investment Essentials are strikingly similar to his peer’s. We’d regard such consensus among two managers with somewhat differing styles as underlining the importance of certain key metrics when hunting for income.

“The first metric that I consider is dividend yield relative to the rest of the equity market. I believe that the ‘sweet spot’ for new investments is between 10 per cent and 30 per cent greater than the FTSE All-Share index. That level is likely to give you a mixture of yield and growth.

“If you invest at a yield more than 30 per cent above the market, you may encounter companies that offer a high yield but little growth. They can often be over-distributing in relation to their dividends, which ultimately leads to dividend cuts and poor share price performance. This does not always happen and there are some companies that are able to grow out of their high yield but it is a clear risk in this part of the market.

“On the other hand, low-yielding, highly-valued shares are in danger of disappointing investor expectations. When this happens shares can get a double downgrade of falling estimates and a derating. I don’t always sell shares when they move to a low yield because it is sometimes worth ‘running winners’ as companies produce above average growth. However, the dividend yield/valuation discipline is helpful in making you ask questions of a lower-yielding share to justify continuing to hold it in your portfolio. The classic example of this was during the bubble market in 1999-00 when many technology shares got very overvalued, paying little or no dividends. They subsequently suffered severe share price falls even if in the long run much of what was predicted about the transformative effect of the internet proved to be correct.”

City of London IT performance

Price: 408p

Premium to NAV: 1.1%

Mkt cap: £1.3bn

Yield: 3.9%

Ongoing charges: 0.4%

Top 10 holdings

British American Tobacco5.10%
Royal Dutch Shell4.10%
HSBC3.80%
Vodafone3.00%
Diageo2.70%
BP2.60%
Unilever2.40%
National Grid2.30%
GlaxoSmithKline2.10%
Imperial Brands2.10%
Top 10 total30.20%
Total holdings117
As at 31 Aug 2016Source: Trust, Winterflood Securities

 

Dividend cover

“We analyse the companies to see whether they can really cover their dividends from their profits using such measures as EPS and free cash flow per share. I focus on free cash flow cover excluding maintenence capex but am aware of all capex. I look at both adjusted and statutory earnings; sometimes adjustments are justified, sometimes not.

“I try to avoid companies that are paying

artificially high dividends and not investing enough for the future. In contrast, companies with dividends well covered by retained profits are in a position to make the investment in capital or people or marketing necessary to grow their profits, leading to higher dividends.”

Balance sheet strength

I prefer to use net debt-to-cash-profit but also look at interest cover and gearing (net-debt-to-equity). I also consider assets such as property and brands, and liabilities such as pension fund deficits.

“I prefer strong balance sheets, especially for cyclical companies. If a company is experiencing a downturn in its profitability, as is inevitable with companies exposed to the economic cycle, a company with a high level of debt is bound to have to focus on making sure it meets its interest payments and keeps its bank manager or bond holders happy. A company with a strong balance sheet is better able to maintain or grow its dividend in these circumstances.

“Some companies with very predictable profits are better suited to carry a high level of debt. A good example would be regulated utilities, such as National Grid (NG.).”

What is enterprise value (EV)?

Market cap only looks at the value investors are putting on the financing that a company has historically secured through the sale of shares to the public. EV attempts to provide a fuller picture of the value being put on a company by taking account of other sources of financing (chiefly debt). For example, a £100m company producing £10m of earnings is a very different proposition if it is also carrying £50m (an EV of £150m) of debt compared with the same company carrying £50m of cash (an EV of £50m). The basic calculation for EV is:

EV = market cap + net debt

(debt - cash)

Other liabilities that are very similar to debt can also be put into the EV calculation; namely pension deficits and long-term commitments to pay rent on things like properties, equipment or vehicles, known as lease liabilities. Lease liabilities are currently not reported on companies’ balance sheets but changes to accounting rules mean they will need to be reported on balance sheets from the start of 2019.

So, arguably a more complete calculation of EV would be:

EV = market cap + net debt + pension deficit

+ lease liabilities

 

What is free cash flow (FCF)?

FCF represents the amount of cash from a company’s activities from a given period that is available to distribute to its shareholders (in the form of dividends or through other means) or to spend on other things, such as acquisitions.

In many regards FCF can be seen as a cash flow equivalent to the post-tax profit number investors pay so much attention to in the income statement and which forms the basis for the denominator of the ubiquitous price-to-earnings (PE) ratio. FCF looks at how much cash is left over for shareholders once all necessary cash expenses (operational expenses, tax, interest and capital expenditure) have been paid.

Some calculations of FCF only account for the amount of capital expenditure (capex) that is necessary to maintain operations. However, the vagaries of splitting capex into maintenance and expansionary capex means many investors find it easier to simply strip the lot out.

Free-cash-flow cover = dividend per share (DPS)/

free cash flow per share (FCFps)