- Dividends that help investors profit from quality not income
- The screen has delivered 379 per cent cumulative total return over the last nine years vs 145 per cent from the market
- Seven new High Yield Small Caps
A classic view of what a 'quality' company looks like can be blind to a kind of dull-but-dependable quality play that can stack up great returns over time. Focusing on the quality of dividends paid and dividend yield can often provide investors with a slant that helps identify quality plays that others can easily overlook.
Such situations may not boast the kind of standout return on investment or high margins that are traditionally associated with 'quality' plays. These businesses may also only offer relatively pedestrian growth prospects. They may also be a bit cyclical and operate businesses that are sensitive to external forces. They therefore may not be truly masters of their own destiny.
But looking beyond the obvious drawback can often unearth quality businesses, which despite having flaws still deliver strong returns over time. That is particularly true if quality is defined by the kind of cash generation and financial strength that often defines solid dividend stocks.
And while the choice to pay a dividend is simply one of many capital allocation options for any company, the discipline of sticking by a dividend can puts useful curbs on management. It reduces the chance that a company will waste its cash on vanity projects, such as value destroying mega-acquisitions and low-return growth projects.
Indeed, if there is no obvious way for a company to generate good returns from reinvesting the cash it generates, the best option is to hand it back to shareholders to see if they can have better luck. These companies also are often very reliable. A case in point is the track record of my High Yield Small Cap screen, which has outperformed the market in eight of the last nine years, delivering a cumulative total return of 379 per cent in the process. That compares with 145 per cent from a 50:50 split between the FTSE Aim and FTSE Small Cap indices.
That said, reliable as the annual performance record has been, the small cap and value leaning did mean a rather gnarly draw down in March 2020. The peak-to-trough fall of the portfolio being monitored at the time was 43 per cent compared with 40 per cent from the FTSE Small Cap and 46 per cent from the Aim All-Share.
The cumulative performance assumes annual reshuffles of the portfolio to the new screen selection at close on the day of its online publication. While the idea of the screen is to generate ideas for further research rather than off-the-shelf portfolios, it is worth injecting some realism into the performance numbers with a hefty annual charge of 2.5 per cent (the wide spread on many small caps make them painfully expensive to trade). Applying this charge substantially reduces the nine-year total return to 281 per cent.
The screen delivered a thumping 57 per cent return over the last 12 months, which followed its first year of underperformance since I started to track the strategy.
|Name||TIDM||Total Return (24 Nov 2020 - 18 Nov 2021)|
|Up Global Sourcing||UPGS||119%|
|Pan African Resources||PAF||11%|
|FTSE Small Cap||-||29%|
|FTSE Aim All-Share||-||22%|
|Source: Thomson Datastream|
The screen’s criteria essentially looks for solid dividends and decent growth. The tests that are conducted separated on constituents of the FTSE All Small and Aim All-Share are as follows:
■ A historic and next-12-month forecast dividend yield among the top half of all dividend-paying stocks screened (see below for changes to this criteria).
■ Dividend cover of 1.5 times or more.
■ Three-year dividend compound average growth rate (CAGR) of 5 per cent or more.
■ Three-year EPS CAGR of 5 per cent or more.
■ Average forecast growth for the next two financial years of 5 per cent or more.
■ Interest cover of five times or more.
■ Positive free cash flow.
This year seven stocks passed all the screens tests. As this screen is focused on dividends as a way of assessing quality rather than out of interest in the income itself, I’ve decided to look at the lowest-yielding stock from the screen, Michelmersh Brick. It’s an interesting proposition. A table with fundamentals relating to all the stocks highlighted by the screen can be found at the end of this article.
|Michelmersh Brick||MBH||Construction Materials||124p|
|Size/Debt||Mkt Cap||Net Cash / Debt(-)||Net Debt / Ebitda||Op Cash/ Ebitda|
|Valuation||Fwd PE (+12mths)||Fwd DY (+12mths)||FCF yld (+12mths)||P/BV|
|Quality/ Growth||EBIT Margin||ROCE||5yr Sales CAGR||5yr EPS CAGR|
|Forecasts/ Momentum||Fwd EPS grth NTM||Fwd EPS grth STM||3-mth Mom||3-mth Fwd EPS change%|
|Year End 31 Dec||Sales||Pre-tax profit||EPS||DPS|
|source: FactSet, adjusted PTP and EPS figures|
|NTM = Next 12 months|
|STM = Second 12 months (ie, one year from now)|
The point of looking for solid dividend payers is to find quality businesses that other investors may easily overlook. Brick maker Michelmersh (MBH) seems to fit this script.
There are several substantive reasons to dismiss Michelmersh as a quality play. It is involved in a capital intensive and cyclical line of work. It also has high levels of fixed costs, which means profits are very sensitive to sales. And a fifth of costs are based on often volatile energy prices. With gas prices rocketing, this latter point is something that has spooked the market recently and is likely to have been a major cause of the shares 24 per cent drop from an April high of 163p.
These are not classic hallmarks of a quality company. In fact, quite the opposite.
However, the company owns extremely valuable assets and is managed in a way that mitigates many of its weaknesses. The scarcity of the brick-making assets Michelmersh owns, coupled with significant obstacles to increase supply due to a strict planning system, underpins a strong competitive position. The sea surrounding the UK provides another, very physical barrier to entry. The cost of shipping is an impediment to imports, which tend to make up about 18 per cent of the UK brick market. And overseas producers are also facing rising input costs.
Tough but tantalising times
Michelmersh is well aware of the havoc energy price fluctuations can bring. The company uses significant amounts of energy-price hedging (agreeing prices in advance) to mitigate the risk. It started the year with 70 per cent of energy prices hedged. In October, house broker Canaccord Genuity said it understood the whole of the rest of 2021 was hedged along with material amounts of the two following years.
That said, the company did tell investors at the time of the half-year results that it expected profits to be weaker in the second half of the year. It also said it expected to beat broker expectations overall.
Companies can only ever temporarily put off the inevitable pain of cost increases with hedging. Prevailing higher prices have themselves to be hedged in eventually. And when finance directors try to get too clever with derivatives to second guess markets it usually ends in tears. Fortunately, Michelmersh also looks in a strong position to pass on cost increases with price rises.
Over the last year, the industry’s output of bricks has been lower than its deliveries. This reflects reduced output in the early days of lockdown followed by a strong recovery in demand. This has led to industry stock levels falling to record lows of less than 300m bricks. At the same time, similar issues on the continent means importers’ market share has fallen to 16 per cent compared with the long-term average of 18 per cent.
These factors all support the industry’s pricing power and profitability. Indeed, the big brick makers are pushing through price rises of about 10 per cent from the start of next year. Hedging is helping Michelmersh be more gentle on its customers, with 8 to 9 per cent rises slated. This should still allow it to grow margins.
Less growth more cash
Michelmersh already commands standout margins compared with its larger peers. This is due to its ownership of most of the industry’s premier brands. So, while brick prices are very sensitive to supply and demand, the company boasts impressive pricing power even when the market is weaker than it is today. Its average brick selling price is estimated to be about 30 per cent above that of the other big players.
There is a flip-side to the 'premier-brand' strategy. The focus on margin and avoidance of low-value high-volume work has impinged on the company’s ability to grow. Michelmersh is the smallest of the UK’s four big brickmakers, with a 5 per cent market share. Still, comparisons between Michelmersh’s own gross margins and that of competitors stands testament to its success (see table). As does the growth in the company’s gross margin improvement over the past 10 years (see graph).
|Michelmersh: Big on margin, small in size|
|Name||TIDM||Enterprise Value||Price||Fwd PE (+12mths)||Fwd DY (+12mths)||FCF yld (+12mths)||Gross margin||Op margin||Days Sales Outstanding|
The strategy has not only been about focusing on product and brand. Michelmersh has worked hard to get close to its customers, deliver high levels of customer service, invest in its facilities, and support its distribution partners. This last point about supporting distribution partners seems to be reflected in the fact that Michelmersh is paid slower than its listed rivals based on days payment on sales is left outstanding (see table).
But, despite the slower payments, this is a business that is good at generating cash. The ratio of operating profit to cash profit (Ebitda) has averaged 102 per cent over the last five years, which is a very healthy level. A company’s ability to turn profits into cash is a key consideration when it comes to assessing quality, and something that is indicated by solid dividend credentials.
And, for Michelmersh, paying dividends represents a very sensible use of the surplus cash that builds up due to the limited scope to spend on growth. Handing cash back is, for it, an important capital allocation discipline. Management has also used acquisitions to increase sales without resorting to pursuing low-value high-volume business. Last time cash levels were as high as now, Michelmersh boosted capacity by 40 per cent with the £32m acquisitions of Carlton. It followed this up in 2019 with a first foray across the channel, buying Belgium brick company Floren for €9.9m (£8.3m). The deal was part funded with a £5m share placing at 90p.
If management cannot find a similar way to deploy cash now, its bank balance is forecast to balloon. The company should generate well over the £3.3m needed to cover this year’s expected dividend and finish 2021 with £5m. This is forecast to rise to £9m the following year and £13m the one after. With returns from idle cash still abysmally low, management will need to think hard about uses for the money that offer the most benefit to shareholders.
The cheapness of the stock based on forecast cash flows is best reflected in the next-12-month expected free cash flow (FCF) yield of 9.3 per cent. That does reflect expectations of a bit of a bumper trading period for the company, but it looks quite serious value all the same. And while there are contradictions for investors to grapple with in regard to the Michelmersh’s quality – significant cyclicality sat alongside strong pricing power – there are clear reasons to think this is an attractive and relatively robust business. What’s more, the recent share price falls, which seem linked to rising energy prices, may underappreciate the company’s strengths. In fact, a more significant near-term risk to performance may simply be keeping output up with demand, given low levels of brick stock.
Seven High Yield Small Caps
|Name||TIDM||Mkt Cap||Net Cash / Debt(-)*||Price||Fwd PE (+12mths)||Fwd DY (+12mths)||FCF yld (+12mths)||Net Debt / Ebitda||Op Cash/ Ebitda||Fwd EPS grth NTM||Fwd EPS grth STM||3-mth Mom||3-mth Fwd EPS change%|
|Impact Healthcare REIT||IHR||£420m||-£42m||120p||16||5.5%||-||2.6 x||80%||16%||8%||2.6%||4.3%|
|Springfield Properties||SPR||£151m||-£21m||148p||9||4.4%||1.5%||1.0 x||256%||10%||13%||-4.8%||1.4%|
|Warehouse REIT||WHR||£681m||-£250m||160p||24||4.1%||-||8.3 x||94%||14%||10%||-4.3%||-1.8%|
|Michelmersh Brick||MBH||£119m||£4m||125p||15||2.9%||9.2%||0.0 x||95%||13%||5%||-7.1%||2.6%|
|*FX converted to £|
|NTM = Next 12 months|
|STM = Second 12 months (ie, one year from now)|