Nine high-yield low-risk stocks

When we last visited the screen, in our December round-up of 2021, it was flying high. With last year’s picks up 14 per cent, the screen had at that point delivered a more than fourfold total return over its life – beating the S&P 500 and all but a thin selection of individual UK shares in the process. That outperformance remained true even when a 1.5 per cent annual dealing charge is factored in, making this dull-and-steady approach to stock selection an excellent driver of long-term gains.

However, by 24 March the screen was in the red over one year, after being laid low by its exposure to two companies engulfed by Russia’s invasion of Ukraine and subsequent sanctions. Strip out those two stocks – iron ore producer Ferrexpo (FXPO) and gold miner Polymetal International (POLY) – and the picks would have returned 16 per cent on average over the period.

As it was, the selections posted a 2 per cent negative total return, against a rise of 10 per cent in the FTSE All-Share. It was the fourth time the Low-Risk High-Yield screen lagged the index in 11 outings, and only the second time it had posted an absolute negative return.

Of course, half of the point of a dispassionate stockpicking methodology is to stand by its selections, including the ones which turn sour. But the results of last year’s picks also emphasise the concentration risk of a screen that whittles down more than 600 stocks to just nine, even when some rules are relaxed.

This is an important point, which bears repeating. One reason we often say readers should think of stock screens as a prompt for further ideas and research – as opposed to readymade, off-the-shelf portfolios – is that the number of stocks in a portfolio matters to performance.

By most measures, a nine-stock equity portfolio is both high conviction and higher risk than a broader index tracker, even when it is based on nominally low-risk criteria. And while the long-term maximum drawdown from the Low-Risk High-Yield screen remains below that of its benchmark, the 2021 picks show that it only takes a couple of bad apples to upset the apple cart. Or in this case, one geopolitical event and a couple of badly exposed miners.

Should a stock-picking method which claims to be low risk avoid such hiccups? In short, yes, and in fact this is what the screen is designed to do. One of its 10 tests – a beta of 0.75 or below – means only companies whose recent trading history has been less volatile than the market can be admitted. But last year, as in previous years, we allowed passing stocks to fail one test. Of the two picks whose beta exceeded 0.75, one returned 50 per cent and another posted a 48 per cent loss.

In the interests of widening the screen’s picks, we have allowed one test to be failed this year, too. This means that six of our nine stocks for 2022 have a beta above 0.75. With an average rating of 1.34, the group is theoretically 34 per cent more volatile than its benchmark. Suddenly, the price for companies displaying long-term consistency – one of the core goals of the screen – is extra risk.

Testing times

As some companies continue to limp back onto the dividend list in 2021, I have kept last year’s other major tweak – which looked for a forecast yield at least as high as the index median – rather than mandating a historic dividend yield of at least 3.5 per cent. Despite this, each pick has a forecast yield of at least 3.2 per cent, and a combined average of 6.1 per cent, roughly double the index.

As in previous years, stocks failing one of the 10 tests made the cut, and details of the tests failed are given in the accompanying table. The criteria are:

■ A forecast dividend yield for the next 12 months above the median average for dividend-paying shares (the 'high yield' test).

■ A one-year beta of 0.75 or less (the 'low risk' test).

■ 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.

This year only one company, the suddenly-in-vogue defence giant BAE Systems (BA), passed all 10 tests. Eight passed all but one.

Within this cohort is Ferrexpo (FXPO), one of the two big losers from our 2021 screen. In ordinary circumstances, nothing should prevent the stock’s reappearance, given that – as noted above – it only failed the ‘beta’ test. But deciding to include the Ukraine-based iron ore pellet producer in this year’s picks took some consideration, in part because the huge uncertainty around the group’s near-term future raises questions of brokers’ faith in their dividend forecasts.

The decision by several analysts to suspend their coverage of the stock is testament to its inherent riskiness, as does a beta of 3.3 (meaning it is three times as volatile as the FTSE All-Share, and the fifth most volatile stock in the entire index).

However, Ferrexpo shares continue to trade, the company continues to operate (albeit at likely reduced capacity, surrounded by war and with export routes heavily curtailed) and analysts continue to forecast a full-year dividend of 26p.

That might seem either fanciful or deluded, given the need for all Ukrainian companies to preserve cash even in a best-case scenario in which the war ends in the coming days or weeks. But weighing those odds feels like an exercise in risk analysis, which is beyond the remit of the Low-Risk High-Yield screen. Perhaps it also one of its flaws. In the interest of balance, Ferrexpo has been left in.

Details of all the other stocks are available in the table, one of which is profiled in greater depth below. A more detailed set of fundamentals can also be found in the the downloadable Excel version of the table here:

Source: FactSet, * FX converted to £

Burberry

The shares of luxury goods companies are sometimes held up as a useful hedge to volatile markets. Not only do high-end fashion houses benefit from customer bases whose spending patterns are less sensitive to economic ups and downs and broad-based consumer sentiment, but branding power is often wielded as a proxy for pricing power. When markets are inflationary as well as volatile, this can provide an extra layer of defensiveness

The long-term trading history of Burberry (BRBY), however, looks anything but low risk. During the financial crisis, its stock plummeted more than 70 per cent. In 2015, there was another sell off amid a downturn in its by then core Asia-Pacific market and concerns around tourism following a spate of terror attacks in Europe. Five years on, Covid-19 showed that even the wealthy stop shopping when everyone is forced to remain inside.

In the past month, lockdowns in China and an unravelling outlook for global travel have once again sent the stock into a tailspin. Within two weeks of the invasion of Ukraine, Burberry shares had fallen 25 per cent.

Before that point, sentiment had been rebuilding. In a third-quarter trading update at the end of January, the group reported a 26 per cent rise in full-price sales compared with two years ago – thanks to strong trading in the Americas region and big improvements elsewhere. With just a few weeks left in its financial year, Burberry was confidently predicting a 35 per cent hike in underlying operating profit.

This doesn’t mean trading is racing away. By the company’s own estimate, tourism contributed to two fifths of revenue across Europe, the Middle East, India and Africa before the onset of the pandemic, meaning a sales gap is likely to persist until the international jet set returns en masse.

In other words, while the in-tray of newly installed chief executive Jonathan Akeroyd looks full, the forces that will determine Burberry’s share price over the coming year are largely beyond his control. Still, brand power remains one asset over which management exercises considerable discretion, and here recent moves have been instructive: in a bid to maintain scarcity and exclusivity over volume-focused discounting, Burberry recently reduced the amount of stock it marks down.

To analysts at RBC, the stock’s current valuation implies investors expect zero like-for-like sales growth over the next two years. By contrast, their base case is for sales to rise 6 per cent in both FY2023 and FY2024, and for a 49-basis point expansion in the gross margin year-over-year.

That would mean the stock is priced at 16 times forward earnings, compared to a 10-year average multiple of 21 – which is where RBC believes the stock should trade. “The coming months/quarters should provide longer duration investors attractive entry points into high quality consumer companies,” the brokerage concludes.

The past decade was marked by many things, including negligible interest rates, low inflation across wealthy economies, and relative peace in Europe. Whether that period mirrors the current appetite for risk assets is for the market to determine. But what felt low-risk yesterday could well turn out to be tomorrow’s headache.