Thank you, dividends

Thus, the main thing – almost the only thing – to raise a smile in what was otherwise a trying year for the Bearbull Income portfolio is that the dividends it received – and subsequently paid out – rose yet again.

Table 1 shows the details. The payout for the first half was down on the year chiefly because of dividend cuts at two holdings – chemicals supplier Elementis (ELM) and student accommodation provider Empiric Student Property (ESP). The timing of payments also pushed income received into the second half. Add in the effect of topping up the income portfolio’s holding in air travel broker Air Partner (AIR), whose payment had been pushed back, and a first-time dividend from a new holding in pubs operator Greene King (GNK) and the Bearbull portfolio’s payout for the second half – which isn’t actually made until 31 December – is 10 per cent higher than a year ago.

Cumulatively, this means that, over its 20-year life, the income portfolio has now distributed over £191,000 from a starting capital pot of £100,000. And – perhaps significantly – this also means that more of the portfolio’s total return has been derived from dividends (£191,000) than from capital gains (£169,000).

In large part this is because of the ‘Mr Market’ effect. This time a year ago, the portfolio’s capital value was almost £47,000 higher than it is today; then the worries set in. Yet if Mr Market recovers from the anxiety caused by Donald Trump’s mercantilist world view and the possibility of a global recession, the portfolio’s value could bounce back.

Perhaps I can even gather some optimism from the fact that the portfolio’s dividend yield is currently running at 6.3 per cent (see Table 1), which implies that some of its holdings are oversold. Well, maybe, but I have to be cautious about that because the weighted average level of dividend cover in the fund is just 1.3 times earnings and clearly some of the payouts are under threat. That particularly applies to the holdings in vertically integrated energy supplier SSE (SSE), which I discuss a few paragraphs further on, and to telecoms utility Manx Telecom (MANX); it may even include touch-screens maker Zytronic (ZYT).

True, Zytronic is paying a dividend for 2017-18 not quite covered by accounting earnings – 22.8p against 22.7p of basic earnings. However, the group is loaded up with cash – £14.6m and no debt against a market value for its equity of £53m – and generated enough free cash to cover the cost of dividends that it paid during the year.

Besides, with the share price down to 320p – 40 per cent below its 12-month high – there is a case for saying that the shares are cheap. Sure, Zytronic has just come off a poor year’s trading, with operating profits down to levels not seen since four years ago. Despite that, even with my cautious way of calculating these things, Zytronic still makes a return on equity of over 14 per cent, which is enough to punch a decent amount of value.

Each of the three ways that I use to estimate value produces figures decently clear of the share price. Simultaneously, the group has a good record of turning accounting profits into cash (linked, it has to be acknowledged, with low levels of capital spending); has not needed to raise new capital in the past six years and has improved employee productivity in each of the four years to 2016-17, although will have taken a hit in the one just reported. Granted, current trading does not seem much to write home about. Nevertheless, the current depressed share price is not a level at which I want to be selling.

Meanwhile, the most disappointing performance of the year has clearly been shares in US gas distributor The Williams Companies (US:WMB). As Table 2 shows, this holding was bought in August but, just four months on, its value is 21 per cent down and, at $23.45, its share price is knocking against its stop-loss level.

True, this fall has occurred against the backdrop of a sell-off in equities, but shares in Williams were supposed to be defensive because the company runs on long-term contracts and offers a nice combination of growth and value. Williams’s growth comes from rising demand for the gas that it distributes through 20,000 miles of pipelines, about half of which comprises its Transco network running from the Gulf of Mexico to the populous north-eastern states. Its ‘value’ credentials are tied to the predictability of earnings derived from its supply contracts, which are linked to the volume of gas sent through its pipelines, not the price.

That ‘growth-and-value’ theme has not played out yet, although it seems its failure to do so has little to do with the group’s trading performance. Granted, Williams’s bosses talk their story bullishly even by the standards of US chiefs, so you might expect them to be upbeat even if the company’s pipelines were running on empty. As it is, they say demand for natural gas is outstripping demand for renewables and that almost 60 per cent of energy-generating capacity in the US that is in late-stage development is for gas.

Such lively demand is feeding down to Williams’s trading performance. Underlying earnings per share (EPS), which were $0.63 in 2017, should hit $0.76 in the year shortly to end, rising to $0.90 in 2019, possibly topping $1 with a strong tail wind. Arguably more relevant, distributable cash flow, which was $2.6bn in 2017 to cover dividend costs of $1.6bn, is likely to rise in both 2018 and 2019, maybe hitting $3bn in the year just about to begin. Per-share dividends, which will total $1.36 for 2018, are likely to be $1.52 in 2019, say the company’s bosses. That pay-out would produce a yield of 6.5 per cent at the current price. For UK investors, that would be a useful chunk of non-sterling income.

Meanwhile, what seems to be eroding the share price is that investors don’t like the amount of debt that Williams carries. By the year end, debt is likely to be 5.0 times the company’s underlying gross profits (so-called ‘Ebitda’, or earnings before interest, tax, depreciation and amortisation). That’s a bit higher than at the start of the year because of acquisitions and a tidy-up of corporate structure, but it’s well down from a ratio of almost 6.0 times in 2015. Wall Street analysts would like to see Williams cut leverage quicker by accelerating a programme of asset sales. That seems unlikely to happen, though. Management seems confident the ratio will eventually drop to an acceptable 4.2 times gross profits, helped more by rising profits than falling debt levels.

Anxiety about Williams’s debt is a conventional response to a rise in US interest rates. That doesn’t necessarily justify such a concern, but nor should I brush it off. It does not help that Williams has become more difficult to analyse since the autumn when it bought out the minority shareholders in Williams Partners, a listed partnership that used to house most of the group’s pipeline assets. Still, before I decide what to do with the shares, I need to get a better handle on the state of that debt.

That’s the top priority for a portfolio that’s fully invested, so there is no capital in search of a home. True, I have doubts about other holdings, but that’s always likely to be the case when a falling stock market drags the price of various holdings against their stop-loss levels.

For example, probably the portfolio’s most vulnerable holding is in SSE. The group’s bosses have made a pig’s ear of the intended spin-off of SSE’s energy-supply side into a separate listed company with Npower, a UK energy supplier owned by Germany’s RWE (Ger:RWE). That proposal – a year in the making – has now been abandoned, which may not necessarily be a bad thing, given that Npower is a serial lossmaker.

But SSE’s bosses insist that they will still hive off the energy supply side, possibly into a stand-alone listed company. It’s debatable what that would achieve – not that SSE’s advisers will say that – and perhaps the best solution for shareholders would be a trade sale with the proceeds being distributed to them. That might provide some consolation for the cut in SSE’s dividend that is more than likely on its way. And it would quite likely be for the best that SSE’s bosses have less capital to mess with.

Lastly, a mention for the income portfolio’s best performer in 2018; a stock that should not even be in the portfolio so many times have I vowed to sell it – step forward GlaxoSmithKline (GSK), whose share price is 13 per cent higher than a year ago. True, it says much about the year’s dreary performance that such an ordinary gain should be the portfolio’s best; and it is debatable whether shuffling its consumer healthcare side into a joint venture with Pfizer (US:PFE) will create value. Certainly, a quick run through my valuation models turns up little to show Glaxo shares as decent value, save rising levels of employee productivity and acceptable cash conversion. Still, come 2018’s results in early February, Glaxo will be due a thorough road check and, perhaps once more, I’ll make the decision to sell, which, as usual, I’ll ignore. We’ll see.