Bearbull Income Portfolio: Is that all there is?

Why is it that investing in UK equities conjures up thoughts of one of popular music’s best-known but least understood songs? Superficially, the answer is in the title of the 1969 hit from the great Peggy Lee, 'Is that all there is?'

Browse through the almost-2,000 equities listed on London’s exchange – really, the number is still that high – and the dull uniformity of what’s on offer feels like investing’s equivalent of shopping in Moscow’s GUM department store as the Soviet empire approached its corrupt and cynical end in the 1980s. Everything is the same and everything is boring. Where are the technology stocks, the platform operators and, most obviously missing given the UK’s record in pharmaceuticals, the young biotechnology stocks? There is a limit to the number of financial services and basic resources companies one can sift through. Is that all there is?

Thus, as I put together a short list of possibilities to fill a gap in the Bearbull Income Portfolio, those I encounter are depressingly familiar. Granted, if the search is for income stocks, then – rightly or wrongly – we are confined by the need to find stocks that generate an above-average income yield from a reasonably reliable dividend and that, of necessity, limits the choice. Even so, it’s not that I’ve been here before; it’s like I never leave. Is that all there is?

This time around, Table 1 shows exactly what there is and I’ve tried hard to bring in some unfamiliar faces where the focus is less on dividend yield and more on dividend cover, even though that means accepting less yield. Thus, using the current year’s forecast earnings and dividends, the average payout ratio of the nine in the table is exactly 50 per cent (equivalent to dividends covered two times by earnings). However, remove from the mix the effect of warehouse operator Tritax EuroBox (EBOX), whose tax status requires it distributes almost all its net profit, and the ratio drops to 44 per cent.

So, for instance, there is Devro (DVO) from the food manufacturing sector. Time was when Devro’s status as a collagen maker made it a borderline pharmaceuticals stock with exciting growth prospects. Those days are long gone. Now it just makes sausage skins, which admittedly come in all shapes and sizes – edible, non-edible, mini plastics, gels; just don’t think about them when you tuck into bangers and mash. Meanwhile, the most recent time its share rating got into the high teens as a multiple of price to earnings was when profits slumped in the mid 2010s.

No matter. The latest word from Devro’s bosses is of decent trading and a promising outlook for 2022. Possibly the share price isn’t up with events, although that’s a tentative assessment since the price has been losing ground relative to the All-Share index since the summer. Yet encouraging numbers emerge from the spreadsheets I use to quickly estimate share values based on accounting profits or cash flow for the weighted average of the previous five years' trading. The estimated value of 242p per share in the table (20 per cent higher than the recent share price) is based on underlying accounting profit. True, capitalise average free cash flow and value looks thinner. On average Devro hasn’t been the greatest at turning accounting profits into cash and that’s not because it has been throwing money into capital spending. At least cash generation was much improved in 2019 and 2020. Meanwhile – and much more conventionally – if Devro makes the numbers that City analysts hope for from 2022 its shares trade on only 11 times earnings.

Others in the table with estimated value above their share price are Royal Dutch Shell (RDSB) – £17.49 of value against a £15.96 share price – and Johnson Matthey (JMAT) – £25.73 value against £19.63. Regular readers will know I have been agonising for weeks about whether to add a holding in Shell to the income portfolio ('Virtue now or later?', 5 November 2021). I am no nearer an answer and the 10 per cent gap between share price and value does not help – it offers insufficient margin for error. Besides, another gap is a concern – that between value suggested by accounting profit and value suggested by cash flow. It is only via Shell's comparatively steady generation of operating cash that excess value can be found.

Yet there is a catch. Falling levels of capital spending mean that comparatively big amounts of operating cash stream through to free cash. But declining capex, if it continues, will restrain Shell’s ability to create value in the future. It may therefore be a concern that the cash flow model coaxes no future value from Shell’s capex. Put simply, Shell does not invest enough – the group’s capital spending is consistently less than its annual charge for depreciating existing assets. True, the model is a bit contrived, but it may be telling us something.

Meanwhile, shares in Johnson Matthey come into the frame because their price has been so weak. Chiefly, that was caused by November’s news that the chemicals specialist is abandoning development of its high nickel cathode materials operation. For a group that generates approaching 40 per cent of operating profit from supplying catalysts for internal-combustion engines, an activity probably in irreversible decline, filling the gap with cathodes for the batteries that will power electric vehicles offered a wonderful symmetry. But no more. Johnson Matthey’s bosses decided the group was too small to compete in a capital-intensive industry whose output is fast shifting towards commodity status.

Thus, with some hope value blasted, its share price lost 24 per cent in November. Longer term, however, Johnson Matthey’s value has not necessarily changed much. Its ability to generate operating profit of comfortably over £500m a year is not diminished even if profit for 2021-22 will be depressed by familiar supply-chain issues in the automotive industry.

Granted, there is also the generic worry that a company’s bosses, having failed in one venture, will, by way of compensation, be encouraged to throw capital at another. That aside, it looks feasible to see the shares as a recovery play that comes with a decent amount of dividend yield; certainly, a notion to be examined.

Of the others in the table, shares in Tate & Lyle (TATE), Severfield (SFR) and Kingfisher (KGF) all sell a little above estimated value. That leaves van rental operator Redde Northgate (REDD), whose shares might be interesting at 18 per cent below value. But, most of all, it leaves tiles retailer Topps Tiles (TPT), whose stock might be a neat solution for the income portfolio since I sold it 16 months ago only because its dividends were suspended during the first, and toughest, of the Covid lockdowns. Now dividends are resumed and the prospective yield is more than enough (see Table 1).

The difficulty is reconciling two wildly contrasting values thrown up for Topps. Use average accounting profits as the driver and, owing to big losses in 2019-20 and a small profit the year before, there is next to no value –19p a share. Use cash flows, much bolstered by a major reduction in working capital in 2019-20, and the reverse is true – 149p per share. The share price sits around the middle at 68p.

Still, it is heartening that it wouldn’t take much profit to justify a value the same as the share price. Put it this way, back in each of 2016-17 and 2017-18 Topps generated about £25m operating profit. Given its current amount and cost of debt, how much operating profit would it need to get a value equal to its share price? About £12m would do it, which – give or take – is the level City analysts reckon Topps will make both this year and next. Worth a thought.

So, if that’s all there is, if that’s all London offers by way of yield stocks, maybe it’s not so bad. Or, at least, we have no choice but to make of it what we can. In the words of that great Leiber and Stoller song, “if that’s all there is my friends, then let’s keep dancing, Let’s break out the booze and have a ball”.

Meanwhile, Table 2 shows that the Bearbull Income Portfolio will distribute £12,989 in dividends for 2021, 24 per cent higher than 2020, with a second-half distribution 45 per cent higher than the previous second half. Still, let’s not get carried away. The payout is still the lowest since 2013 and 22 per cent below 2019’s distribution. In addition, the second half was helped a little by three dividends from Real Estate Credit Investments (RECI) – usually the third of those falls in January – and a lot by special dividends from Berkeley Group (BKG) and Anglo American (AAL). True, in 2022 beating 2021’s first half should be straightforward, but making an impression on the second half will be more demanding.