Safe yields find safety in numbers

While some may rely on the superiority of their insight and analysis to steer clear of these dangers, a more humble approach is to seek protection through diversification. The results from last year’s Safe Yield screen is a case in point.

Last year I provided two different takes on the screen's results. One highlighted the shares that passed all the screen’s criteria, a number of which turned out to be value traps and none outperformed the market. However, I also highlighted a bigger selection of shares based on a weakened criteria that I’d used to boost results during some fallow years for the screen, and had worked well in the past. The increased diversification of the larger selection really boosted the performance of the screen, or at least diluted the pain caused by the value traps in the more concentrated portfolio. In all, the concentrated portfolio produced a negative total return of 11.3 per cent, while the more diverse portfolio registered a negative 2.1 per cent. Both were much worse than the total return from the FTSE All-Share, which was a positive 7.5 per cent.

2017 performance

Source: Thomson Datastream

While this screen’s approach of looking for a solid track record and low share price volatility compared with the wider market (low beta) can give a rough-and-ready indication that a share may be relatively 'safe', it is far from a guarantee. Arguably, it is especially difficult for this screen to separate the wheat from the chaff following a long bull run and lengthy economic recovery, when many risky cyclical shares on paper boast credentials that make them look like dependable defensives. Hopefully the two stock write-ups accompanying this year’s screen help illustrate some of the risks that the screen finds hard to spot.

Over the seven years I’ve run this screen it boasts a cumulative total return of 125 per cent (this is calculated using performance from last year’s concentrated portfolio, which was worse than the larger portfolio) compared with 77 per cent from the FTSE All-Share, which is the index the screen is conducted on. If I factor in a 1.5 per cent annual charge to reflect dealing costs (this column presumes the screens are primarily of interest as a source of ideas rather than off-the-shelf portfolios) the total return drops to 103 per cent.

The criteria used by the Safe Yield screen is outlined below. Only four shares passed all the tests this year, with a further 23 passing on weakened criteria which allows them to fail one test as long as it is not the dividend-yield test. All the stocks are listed in the tables below, along with some fundamental data and I’ve taken a closer look at two of the shares that passed all the tests.

■ Dividend yield of at least 3 per cent.

■ Dividend cover of at least two times.

■ Interest cover of at least five times.

■ Dividend growth in each of the past three years.

■ Forecast earnings growth in each of the next two financial years.

■ An average return on equity over the past three years of at least 12.5 per cent.

■ Cash conversion (measured as cash from operations as a percentage of operating profit) of over 100 per cent.

■ A market capitalisation of at least £250m.

■ Beta of 0.75 or less.

Source: S&P Capital IQ

Costain

For those looking for 'safe' income, recent memories of the demise of Carillion may be enough to disregard a sector peer such as Costain (COST). Indeed, the infrastructure specialist operated two joint ventures with Carillion at the time of the latter group’s collapse, although these projects have continued with minimal disruption as Costain has taken on a larger share. And like other construction sector peers, Costain takes on large, complex, long-term contracts on which it earns relatively low margins while carrying noteworthy balance sheet risk.

However, Costain’s financial position offers some grounds for encouragement for investors enticed by the group’s commitment to a progressive dividend policy based on two times underlying earnings cover. Two noteworthy balance sheet developments last year were a jump in average month-end net cash from £69m to £97m and a collapse in the pension deficit from £60m to £19m. That said, brokers forecast a temporary slump in free cash flow (FCF) next year and pension contributions of £9.6m plus a dividend-linked top-up are currently scheduled until 2031.

Another encouraging sign from last year’s accounts is that the group needed to make minimal adjustments for a change to accounting rules dictating how revenue from long-term contracts is recognised. A number of companies that have recently run into difficulties, such as Capita, have had to make marked adjustments to account for this accounting change.

Meanwhile, although group margins may be low, which is typical for the industry, they are expected to rise in coming years. A key reason for this is a recovery in the profitability of the natural resources operation (one-fifth of sales and 8 per cent of profit), which broker Liberum expects to increase margins from 1.9 per cent last year to 3.1 per cent come 2020.

The profitability of the group’s infrastructure business, along with its ability to win work, may also be boosted by the group’s focus on technology. Over the three years to the end of 2017 there has been a threefold increase in Costain’s technology and consultancy headcount, which by the end of last year stood at 1,300. And the group has been winning significant contracts that employ technology to improve infrastructure performance, such as the M6 smart motorways contract.

In the aftermath of Carillion’s collapse, Costain may also benefit from the government adopting a more rounded approach to its relationship with contractors. There should also be work to pick up from the re-tendering of Carillion’s contracts. So while Costain by its nature may not be the safest of 'safe yield' shares, there are reasons for optimism. Indeed, a reflection of how differently it is viewed by investors to Carillion is the fact that there is currently no short interest in the shares compared with over 25 per cent at Carillion prior to the rot really setting in.

RPC

Shares in European plastics giant RPC (RPC) have had a tough few years. The earnings multiple commanded by the shares has de-rated by 43 per cent (based on Bloomberg consensus next 12 months forecast), while the company has experienced a 35 per cent de-rating based on enterprise value/forecast cash profits (EV/Fwd Ebitda), and the dividend yield has almost doubled.

The curious thing about this de-rating is that it has been based on both a falling share price and also marked increases in forecast earnings and dividends. Indeed, brokers have spent the past two years substantially upgrading EPS forecasts. Earnings expectations for the current year are 25 per cent above where they were two years ago and expectations for the following year are 27 per cent ahead. While this upgrade cycle has slowed markedly in the past 12 months, normally such upgrades prompt share ratings to move upwards and definitely not fall, as has been the case with RPC (n.b. the numbers in the accompanying table are from a different source to the numbers in the graph below).

So what’s going on? An increase in short interest from zero at the start of October last year to 8.1 per cent now – making RPC the 11th most shorted of the 587 shares monitored by Castellain Capital’s short tracker – suggests there are grounds for concern.

There appear to be two main causes of anxiety. Firstly, RPC has been trying to play a leading role in the consolidation of the European plastic packaging industry. Indeed, the earnings upgrades over the past two years can principally be attributed to a spate of significant acquisitions that were part-funded by the sale of new shares. However, investors became spooked by the pace of acquisitions and those concerns were exacerbated by a report from investment firm Northern Trust in March last year. The report suggested RPC’s deal frenzy may be disguising an underlying deterioration in its business due to weak pricing power and rising costs. The report also accused RPC of very aggressive accounting policies including inconsistent definition of adjusted profits and free cash flows.

These worries have since been aggravated by weaker-than-expected free cash generation, although this can partly be explained by management targeting higher growth. What’s more, the conduct committee of the Financial Reporting Council has requested clarification on a range of accounting policies, including alternative performance measures, cash flow statement, provisions, judgments and estimates, and operating segments. The group says it has satisfied the regulator on most of its enquiries, but it has also had to provide additional information on some subjects.

The second concern for investors is based on a clampdown on the use of single-use plastic packaging by the EU and a hardening in attitude towards plastic waste in general. That said, RPC has assured investors it “does not manufacture any of the items that will be restricted under the proposed EU directive”. There is also the possibility that its scale will allow it to play a leading role in the development of greener packaging solutions, potentially resulting in a stronger competitive position and the opportunity to buy smaller rivals struggling to keep up with new regulation.

In all, RPC looks like something of a contrarian gamble. The pace of acquisition has slowed substantially and the shares’ low rating means rights issues to fund deals look unlikely. The company has also said it is looking to fund any further deals, or alternatively shareholder returns, with disposals of non-core businesses and its own cash generation. If negative sentiment dissipates, the de-rating of the last two years gives the shares the potential for major gains. However, as illustrated by the marked rise in short interest, 'safe' RPC is not.