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OPINION

Tools for the job

Tools for the job
November 3, 2016
Tools for the job

There is nothing untoward about those figures. On the contrary, they would prompt me to look further if only because those ratings compare favourably with London's major broad-based index, the FTSE All-Share. By the weighted value of the 603 components of that index, it trades on a multiple of almost 30 times 2016's likely earnings, while its prospective dividend yield is about 3.3 per cent, although that comes from an aggregate payout that is not even covered once by its earnings.

True, the All-Share's rating conceals many distortions, most of which are caused by accounting losses within the mining and oil & gas sectors; these force up the average PE ratio and depress dividend cover. Yet take the 'industrials' sector grouping, a big part of the index (117 components) where profits are fairly free from distortions - even here the average earnings multiple for 2016 is almost 27 and the cover on dividends that produce a 2.6 per cent yield is slightly below 1.5 times.

So our unnamed stock is much more attractive than the industrials sector - half the earnings multiple and twice the dividend yield from about the same level of cover. The difficulty is that the stock can't be bought, but it does exist in the shape of the Bearbull income portfolio.

Predictably enough, my intuitive response to seeing the income portfolio's rating compared with the All-Share index or the industrials sector is to be pleased. It's good to know both that I am getting a two-times market yield without overloading the portfolio's ability to make the necessary payouts and that the portfolio is not populated with holdings whose ratings look stretched.

Arguably, the most vulnerable looking - certainly the highest rated - is the holding in pharmaceuticals giant GlaxoSmithKline (GSK). This trades on 19 times 2016's forecast earnings, a rating that - as so often with Glaxo - assumes that somehow the group's coming years will be better than the past. I've been sceptical for a long time (see Bearbull 19 September 2014) and the stock only struggles along in the portfolio because there always seem to be more pressing issues.

One such has been what to do with shares in construction group Carillion (CLLN) - see Bearbull, 7 October 2016. Yet in terms of its relative rating, a holding in Carillion could actually have merits. That's because its shares are the lowest rated of the income portfolio's 14 holdings, coming in at barely seven times forecast earnings for 2016. That's another way of asking, how much downside is there in the share price? After all, it's hardly a rating that implies the market expects great things of Carillion.

Further support for Carillion's corner comes from a ready-reckoner way of assessing the quality of dividend yields. That's done by adding together the yield and the dividend cover. True, the answer is mathematically illiterate, but it provides a crude way of comparing yields. Thus Carillion's 'score' of 9.2 (a 7.3 per cent yield plus cover of 1.9 times) is the highest number in the portfolio.

That does not make Carillion the best holding in the fund; indeed, its thin profit margins and low return on equity imply quite the reverse. But it does highlight Carillion's possible advantages. Compare it with, say, the holding in Manx Telecom (MANX) where the score is just 6.4 (4.9 per cent yield plus 1.5 cover). That prompts the question: am I willing to tolerate Manx's comparatively low yield when dividend cover is so thin? Answer - quite possibly, because Manx's utility nature means its profits-generation is more reliable than most. Nevertheless, the facts of Carillion's fat yield and satisfactory cover indicate that, in the portfolio context, its shares may still be able to do a job.

True, other holdings have lower dividend scores - touchscreens maker Zytronic (ZYT) or even the portfolio's newest holding, aircraft maker Boeing (US:BA). Zytronic's score results chiefly from the rise in its share price - up 94 per cent since I bought the holding three years ago. I have already taken some profits and may well sell the rest soon (although probably not before next month's full-year results). Boeing, by dint of its New York listing and its revenues in dollars, fulfils a new role for the portfolio. However, if its shares continue to fly - at £117.27, the sterling price is up 16 per cent since I bought in September - the price will soon be above my guesstimate of intrinsic value (£120) and that will give me a nice dilemma.

There is, however, an underlying point in this commentary. I am not so much talking about the income portfolio's shares themselves as the need to monitor the progress of any equity portfolio and the importance of having the tools to do that. Many of those are provided by the 'Bearbull Ideal Portfolio Manager', which was introduced to readers on 29 May 2015 and is available via this link.