Eight high-yield shares hoping for low risk

What constitutes risk for this screen, and for CAPM theoreticians, is something called beta. This simply measures the volatility of a stock relative to a relevant index. The higher the beta, the riskier the stock. My high-yield low-risk screen looks for shares with relatively high yields and low betas that also pass several other tests that suggest good dividend paying credentials. The full criteria are:

■ A dividend yield of 3.5 per cent or more (the 'high yield' test).

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

■ Ten years of unbroken dividend payments.

■ Ten 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.

Last year the stocks selected by the screen disappointed on the whole, delivering a 1.1 per cent total return, which was well behind the 8.8 per cent from the FTSE All-Share index. However, over the full eight years I’ve run this screen, the outcome has been a lot more impressive. Since March 2011 the cumulative total return of 227 per cent compares with 76.5 per cent from the index. If I take the important step of factoring in a notional annual dealing charge of 1.5 per cent (the screens run in this column are regarded as primarily a source of ideas for further research rather than off-the-shelf portfolios) the total return falls to 190 per cent.

2018 performance

Only two stocks passed all the screen’s tests this year. To bulk up the numbers, I’ve also included stocks that passed the key high yield and low risk tests but failed on one of the other eight criteria. This gives me another six stocks. Details of any tests failed are included in the accompanying table. Another aspect to note about the table is that Admiral’s dividend yield includes a special payment. Its basic yield comes in at 4.1 per cent.

By no means all the stocks highlighted by the screen look low risk to me. I’ve taken a closer look at one of the stocks that looks a riskier dividend play: Mears. Indeed, if anything Mears (MER) looks more interesting as a risky contrarian investment based on its low valuation, the withdrawal of competition from its troubled sector, and plans to wind down certain capital-hungry activities.

Mears (MER)

It’s a worry for income investors when companies start to talk about the need to focus on debt reduction. That’s what social housing and care services firm Mears did when it released its full-year results last month. While year-end net debt may not look too bad (see table), average net debt during the year of £113m was above the £110m target. What’s more, this needs to be seen in context of the group’s heavy reliance on renting assets. The concerns of income investors are also likely to be raised by the fact the company resorted to a share placing to fund a recent acquisition; £22.5m was raised at 331.5p in November to buy Mitie’s property management operation. And while it may be tempting to focus on the 3 per cent increase to the 2018 dividend that Mears pushed through last month, other aspects of its full-year results were much less reassuring, especially the performance of its development business.

As a provider of housing and care services to local authorities and housing associations, Mears seems an unlikely victim of the downturn in the market for private-home sales. However, this was the key reason its development business caused a massive drain on cash in 2018. The dire performance also highlighted the division’s outsized high working capital needs compared with an underlying operating profit that represented just 3 per cent of the group total.

The problem at the division stems from the fact that most social housing developments give a proportion of plots over to private sales to help fund the scheme. Unlike the other homes it build, Mears tends to fund the building of private homes up to the point of sale. This meant a slowdown in private sales during 2018, particularly in the final quarter, led to a surge in debtors (amounts owed to Mears) and inventory levels. Coupled with the rest of Mears’ divisions paying bills more quickly, this meant a reported operating profit of £30.8m translated into just £1.6m of cash from operations before tax. No wonder the company’s new chairman found that the two-thirds of shareholders he met prior to the results being released were anxious about debt and cash generation.

The good news is the company believes its development activities will not be a drain on capital this year and may generate modest cash inflows. What’s more, Mears is now looking to wind down these activities over the next three years – something that contributed to cuts in broker earnings forecasts for the current year. Mears also plans to wind down its £30m property-acquisition facility, which since being set up in 2017, has been used to finance the early stages of contracts prior to securing longer-term funding partners.

While the financial logic of winding down these risky operations is convincing, management faces a balancing act in doing so. Mears’ contracts often intermingle these development and property-acquisition services with more lucrative property maintenance and management work. The question is, will clients still find the maintenance and management offering as compelling when they’re not being offered the use of Mears’ balance sheet to kick start projects? This question is particularly salient because Mears has a very busy period of re-bidding ahead of it in 2019 with contracts with an annual value of £115m up for renewal in both 2020 and 2021.

Rebids are already happening against a backdrop of increased public sector in-sourcing; given added impetus by the collapse of Carillion. And investors’ nerves are also unlikely to be soothed by the fact that over the past two years the contract win rate at the housing division (87 per cent of sales and 91 per cent of profit) has been below the historical norm.

However, it’s not all doom and gloom. Mears is considering looking for a financing partner that could help plug any funding gaps. Meanwhile, customer satisfaction is generally high and the order book finished 2018 ahead by 23 per cent at £3.2bn. Margins have also jumped at its care business after efforts to exit problem contracts.

What could also prove significant is the potential for problems at major rivals to reduce competition and ultimately boost returns. While Mears’ services are blue collar and therefore relatively low margin, as a market leader it should benefit. “I think the important thing is that Mears has much more capability and breadth than anyone else in the market,” says Liberum analyst Joe Brent.

There are also signs that the danger of contractor failure (ie, Carillion) is already leading to more accommodative contract terms. An example of this can be found in Mears’ biggest ever contract win: a £1bn, 10-year contract with the Home Office to house asylum seekers won in January. This parks volume risks with the client and provides a more equitable reward/penalty split. The contract is expected to generate Mears £100m of sales in 2020 and achieve a 6 per cent margin. That said, while the contract does draw on Mears’ core skills, its complexity means successful deployment should definitely not be taken for granted.

The risks faced by Mears are too great for its shares to represent a good bet for investors that want secure income (the type of situation this screen aims to identify). Cutting the dividend would seem a straightforward remedy to any further balance sheet strain: should there be a further nasty turn from the development business; should significant rebids prove unsuccessful; or should deployment of the asylum contract go awry.

That said, the shares’ low valuation, reduced competition, and plans wind down low-profit, capital-hungry operations, means an intriguing contrarian angle exists. Here, the ideal scenario would be a year of successful rebids in 2019 accompanied by a pick-up in private sales to release cash from the development business. The dream scenario would then see a 2020 sales and profit boost as the complex asylum contract successfully hit its stride, coinciding with the release of more capital as the development arm and property acquisition facility were wound down. The icing on the cake in 2020 would be significant order wins from a large Ministry of Defence (MoD) contract that’s due to be awarded that spring; this is now a key bidding focus for Mears which management has expressed optimism about.

This is a pretty good contrarian investment case, but only for investors with a healthy appetite for risk. Until there are clearer signs that such a scenario is playing out, the shares feel something of a punt. The extent of disappointments over recent years means the shares may prove slow to move even if positive signs do start to emerge.