Dividend hugging in harsh times

Throughout Friday, the azure blue sky above Brisbane was marred by the criss-cross pattern of contrails, as investors panicked and took the first flights to safety they could find.  Gold was a popular holiday spot, whilst Equityville and Commodity City were deserted come close of business.

And really, who can blame them?  This graph shows the % change in the ASX200 since the start of the year.

Not inspiring stuff for any buy and hold investor (although a welcome sight for traders and cashed-up value investors).  Given the US and EU are in a competition for political ineptitude, most people (your blogger included) believe things will only get worse before they get better on the sovereign debt front .

At times like this, those still brave enough to invest in equities often start looking for stocks with high dividend yields.  These should become more numerous as stock prices continue to drop, however there’s a couple of traps in this strategy:

  1. The price drops that create the high dividend yields often happen for a reason (I bet ABC Learning had a decent dividend yield towards to end).
  2. Yeilds are typically quoted “backwards” looking – i.e. they based on the last full year dividends, at best on the next lot of forecasted dividends.  Companies will (and often should) cut dividends when times get tough and earnings drop, so that high dividend yield may disappear come the next reporting season.
  3. A high yield doesn’t mean continued good returns – if the company’s return on equity (ROE) is below your required return as an investor, then in the long run it will provide a below-par return on your invested capital.

The following are three examples of dividend-yield traps (yield as of 19/8/11, including all dividends paid but not including franking credits)

Lemarne Corporation (LMC), yield 35%: LMC owns a single electronics manufacturing business in Malaysia.  Although now debt-free, its ROE has dropped from above 30% to 12% over the last 5 years and it no longer franks any dividends.  Having a single operation in Malaysia also exposes it to the MYR/AUD forex movements – not exactly an electrifying investment.

Vision Group (VGH), dividend yield 55%: VGH one of the largest providers of private ophthalmic services in Australia.  It is also heavily indebted, recently closed practices in Rockhampton, Hervey Bay and Bundaberg and posted a loss last year equivalent to 40% of equity.  A dividend yield stock for the short-sighted.

Infigen Energy (IFN), dividend yield 44%: IFN develops, maintains and manages wind energy assets in America, Europe and the Asia Pacific. Another heavily indebted company that has posted losses for three of the past 5 years, with positive years producing paltry ROEs of 1.7% and 2.7%.  Also at risk of Don Quixote puns.

Avoiding the Traps

The best way to avoid the traps is to apply a few fundamental investing filters.  I’d look for companies with:

  • A consistent (or increasing) ROE that’s above my required return (15%)
  • Manageable debt
  • No recent, major setbacks (and subsequent price drops)
  • Not in a sector facing serious challenges (e.g. retail)
  • Not dependent upon commodity prices

Using these criteria, I’ve chosen 5 high-yield (+7%) stocks that the dividend huggers might want to get cosy with.

Telstra – 9.0% yield, ROE 30%, net debt at 3 x NPAT

Telstra – the former government-owned come quasi-private monopoly telco – has been a perennial “Mum and Dad” stock and dividend-hugger staple for a decade.  The Prince and I have railed against it as a dividend trap previously (see here and here), however the NBN has been a game changer.  The current agreement will shower TLS with billions of dollars of cash for the next 30 years in exchange for their network assets.  If they choose to distribute this cash stream to shareholders, then TLS will become a service-only telco with a nice annuity stream attached to it.  The dividend-huggers delight.

Infomedia Ltd (IFN) – 11.7% yield, ROE 27%, no debt

IFM provides electronic parts catalogue and data management systems for the automobile industry. Infomedia has headquarters in Sydney and support centres in Australia, Europe, Japan, China, Latin America and North America.

I know very little about IFM (a contender for this week’s Equities Spotight maybe), however their raw numbers look good and they sell their systems to some 160 countries worldwide.  They are exposed to forex movements due to their overseas operations; however this small-cap may be a decent dividend yielding stock.

Melbourne IT Ltd (MLB) – yield 9.1%, ROE 18%, net debt covered by 1.5 NPAT

MLB is an online solutions provider, focusing on professional consulting and corporate domain name management services to business.  Despite exposure to forex movements, MLB services division still seems to be signing new business.  Debt was reduced over the year, although intangibles were still very high (not unexpected for an internet-based business).  Once again. A business with solid fundamental numbers.

Equity Trustees Limited (EQT) – yield 9.1%, ROE 15%, no debt

EQT is a financial services company that provides private client, trustee, estate administration and funds management services.  First half FY11 revenues and NPAT were up and the latest guidance was for more improvement in the latter half.  ROE has been solid for several years and the company has no debt.

Supply Network limited (SNL) – yield 12.1%, ROE 14%, net debt less than 1 x NPAT

SNL is the listed holding company of a group of related entities dealing in the importation, distribution and sale of after-market parts to the commercial vehicle industry.  Their operations are spread throughout Australian and NZ.  Revenues in both NZ and Australia increased last year – an impressive feat given the troubles both economies have been facing.  ROE has been decent and debt levels are quite low.

Those that didn’t make the cut

To be honest, finding decent high-yield stocks was quite a challenge.  Most of them had low ROE, high debt or were high yielding only because of a large price drop.  There were also some well-known stocks that I discarded because of their sectors – Myers and David Jones in the retail sector and Mortgage Choice and Devine in property.  For similar reasons, I didn’t include any of the big 4 banks because their traditional revenue well – ever-growing mortgage numbers – has run dry.  Tabcorp and Tatts almost made the cut, but uncertainty surrounding recent demergers, government licensing and high debt saw them axed.

Is dividend hugging the best strategy?

Personally, I am not a fan of chasing dividends.  For a value investor, dividends only tell part of the story.  Capital growth (i.e. reinvestment of profits) is important as it can compound the size of future dividends.  The split between reinvestment and dividend distributions is also important from a capital management perspective – high ROE companies with growth opportunities would be better retaining profits than distributing them and vice versa.  And of course, as I always bang on about, ROE is the best indicator of a company’s performance.

Don’t get me wrong – dividends are important, but they will be accounted for in any decent intrinsic value calculation.  If I can find a high-dividend stock with a consistent 20% ROE that distributes all its earnings, I’ll be first in line at the share registry.  However, chasing a stock for its dividend yeild – without considering all the other financial elements of the company – can be fraught with danger.  Choose the right stock and you’ll have a good annuity-like investment.  Choose the wrong one, and you’ll end up with a sub-par investment.

Hugger beware.

Comments

  1. Thanks for this.

    I’m no expert, but doesn’t the payout ratio need to be considered? Telstra and Equities Trustees Limited both have payout ratios in excess of 100%, at 107% and 115% respectively. Is this sustainable?

    • Sure does Pantone – and no, none f those examples are sustainable as it eats into the equity base. As I stated, the split between reinvestment and dividend distributions is important from a capital management perspective. When companies go distributing more than they earn you have to start asking what their drivers are. Are they trying to increase share prices by paying unsustainable dividends? Or are they just giving the “market” what they think it wants, less the share price gets killed? Either ways, not the best capital management strategy in most cases.

  2. Sandgroper Sceptic

    Good to see you are coming around on Telstra. It is definitely not a “Wonderful” company but the pessimism surrounding its propsects mean the share price reflects reasonable value and as you say there is potentially some upside from the NBN. It has outperformed cash since I bought it in my SMSF in 2009 (about 10% pa factoring in franking credits).

    • Only if they choose to give it back to shareholders Sandy. If they on-sell it to some super or managed fund, then go about investing it in their usual manner, I’ll change my tune.

  3. ROE in a company isn’t everything to an investor.

    Take AEU as an example. ROE isn’t flash at all.

    Now, lets look at it as an investment in the underlying assets. In this case, property, via the 330+ child minding centres in Aus and NZ which are leased for 10+ years with CPI adjustments. Oh yeah, AEU has an LVR of 40%…not too bad and about average for REITS.

    So, here’s the value equation:

    For 85c you get an NTA of $1.19 and a 9c pa distribution which is paid quarterly.

    Think about the security. This business model isn’t going away. In fact it has govt and society protection status. And what a simple model. Collect the rent, tenants pretty well pay all outgoings, and pay the distributions.

    The

    • Hi Porty

      Government backing/social security doesn’t guarantee success – look what happened to ABC Learning (which I believe AEU picked up the remnants from). Colossal fubar for those investors, irrespective of the government revenue streams and high demand the company should have profited from

      We’ll have to disagree on the importance of ROE. I believe it is the MOST important measure of a company’s success. It tells you how efficiently they are converting shareholder capital (your money) into profits. With the numbers you supplied, AEU is providing 9c in distributions off the back of $1.19 of NTA. That’s a 7.5% return – as an investor in equities I’d want 15% or more for the risk involved. Also, Commsec says they are providing earnings of 1.7 cents – much lower than the 9c you stated. Is Commsec in error, or are AEU distributing more than they earn? If the latter, that’s another reason I’d stay away from AEU.

  4. Q…I do agree with the importance of the ROE concept when looked at as a business and you are absolutely correct that a 9c distribution (which is their estimate for 11/12 following a cap raising and a lower interest rate achieved on lower debt levels) on an $1.19 NTA isn’t all that brilliant.

    But that’s my point. I am not buying at $1.19, the current market price is 85 cents and so my return as an investor is 10.6%.

    As a professional investor with a need to earn my keep, I’m comfortable with this and it sure as heck beats the bank deposit rates. I regard the addiitonal risk as minimal.

    I’m perfectly comfortable for AEU to continue to operate at around the 7.5% ROE provided that over time the market recognises this for the investment it is and closes the discount of SP to NTA.

    Put another way, the previous holders who provided the E for “Equity” in the ROE formula at $1.19 are the ones who have taken a rather severe haircut! Not me. I am an investor and the way for me to look at this is my return on investment…not return on equity.

    As a matter of fact, I sold a number of residential investments and sunk the funds into AEU.

    Why wouldn’t I? This is akin to buying a $1.19m property for $850k (using todays share price as an example) where my net return is $90,000 a year! $1,730 a week in rent and no outgoings!!!! Plus no stamp duty or real estate commissions and with the ability to sell the investment brick by brick if necessary.

    Where can you get such a return on any residential or commercial investment in Australia?

    Yes, I agree with commentary of many on MB that our residential market is in for a significant shakeup…in this instance I reckon the current discount to NTA will provide me with ample protection.

    Final Point: We may have a philosophical difference around this theme.

    You appear to be stating that investment success comes from “buying good things”. But, It has been demonstrated time and time again that no asset is so good that it can’t become a bad investment if bought at too high a price.

    My approach is “buying things well” and there are few assets so bad that they can’t be a good investment when bought cheap enough.

    Just a bit of background history. AEU is the former holder of the properties in the ABC stable. It is a passive landlord with 99% of its properties occupied under long leases with a 6 month deposit in an industry that is growing and enjoys favoured govt status.

    Also your commentary about the difference between the 9c estimated forward distribution and the reported NP of 1.9c is correct due to a number of once off adjustments relating to unravelling a number of complex overseas loans that were hedged etc etc. Now the money is Aussie bank advanced for three years.

    That’s how I see it and if you think I am too close to see the forest for the trees, I’d be interested in your thoughts.

    • Thanks for the comprehensive commentary Porty – great stuff to read and I always love having my views challenged. Point taken on your purchase price vs earnings. My concern would be whether their earnings levels are sustainable given the track record I am seeing on Commsec. After a big step change in 08 they posted a 6c loss, then a 2.6c NP and then this years 1.7c NP. I haven’t looked deeply at the numbers of AEU so I may be missing something the raw numbers don’t show. You’ve obviously done the research so you’re far better place to provide informed opinion on forward earnings. Maybe I can’t see the trees for the ROE forest 🙂
      I think our philosophical difference may lie in our conservatism – we think investment success comes from buying good things at the right price, however we are conservative in the filters we apply to those good things. High ROE, low debt, +5 years of continuous profitable operation (AEU would be filtered out at that point), low intangibles etc.
      I hope AEU goes well for you – I’ll keep an eye on it myself now. In fact, come the housing/property correction all REIT’s will be on our radar – we expect some bargains to come about!

    • I think much of the issue might come from trying to analayse a property trust as if it was a traditional company.

      LPTs (AREITs) can distribute more than their apparent earnings, mostly due to D&A etc. This is distributed as a tax deffered component (and hence reduces the unit cost base) but accounted as an expense. So the income is really a couple of cents of traditional earnings and a few cents of property investor tax dodgy stuff.

      Property trusts also dont pay tax (trust distributions taxed in the hands of the unitholder) so in effect a trust is distributing EBTDA (missing the I).

      I agree that ROE is important (vital) when the earnings are being retained to expand the business, but given a property trust has to distribute 90% of earnings this clouds the issue significantly.