Over the past year the market's taste for stocks offering reliable dividend income has diminished somewhat due to expectations that the interest rate cycle is set to turn. The argument that has been gaining in popularity with investors during that time is that the monetary tightening that has started in the US will continue and spread to other developed economies. This has led investors to question whether it still makes sense to pay historically high prices for dependable income stocks. Nevertheless, the high-yield, low-risk stock screen still managed to produce a decent return over the past 12 months, albeit inferior returns to the wider market, which had its performance driven by the stellar recovery in the resources sector.
The criteria of this screen is poorly suited to highlighting the kind of deeply contrarian plays that resources stocks represented this time last year. This is due to the screen's insistence that companies demonstrate consistent records of profitability and high returns. That said, as reflected in this year's picks, it is not above picking contrarian plays. And despite missing out on the big gains from resources stocks, the screen managed to pick out some big winners last year, which helped it produce a total return of 13.3 per cent. Still a way off the 23.5 per cent from the FTSE All-Share.
2016 PERFORMANCE
| Name | TIDM | Total return (5 May 2016 to 10 Apr 2017) |
|---|---|---|
| XP Power | XPP | 40% |
| Headlam | HEAD | 38% |
| Jardine Lloyd Thompson | JLT | 37% |
| Chesnara | CSN | 30% |
| Hiscox | HSX | 24% |
| GlaxoSmithKline | GSK | 19% |
| S&U | SUS | -0.2% |
| SThree | STHR | -6.2% |
| Mitie | MTO | -18% |
| Go-Ahead | GOG | -30% |
| FTSE All-Share | - | 23% |
| High-yield low risk | - | 13% |
Source: Thomson Datastream
This is the second year out of the six I've monitored the screen that it has underperformed the wider market. Since I started to run the screen in 2011 it has produced a cumulative total return of 164 per cent, compared with 62 per cent from the FTSE All-Share. If I factor in a 1.5 per cent annual charge to account for the cost of switching from one portfolio to the next at the time of publication, the six-year total return drops to 141 per cent.
Source: Thomson Datastream
The screen itself is relatively straightforward, concentrating on stocks offering a decent yield and showing a number of classic characteristics associated with reliability and quality. Perhaps the most noteworthy omission from the criteria is any cash conversion test, but when a screen gets stuffed too full of criteria it tends to produce few, if any, results. Indeed, during two of the past six years I've had to loosen the tests stocks are required to pass to get a sufficiently large number of results. Fortunately, that is not the case this time around. The full screening criteria are:
■ A dividend yield of 3.5 per cent or more. ■ A one-year beta of 0.75 or less. ■ 10 years of unbroken dividend payments. ■ 10 years of positive underlying earnings. ■ Underlying EPS higher than five years ago. ■ Underlying dividend higher than five years ago. ■ A return on equity of 12.5 per cent or more. ■ A current ratio of one or more. ■ Market capitalisation of more than £100m. ■ Dividend payments covered 1.5 times or more by earnings. |
Seven FTSE All-Share stocks passed all the screen's tests. They are listed below from highest to lowest yield including special payouts. I've also taken a closer look at three of the stocks chosen from the top, middle and bottom of the table.
Seven high-yield, low-risk shares
| Name | TIDM | Mkt cap | Price | Fwd NTM PE | DY | DY+ special | 5-yr DPS CAGR | 5-yr EPS CAGR | Fwd EPS grth FY+1 | Fwd EPS grth FY+2 | 3-mth mom | Net cash/ debt (-) |
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Next* | NXT | £5.9bn | 4,110p | 10 | 3.8% | 4.9% | 12% | 13% | -6.3% | -1.5% | -0.6% | -£882m |
| Headlam* | HEAD | £523m | 621p | 14 | 3.6% | 4.9% | 9.8% | 8.4% | 15% | -5.0% | 28% | £53m |
| Charles Taylor | CTR | £156m | 231p | 10 | 4.5% | 4.5% | 1.0% | 4.3% | 0.6% | 5.3% | 7.3% | £88m |
| S&U | SUS | £250m | 2,093p | 10 | 4.3% | 4.3% | 17% | 18% | 19% | 14% | -5.6% | -£50m |
| Berendsen | BRSN | £1.3bn | 762p | 13 | 4.3% | 4.3% | 7.1% | 9.6% | -7.8% | 6.7% | -13% | -£445m |
| Dunelm | DNLM | £1.3bn | 624p | 13 | 4.1% | 4.0% | 16% | 6.8% | -9.8% | 14% | -22% | -£111m |
| Fidessa* | FDSA | £1.0bn | 2,604p | 28 | 1.6% | 3.6% | 3.1% | 2.6% | 0.1% | 9.1% | 16% | £95m |
*Includes special dividend
Source: S&P Capital IQ
There are plenty of reasons to be negative about fashion retailer Next (NXT), but the dividend is not one of them. Indeed, while the dividend yield figure in the table is bulked up by a special payment, this may well be just a small taster of what is to come. Indeed, at the start of the year the company said that, given the uncertainty about the outlook, it would be looking to return surplus cash to shareholders in the form of special dividends rather than its previous approach of buying back shares. Importantly, Next has a track record of producing lots of surplus cash (£330m last year). Paying special dividends is the same tack Next took during the heightened uncertainty experienced in 2008, and the company points out that anyone using their special dividends to reinvest in the shares would have done very well. Based on the low end of its guidance for cash flow, Next expects to make quarterly special payouts of 45p. Adding this to a maintained 158p basic payout would give 338p for the year, equivalent to an 8.2 per cent yield.
While Next has proved itself to be a very cash-generative business over the years, cash is a function of profit, which has started to fall due to the very tough high-street conditions experienced by its retail business. Last year a 2.9 per cent fall in retail sales led to a 15.8 per cent drop in operating profit from £402m to £339m, reflecting the high level of fixed costs its bricks and mortar operation has to bear, such as staff and rent. With many analysts pessimistic about the consumer outlook and costs experiencing upward pressure, 2017 is expected to be another challenging year. What's more, the company feels it has taken its eye off the ball on its core product range and investors will be watching closely to see if actions taken to remedy this are working.
More significantly, though, the existential threat of internet shopping is likely to continue to prey on investors' minds. Next points out that rents on new stores keep falling to reflect the challenges. What's more, its analysis of a scenario where recent declines continue for a decade (not something its management expects) suggests the retail business should remain satisfactorily profitable even without the safety valve of rent reductions.
And among traditional retailers, Next has been a frontrunner in taking its products online through its internet and catalogue shopping business, Directory. That said, this division also faces challenges as customers are moving away from using credit, which provides a lucrative source of interest income for Next. While interest income actually showed a noteworthy rise last year, this was due to an increase in customer borrowing caused by a reduction in minimum payment requirements. This process has now pretty much run its course and while credit-customer losses have slowed notably recently, the company expects declining use of credit to be an ongoing issue.
Other areas of the Directory business show considerably more promise, though, especially rising international sales and sales of non-Next brand clothing. Overall, Directory profits last year rose by nearly a tenth to £444m.
Given the uncertainty faced by Next, the dividend represents the key lure. However, while the focus that has been put on Next's decline makes it hard to stray away from a pessimistic viewpoint, it is worth bearing in mind that were a recovery to kick in there could be some decent re-rating upside (last IC View: Hold, 4,140p, 23 Mar 2017).
Sub-prime lender S&U (SUS) produced an uninspiring performance as part of last year's 2016 selection of high-yield, low-risk shares and there are grounds to continue to be concerned. This may seem churlish given that the company increased earnings per share by 28 per cent last year and raised its dividend by 20 per cent. But investor nervousness centres around the potential for a turn in the credit cycle and the recent performance of S&U has provided some grounds for concern. Most notably, the company has seen costs of loans increase due to a rush of competition into its key market in sub-prime motor finance.
Motor finance is an area of the credit market that found itself underserved in the wake of the credit crisis as big banks withdrew from lending to fund car purchases. This left the field open for established small players in this niche market, such as S&U, to embark on very profitable growth. S&U's expansion has been aided by the sale of its door-to-door lending business in 2015, which gave it extra capital to plough into the promising motor-finance business, Advantage.
However, one of the basic rules of business is that where there are large returns on capital being made and few barriers to entry increased competition is not far off. The issue of competition can be particularly pernicious for lending businesses due to what is referred to as the credit cycle. This is the process by which, as competition increases, returns get pushed down at the same time as the riskiness of loans being made gets pushed up. When an economic downturn hits - and there is plenty of pessimism around about the outlook for the UK - this can come home to roost in the form of sharp rises in value-destroying impairments. Therefore, investor sentiment will not have been helped by news that impairments as a percentage of revenue were up at Advantage from 16.8 per cent to 20.1 per cent. The company put this down to a change in the business mix.
Market nervousness will also not be helped by developments in the car market that have seen many more purchases of new cars on so-called personal contract purchase (PCP) schemes - whereby cars are bought on credit and a minimum resale price is guaranteed at a later date. Some worry that the recent increase in this activity could lead to a glut of nearly new cars on the market, which some fear will push down second-hand prices - the key collateral in motor finance.
However, while there are grounds for concern, S&U is an experienced operator, which should help it weather any storms. Also, while competition may have increased, the cycle has not yet turned and brokers expect earnings at the business to continue to grow. The company is also looking at new avenues for growth in bridging loans (last IC View: Buy, 2,111p, 28 Mar 2017).
If S&U can be seen to offer a high yield due to its growth being at risk from the possibility of economic setbacks (see above) Fidessa (FDSA) looks as though it has a high yield for the opposite reasons: little growth but limited risk from a downturn, either. The financial software specialist was once a growth darling, but the financial crisis choked off its expansion as clients went out of business and consolidated. As progress stalled, much was made of the potential for the company's derivative product to reignite growth, but the division has underwhelmed and remains only a small part of the whole at about 12 per cent of revenue.
Sterling's weakness helped push reported numbers upwards last year as the company generates most of its sales from overseas. Indeed, while constant-currency profits before tax only nudged up 1 per cent, reported numbers were 25 per cent ahead. Some of these benefits are likely to be offset over the coming year by the cost of a major office move in the US.
While underlying growth may continue to prove elusive, what Fidessa can offer investors is reliability and strong cash conversion based on a stable customer base and regular recurring revenues (87 per cent of the total). These characteristics have resulted in a regular stream of 'special' dividends (50p of last year's 92.5p total payout) from the company, which has made it one of the best income plays in the software sector - a part of the market not normally associated with providing good yields (last IC View: Hold, 2,491p, 15 Feb 2017).
