How do you like your dog stocks – hot dogs or working dogs? These are the only two types of hound worth bothering with. Hot dogs aren’t necessarily good. Sure, there is momentum in their share price – that’s why they’re hot – but there is no dividend. Working dogs – as the name implies – come with dividends, but usually little momentum.
I’m sniffing in this field because it’s likely that the Bearbull Income Portfolio will shortly have cash to invest when its holding in Manx Telecom (MANX) is gobbled up in an agreed offer from a private equity buyer (see Bearbull, 22 March 2019). Granted, hot dogs with no income shouldn’t interest me, except that somehow they’re always fascinating.
Take Serco (SRP), maybe best known in the UK for tagging asylum seekers and operating speed cameras. It’s hot because its shares have risen 47 per cent in the past year even though they remain the 22nd worst performer of the 363 in the FTSE All-Share index with a five-year price history (for a full list, click on the link below).
Much was expected of Serco when Rupert Soames took over as chief executive in 2014. After all, the acquisition-driven outsourcing group had recruited a boss whose business CV was as glittering as his family antecedents. If Mr Soames could bring to Serco’s share price just a touch of the magic he brought to that of Aggreko (AGK) – it was easily a 10-bagger during his 11 years as the chief – then shareholders would be well pleased.
It seems an understatement to say that Serco has been a bigger challenge than expected. At 130p, its price is still over 60 per cent lower than when Mr Soames walked in. But, in announcing 2018’s results, Churchill’s youngest grandson was keen to claim that the group had passed an inflection point from which – implicitly – the momentum would only be upwards.
He based his confidence on such factors as free cash flow turning positive for the first time in four years, a debt-to-cash-profits ratio of just 1.1 times and a book-to-bill ratio (new orders over amounts billed) of over 100 per cent for the second year running. The factors that had produced these improvements would feed through to moderate revenue growth in 2019 and 2020 and – more important – profit margins, which were 3.3 per cent in 2018, would head towards 5 per cent over the longer haul. City analysts – always keen to latch on to a recovery story – have been quick to suggest that means earnings for 2021 clear of 9p (5.2p in 2018). So, wouldn’t you just know it, Serco’s shares aren’t really rated that highly at all.
If you detect some scepticism, you’d be right largely because it’s child’s play to breeze through figures such as these and contrive a recovery play. Yet for all the certainty in revenues brought by long-term contracts, costs put incessant pressure on margins and, in the shadows, Serco’s public sector contracts – especially those linked to social care – are always just one failure away from a public relations meltdown. Still, if I were running a recovery portfolio my instinct would be to take a detailed look at prospects.
Close in on the needs of the income portfolio, however, and, where there is an acceptable dividend yield among the poorest-performing stocks, there is rarely momentum. One exception would be pubs operator Greene King (GNK) – share price 40 per cent up on the year – but its shares are already in the Bearbull portfolio. Another is energy generator Drax (DRX), whose depressed price has recovered 36 per cent in the past year.
The trouble with Drax is almost an ethical one. If it were still just a coal-fired generator, then it might be ‘dirty’, but that would be clear for all to see. Now, however, 75 per cent of the electricity generated at its north Yorkshire plant comes from burning wood. As such, Drax epitomises the myth that burning so-called biomass produces low-carbon energy. If and when Drax can scale up its pilot scheme to capture and store carbon, I might change that view. Until then, I see Drax more as an example of the gullibility and cynicism that pervades – and distorts – the western world’s energy markets than a would-be income stock. Pompous, I dare say, but there it is.
Much simpler – but also with a bit of price momentum and a decent yield – are shares in LSL Property Services (LSL), which does what its name implies – estate agency, surveying, property management. As such, it operates in intensely competitive markets where barriers to entry are low. Not a great ‘come on’, but perhaps the shares are worth a look.
Much more interesting – though less likely as an investment – are shares in fashion brand Superdry (SDRY) where the yield is 5.8 per cent with the price at 534p; that’s 69 per cent down on the past five years and 66 per cent down on the year. With unhappy shareholders voting Superdry’s founder, Julian Dunkerton, back on to the board, more disruption looks in the offing. One unknown is whether that will endanger the dividend. The cost of a maintained payout is £25m, which is £5m more than free cash flow in the past 12 months, but the group is still debt-free. So maybe the dividend will survive at least for a while. Even so, I’d want this dog stock to heat up before I even thought about buying.