Three safe-yield buys

2016 PERFORMANCE

BUY-AND-HOLD PERFORMANCE OF SAFE YIELD SCREENS

Source: Thomson Datastream

Looking at the annualised buy-and-hold performance of the screens run in each of the past six years relative to the FTSE All-Share (see chart), buy-and-hold has been superior to the strategy of jumping from one safe yield portfolio to the next on the date of publication about half the time. The chart shows annualised numbers for both the raw cumulative performance and the performance once an annual charge of 1.5 per cent is factored in to represent the notional sharedealing cost associated with backing a new set of screen results each year.

Safe yields, buy-and-hold annualised out/underperformance

All in all, the cumulative performance of the screen looks good, although not as good as the result from simply holding the original six share picks from the 2011 screen and reinvesting all the income. The 2011 shares were John Menzies, Clarkson, Cranswick, Hiscox, AstraZeneca and Beazley, which between them have managed a 244 per cent total return. The total return from the safe-yield strategy from switching between portfolios each year stands at 151 per cent over the six years, compared with 63.2 per cent from the index or 129 per cent after factoring in the 1.5 per cent charge.

Safe-yield vs FTSE All-Share

My main concern - aside from the role of luck - with the screen’s ability to sustain its strong run is the same as it was last year; namely, the potential end of the low interest-rate environment that has increased the attraction of reliable high-yielding shares. On this front, some comfort can be taken from recent signs that the Federal Reserve could soften its stance on monetary tightening due to persistently weak inflation data, especially wage inflation. However, valuations for the market as a whole are very high by historic standards, so there remain reasons to be worried. That said, an average forward earnings multiple for the six stocks passing all the screen’s tests is relatively modest at 14.

The screen itself is not that imaginative. It looks for a decent dividend that looks well supported by fundamentals and appears to offer growth prospects. It also looks for stocks with low betas, which is a measure of how sensitive a share price has historically been to wider market movements. A low beta is often regarded as an indicator that a company’s business may have defensive qualities – ie, be less sensitive to the economic cycle.

■ 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.

For the first time in a few years, a reasonable number of shares (six) have passed all the screens tests. However, along with a table detailing these fully-fledged safe yield shares, I’ve included a supplementary table of companies passing the weakened test critieria resorted to in previous years (dividend yield test and all but one of the screens other tests) as these stocks have not done too badly in past periods. The shares are ordered based on a combined ranking measuring their attractiveness for yield and forecast earnings growth. I’ve also taken a closer look at three of the six shares that pass all the screen’s tests.

SAFE YIELD SHARES

Full Marks

Nearly-there

Source: S&P Capital IQ

Telecom Plus

Over recent years Telecom Plus (TEP) has struggled to grow its business, but it has not struggled to pay its dividend. Despite expectations of muted profit growth in the financial year to the end of March 2018, the company has stated that it intends to lift its dividend payout to 50p, equivalent to a 4.6 per cent yield.

Telecom Plus operates a buyers club for its customers that tries to get them a better deal on a range of bills. The biggest part of the business is energy and this is where the company has run into problems. Having locked in a long-term deal to keep prices below those set by the big six, it has seen new entrants to the market undercut its offers as they’ve attempted to exploit falling wholesale prices. However, a number of these companies have started to struggle and prices are heading back up, which should make it easier for Telecom Plus to compete and win more business.

While waiting for the energy market to get back to a more 'normal' state, Telecom Plus has been busy trying to find ways to pep up growth. It has changed the way it incentivises distributors which is expected to weigh on profits this year, but has led to more customers taking on more of its five established services (gas, electricity, mobile, broadband and landline). The more services customers take, the more profitable they are and the longer they tend to stay with the company. Telecom Plus has also been looking at new markets to move into and has recently entered home insurance. It has also reduced its plans to return cash following the sale of a subsidiary from £70m to £25m to give itself more firepower to pursue opportunities.

The balance sheet is strong and the dividend is supported by solid cash generation. While the earnings multiple does not scream value, the yield should provide good support for the share price, and if customers start flocking to the company once more, there could be good upside.

Last IC View: Buy, 1,227p, 14 June 2017.

Playtech

If a lack of customer growth is a key reason behind the attractive dividend yield on offer from Telecom Plus, the same cannot be said of safe-yield share pick Playtech (PTEC). However, while the net cash position and current strong trading mean the yield looks well underpinned, some readers are likely – for good reason – to take issue with the tag 'safe' being applied to this company.

Israeli gaming technology provider Playtech is benefiting from growth in its end markets and is also expanding through acquisition. The strategy has served it well, but the shares’ rating hardly reflects the growth on offer. The key reason for this is that there are aspects to the business that make investors uneasy. The gambling business, which represents over 90 per cent of revenue, serves many unregulated markets. The possibility that new, tough gambling laws will be introduced in these jurisdictions creates uncertainty about revenues. Meanwhile, the group’s move into the contracts for difference (CFD) market has been overshadowed by the Financial Conduct Authority (FCA) desire to clamp down on the practices of this industry, where investors run the risk of making potentially ruinous losses in ultra-quick time.

However, Playtech continues to increase the proportion of its gambling sales that are regulated and it has the scale and experience to make the best of any new rules that are introduced. Management believes the changes in the CFD market could play to its advantage by creating new barriers to entry to smaller operators. Again, its scale and experience in handling compliance should play to its advantage. In fact, smaller rivals that struggle to adapt to new regulations could prove good pickings for acquisition.

The shares are priced on an earnings multiple that is below that of peers. While the risk factors go some way towards helping explain this, such concerns should be countered to some extent by the fact that contracts with nine out of 10 of its current technology licensees are long term, and the group has a wide geographic spread. What’s more, a problem contract with Sun Bingo has recently been performing better than brokers had expected, which provides some additional reassurance.

Last IC View: Buy, 886p, 23 February 2017.

Inchcape

Not all that long ago car dealers were basking in the glory of soaring new car sales and the prospect of a boost to higher-margin aftersales work further down the line. But the mood has changed to one of trepidation in recent years. The financing deals that helped boost high car sales, so-called PCP arrangements, are now seen as a potential risk to both the lending and car industries.

PCP loans work by providing financing for a car purchase with the guarantee that the vehicle can be sold back at an agreed minimum price later. Historically, cars have usually been sold back above the minimum, which provides a nice downpayment for a spanking new set of wheels funded with a new personal contract purchase (PCP). The fear is that the popularity of these deals is leading to a glut of nearly new cars, falling prices, losses for those holding PCP loans backed by questionable collateral, and ultimately an unseemly end to the party.

While this gloomy scenario has the potential to hit both Inchcape’s (INCH) new and used car businesses, the group should be somewhat protected from any fallout by its international diversification. That said, there are grounds to worry that its most recent international foray could cause headaches. Last December it paid £234m for a large dealership chain in South America. At the time, general expectations for an ongoing recovery in commodity prices were higher than they are today and the link between the region’s economies and commodities means the acquired business may face tougher than expected trading.

All these worries aside, though, the group’s most recent trading update in March was encouraging and led to modest analyst upgrades.

Last IC View: Buy, 796p, 9 Mar 2017