Eight low-risk, high-yield shares

Indeed, the most recent 12-month result marks the fifth year out of the seven years I’ve run the screen that the stocks selected have beaten the FTSE All-Share index.

ANNUAL LOW-RISK HIGH-YIELD RETURNS

Source: Thomson Datastream

What’s more, while it’s impossible to reject the argument that this could simply be down to luck, especially given the concentrated nature of stock selection, the margin by which this screen has beaten the index has certainly been impressive. The screen now boasts a cumulative total return over seven years of 218 per cent, or 186 per cent if I factor in a notional annual charge of 1.5 per cent to account for the cost of reshuffling portfolios. That compares handsomely with the 59.4 per cent total return from the index over the same period.

The performance of last year’s stock selection was particularly buoyed by two companies that received takeover offers during the period (Berendsen and Fidessa). What’s more, despite significant exposure to stocks exposed to the UK consumer (Next, S&U, Dunelm and Headlam), on aggregate these four shares slimly outperformed the index despite the marked trading difficulties that has beset this part of the market.

2017 PERFORMANCE

Source: Thomson Datastream

Targeting stocks with a low beta is a key reason for my inclusion of the words 'low risk' in the name of this screen (nb: take that description with a pinch of salt). A beta tracks how sensitive a stock is to wider market movements. Often a low beta is taken as a crude indication that a stock may possess defensive characteristics, although a quick glance at the stocks selected this year is likely to tell readers familiar with the UK market that plenty of 'cyclical' shares manage to pass this test. A low beta may also suggest a stock has other steady-and-stable characteristics, such as a strong balance sheet.

While 'beta' is a bit of a blunt measure, the screen attempts to make more use of it by lumping it in with an assessment of a company’s track record for dividend and earnings growth. Often a good indicator of a company’s ability to sustain and increase its dividend is simply the length of time it has grown the payout in the past. If nothing else, the dividend record often becomes something of a badge of honour for the boards of such companies, which are loath to cut the payout until the bitter end – this was the case with many commodity companies following the end of the so-called 'commodities super-cycle'.

The full screening criteria are:

■ A dividend yield of 3.5 per cent or more.

■ A one-year beta of 0.75 or less.

■ 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.

In total, eight FTSE All-Share stocks passed all the screen’s tests. These are detailed in the table below ordered from highest to lowest dividend yield. I’ve also taken a bit of a closer look at two of the higher-yielding stocks from the table.

2018 LOW-RISK, HIGH-YIELD STOCKS

Source: S&P Capital IQ

Go-Ahead

Bus and rail company Go-Ahead (GOG) is unlikely to make a reappearance in this screen’s selection next year. The reason for this is that both earnings and the dividend look like they have decisively stopped growing. However, while EPS is forecast to go into reverse, brokers are for the time being predicting that the dividend will be maintained. As a rule, not much faith should be put in dividend forecasts for companies that have seen a pronounced deterioration in trading. Indeed, just as companies with illustrious dividend record often stand by the payout long after the writing is on the wall, so brokers' predictions tend to mimic this belligerence. However, there are some more solid grounds for optimism about Go-Ahead’s payout based both on other aspects of the financial forecasts and the fact the company maintained its half-year payment.

Much of the recent pain experienced by Go-Ahead centres on the high-profile commuter nightmare associated with its Southern rail franchise. While profits will drop as a result, the company appears to be getting back onto a firmer footing and is focusing on protecting its core business while selectively bidding for new work and expanding overseas.

The half-year results in late February were a source of encouragement. While broker upgrades following the stronger-than-expected numbers were mainly due to one-off items associated with the sale of a rail franchise, there were also signs of improvement at its other rail and bus businesses. Perhaps, just as importantly, shareholders did not have to contend with any fresh bad news.

If this kind of trading is a taste of things to come, the dividend may well prove sustainable. The payout should have decent earnings cover this year of 1.8 times. In addition, given concern about the state of the rail industry, broker Liberum points out that non-rail-earnings cover stands at 1.3 times. And while EPS is forecast to fall in 2019, cover of a maintained dividend would still stand at a decent 1.6 times, with profits predicted to rebound the following year. Free-cash-flow (FCF) forecasts provide some encouragement, too. While the current year is expected to produce limited FCF due to necessary investments in the bus and rail businesses, 2019 FCF cover is forecast to be reasonably healthy thereafter (see table).

Source: Investec Securities

Some comfort can also be taken from the fact that adjusted net debt represents just one times cash profit. Adjusted net debt excludes cash balances tied up in the rail operations and restricted by the Department for Transport – this is not factored into the numbers in the main screen results table. That said, the company also has substantial operating lease liabilities, particularly in conection to its use of the rail network, which represent a form of financial 'gearing'. SharePad puts an estimated value on this lease liability of some £8bn.

Headlam

Floor covering specialist Headlam (HEAD) is feeling the impact of declining consumer spending in the UK. Having seen its UK like-for-like sales fall by 1 per cent in the second half of 2017, the trend worsened at the start of this year, with a 6.5 per cent like-for-like slide in January and a 5.6 per cent drop in February, with a slowdown in orders from a single large customer having a pronounced effect.

Admittedly, January and February are traditionally quiet months and the group’s results tend to be weighted towards the second half of the year. Still, the portents from the first two months of 2018 are nevertheless a concern. Trading is much stronger in continental Europe but this is of limited comfort given the region last year only accounted for 14 per cent of sales and 3 per cent of profit, with all the rest coming from the UK.

The shares may struggle to make ground while concerns about the domestic market linger. Indeed, the cyclical nature of the business and the relatively low operating margins means a serious economic downturn would be likely to present serious problems for both profits and the dividend. However, without a worsening of the recent downturn in trading, dividend prospects do not look too bad. In fact, even as the company reported on the weak start to the year, it unveiled a 10 per cent hike in its payout, supported by a 34 per cent rise in free cash flow (FCF) to £41m – a 116 per cent conversion rate. FCF conversion is likely to drop substantially in the next two years as the group invests £24m in the delayed development of a distribution centre in Ipswich, which should improve its national distribution network and aid growth prospects.

However, should trading hold up, Headlams' eye-catching cash pile means it is well positioned to invest in the business without endangering the dividend. The company has also been active, making acquisitions to boost growth (three last year and one so far this year). And while operating margins may be relatively slim at 6.2 per cent, Headlam has been making efficiency improvements to support its underlying profitability. The focus on defending margins may be part of the reason for the recent fall-off in sales.