Yield Stocks: Where Are The True Opportunities?

This story features TELSTRA GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: TLS

By Rudi Filapek-Vandyck, Editor FNArena

This story should be read in conjunction with Monday's Weekly Insights "Are You In Tune?"

One of my favourite observations of the past decade: stockbrokers and dividends, they simply do not mix.

My favourite pastime is watching stockbrokers at seminars, public forums and on live financial TV handling questions about dividend stocks and yield strategies. It's like throwing a lump of cryptonite into Superman's lap. As one credit card company would put it: priceless.

The seemingly unimpregnable "I know what I am doing, trust me" shield is instantly being replaced with an inner-soul struggle that seldom ends without a (very predictable) reference to Telstra ((TLS)), Tabcorp ((TAH)) or Adelaide Brighton ((ABC)).

Problem is, of course, until recently Telstra had been the champion in destroying shareholder's capital and it has been very difficult to make a strong case for owning either of the other two post 2007. To put it simply: when I toured the country in 2009 and 2010 to educate investors about the merits of dividends for superior investment strategies and to explain how it's done, both Telstra and Tabcorp prominently featured in my slides as in what happens when investors pick the wrong stocks even though they seem to promise a high yield.

Admittedly, and as noted in my writings since February 2010, Telstra now seems to have turned the corner, but I am still not keen on Tabcorp and note that most stockbrokers who guide their clientele towards the stock casually forget to point out the yield will take a dive in years ahead. That goes for Tatts ((TTS)) too.

It's really a shame that equity strategists supplying one of the largest networks servicing retail investors in the country, that of RBS Morgans, have as yet been unable to move past the regularly re-appearing observation that high yield strategies are code for share market underperformance (or something along these lines). My response is always: D'oh!

One only has to reflect back on retail stocks such as David Jones ((DJS)) and Billabong ((BBG)) to instantly know that jumping on beaten-down stocks simply because they appear to be offering the promise of a high yield is playing with disaster. But what about going the extra-mile and figuring out what does work?

Times are changing though and there's no force as strong as investors complaining and abandoning the share market altogether at a time when trading volumes are only a fraction of what they used to be. Deutsche Bank, Macquarie and Goldman Sachs have all been releasing research about dividends and dividend strategies recently. I suspect we will only see more of it in the weeks, months and years ahead. And yes, those other brokers, RBS included, will eventually have to submit to the market's new reality as well.

Both Macquarie and Goldmans have genuinely put in the extra effort which in both cases has led to the same conclusion: well-executed dividend strategies have proved the superior strategy in the share market throughout the decade past. Hallelujah! I have only been saying exactly that for years now! However, it's good to see my own analysis receive backup from the experts at two of Australia's most prominent investment services providers.

Before we look into more detail into the conclusions from these dividend research reports, investors should note I gave a presentation to ASX Investment Hour last year which pretty much sums up the whole subject: why you should pay attention, some cold hard facts and what rules to follow and what not to do (for your own sanity). I strongly recommend that if you haven't already viewed this broadcast, you do so now.

To catch up on all the important Dos and Don'ts for dividend investment strategies:

http://www.brrmedia.com/event/frame/81534

(you'll instantly discover why this presentation is known as the "Alien one")

In addition, here's another brief analysis of so-called "Dividend Aristocrats", by the team at InvestmentU who has, over the years, released very similar reports as mine on this particular subject: http://www.investmentu.com/2012/March/dividend-aristocrats.html

(Again, the underlying conclusion is the same: dividend strategies do not only work, they generate superior results in the long run)

Research by quant analysts at Goldman Sachs (using 15 years of data, including the disastrous 2008) throws up a few conclusions that are more than worth pointing out:

– passive dividend investing (alternative label "lazy") does result in significant underperformance (barely positive on GS's analysis)
– but do your homework and significant outperformance should be your reward
– picking the correct dividend stocks reduces the risk, but does not by default make your investments defensive (this is a very important conclusion to remember at all times)
– also "franking" only adds 0.4% in average annual returns, according to GS research, so maybe investors shouldn't overemphasise it? (In other words: don't ignore a good opportunity simply because it doesn't offer full franking credits, see Amcor ((AMC)) as an example in recent years)

So what does that mean "doing your homework"?

GS advises investors should be able to avoid "yield traps" when using the following seven filters for selecting potential yield investments in the share market:

– at least 50% franking
– payout ratio no more than 70%
– debt/equity no more than 70%
– forecast growth in dividends
– Return on Assets (ROE) of at least 10%
– earnings risk of less than 10%
– 3 months momentum for the share price is better than negative 10%

In my personal view, what is missing in this exercise is the longer term view on a particular sector. It is my view that dividend investing strategies should be combined with positive longer term dynamics for the company and for the sector in which it operates. This pretty much excludes discretionary brick-and-mortar retailers as well as traditional media companies.

GS' quant analysts have not incorporated such extra layer, which is why their exercise has come up with candidates such as Myer ((MYR)). My view is, regardless of whether GS's view proves correct in the years to come, why would anyone take on the extra risks? In addition, miners and dividends have never truly gelled in Australia.

This is because mining is intrinsically a highly capital intensive business and dividends can instantly be replaced by a better investment opportunity anytime. Also, the high reliance of miners on the pricing of their products adds an extra layer of risk to future dividends. Both resources giants BHP Billiton ((BHP)) and Rio Tinto ((RIO)) could potentially decide to pay out double what they do today, and it would put an instant floor under their share price, but any progress in this matter is slow and may not happen for years, or maybe not at all.

For the perfect example of the dangers of owning mining stocks for their dividends, look no further as to what happened to the Iluka ((ILU)) share price last week.

Enough from me, here's what the quant analysis from Goldman Sachs generated in terms of concrete names for the future:

Top 10 stocks with sustainable dividends:

– Myer
– Iluka
– Tatts
– Metcash ((MTS))
– ANZ Bank ((ANZ))
– Telstra
– National Australia Bank ((NAB))
– Westpac ((WBC))
– UGL Ltd ((UGL))
– Tabcorp

Top 10 stocks with the least sustainable dividends:

– Seven West Media ((SWM))
– Sydney Airport ((SYD))
– Bendigo and Adelaide Bank ((BEN))
– Bank of Queensland ((BOQ))
– CSR ((CSR))
– Spark Infrastructure ((SKI))
– Stockland Group ((SGP))
– JB Hi-Fi
– Australian Pipeline Trust ((APA))

Personally, I don't like the first three and the last name of the Top 10 list and as far as the danger Top 10 goes the presence of Spark Infra and Australian Pipeline Trust most definitely is a surprise given their recent outperformance in the share market, as well as their reputed attractiveness on analysis by other experts in the market.

Also, while major banks feature heavily in the sustainable Top 10, analysts at UBS highlighted last week that banks have continued to increase their payout ratios in the face of virtually no top line growth and downward pressures on margins. This places their dividend payments under elevated threat from a rise in bad and doubtful debts (BDD). This is a real risk investors should not just ignore, warn the analysts. The warning was repeated by Macquarie analysts on Monday.

This reminds me of one of my own rules for dividend investing: don't play dividends in combination with weakness, but seek dividends that come with strength. Of course, to put these risks in the correct framework: even during the height of the GFC banks still paid out dividends, they simply had to endure a temporary reduction in instant shareholder reward. And banks' boards will do all that is in their might to continue to please their shareholders with higher dividends, that simply is a given in Australia.

Analysts at BA-Merrill Lynch have observed that infrastructure stocks in Australia have significantly outperformed the broader market over the past twelve months, even though April saw the sector underperforming. The analysts believe high dividend yields in the sector remain the major attraction, especially with most retail investors in Australia sitting on the sidelines, while rewards for keeping funds in term deposits are falling.

BA-ML's favourite in the sector is Transurban ((TCL)), followed by QR National ((QRN)) and DUET ((DUE)). Spark Infra and Australian Infrastructure Fund ((AIX)) are equally rated Buy. Note that the broker's ranking puts the above mentioned Sydney Airports and Australian Pipeline Trust towards the bottom of the list.

On FNArena's consensus forecasts, Transurban offers a 5.5% yield (FY13), but QRN's is only on 3.2%, with DUET offering 8.8%, Spark 7.3% and AIX 5.1%.

Note that Transurban has featured regularly in my own stories on dividends in years past.

Market strategists at Deutsche Bank recently noted the dividend payout ratio in Australia is currently a little below the historical average, suggesting there may yet be some positive surprises for dividend investors in the years ahead.

Similar to GS (see above), Deutsche Bank advocates using extra filters when selecting potential targets in the share market. Deutsche's filters included forward dividend yields, future DPS growth, valuations, earnings momentum and stock beta.

Stocks screening well that fundamental stock analysts at the firm rate as ‘Buy’ include:

– AGL Energy ((AGK))
– Primary Healthcare ((PRY))
– Crown ((CWN))
– Lend Lease ((LLC))
– Boart Longyear ((BLY))
– UGL Ltd
– Stockland Group (see above GS)
– Goodman Group ((GMG))
– ANZ Bank

Other stocks screening well include Insurance Australia Group ((IAG)), CSR (see above GS), OneSteel ((OST)), JB Hi-Fi and QBE Insurance ((QBE)).

My main observation with Deutsche Bank's analysis are that some of the stocks selected are in GS's Danger Top 10 list, probably reflecting a fair degree of subjectivity that goes into these analyses. I personally would also take into consideration a factor such as share price volatility. After all, how much comfort does one investment offer when the share price's surges and falls regularly exceed the size of the dividend cushion?

For this reason I would not consider Boart Longyear or OneSteel for dividend oriented investment strategies (I might still consider them a worthy investment though). Similar to GS, Deutsche Bank seems to have no consideration for longer term structural trends, given the presence of JB Hi-Fi.

Finally, as pointed out in Monday's Weekly Insights, Macquarie put everyone else in its shadow with its elaborate, in-depth effort on dividends on Monday. Macquarie's in-house view is that investment returns from equities in the years ahead will be lower than the historical norm pre-2007 and this means one thing above anything else: dividends will become ever so important for investors in the share market.

Contrary to the quant analysis from GS and Deutsche Bank, Macquarie added some brain power and broader trend and sector considerations to its various reports. Its list of favourites includes:

– Telstra
– Stockland (see above GS and DB)
– Metcash
– National Australia Bank
– Mirvac ((MGR))
– Commonwealth Bank ((CBA))
– ANZ Bank
– Dexus ((DXS))

Note that Macquarie agrees with the assessment made by UBS on future threats for banks and their ability to continue growing dividends, but the banks are still considered solid enough to feature high on Macquarie's list of favourites. At the risk of sounding like I've just been hired by the "Golden Doughnut" (which I have not) but that pretty much resembles my own view on the banks post 2009.

Or as one of my favourite market observations goes: banks are in no-growth mode yet total investment returns have been better than for the fast growing miners and energy companies. Note that, dividends included, both ANZ Bank and CommBank have now fully recovered all losses endured after the peak of November 2007. Shareholders in BHP Billiton ((BHP)), Woodside Petroleum ((WPL)), Fortescue ((FMG)), Newcrest Mining ((NCM)) and others are nowhere near such achievement.

Note that, on Macquarie's assessment, the following stocks also have a low chance of turning into a dreaded "yield trap":

– UGL Ltd
– Commonwealth Property Office Fund ((CPA))
– Wesfarmers ((WES))
– Sonic Healthcare ((SHL))
– GPT Group ((GPT))
– Lend Lease
– Amcor
– Woolworths ((WOW))
– Tol Holdings ((TOL))
– Coca-Cola Amatil ((CCL))
– Primary Healthcare
– Brambles ((BXB))

Macquarie analysts had to bend the rules a little bit to get excited about Telstra. The telco is included as a favourite because of projected free cash flow (which should guarantee the dividends) plus, of course, the financial windfall that should come its way through the government sponsored NBN project. Macquarie thus predicts investors will see more dividends than just 28c per annum in the years ahead.

Macquarie also believes Telecom New Zealand ((TEL)) should equally be on investors' radars for dividend investment strategies. Smaller telcos such as iiNet ((IIN)) and TPG Telecom ((TPM)) are more likely to opt for acquisitions and capex, making their dividends less reliable, point out the analysts.

Among utility stocks, Macquarie thinks AGL Energy, Spark Infra, SP AusNet ((SPN)) and Transurban are the standouts, but each carries its own specific risks.

In the transport sector, Macquarie has discovered what could be tomorrow's positive surprise, arguing the present yield on K&S ((KNS)) shares (circa 8%) most definitely looks sustainable.

Amongst smaller cap companies, Macquarie thinks the yield for Thorn Group ((THG)) is sustainable, even though the company's maturing operations are currently ex-growth, while Ardent Leisure ((AAD)) seems to have a challenge at hand to further fund capex wthout diluting shareholders interest too much. Macquarie suspects Ardent will take on more debt. There are more earnings risks involved than meets the eye, suggest the analysts, because Theme Parks in Queensland represent more than 40% of group earnings.

Another stocks which is not particularly popular, but should still offer a high and sustainable dividend is STW Communications ((SGN)), offers Macquarie. The analysts also suggest Southern Cross Broadcasting's ((SXL)) dividend is best regarded the most solid and sustainable in the industry. (You know my view on traditional media stocks).

Macquarie is also confident Wotif.com ((WTF)) will further grow earnings and dividends, as will Fleetwood ((FWD)). The analysts point out the former has grown dividends every year since listing, while the latter has increased dividends in all but one year since listing 17 years ago. It is for the same reason that I have been pointing towards Fleetwood myself in years past.

Bottom line: There are plenty of opportunities available to achieve yield and income via the share market. If you agree with the outlook of Macquarie and myself, then yield is the most important feature for equities in the years ahead. But investors will have to do their homework and mind valuations as much as the promise of yield.

I hope all of the above will be of great assistance.

As a last note: Emerging Markets specialists at Citi have just released a note and you guessed it, they think true value in those equity markets is equally located among the dividend paying stocks.

This story should be read in conjunction with Monday's Weekly Insights "Are You In Tune?"

See also story on AREITs FNArena intends to publish tomorrow.

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