REPEAT Rudi’s View: Chinese BS and Market Beating Dividend Stocks

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(This story was originally written and published on Wednesday, December 08, 2010. It has now been re-published to make it available to non-paying members at FNArena and readers elsewhere).

By Rudi Filapek-Vandyck, Editor FNArena

I am not sure whether WiklLeaks founder Julian Assange has a large following inside the financial sector, but this latest round of inconvenient revelations from the US Department of Hidden Truths makes for highly enjoyable reading, to say the least. One can only wonder what then Prime Minister Kevin Rudd was thinking when making those silly suggestions about using military force against China, if need be, when in company of top members of the US administration. Certainly, Kevin's got some explaining to do, one would assume, at some point. If not in the presence of members of parliament or government in Canberra or the US, then certainly on his next meeting with Chinese representatives.

The Top Reward for this month's WikiLeaks revelations, in my view, goes to the man widely considered the next strongman in China, Li Keqiang. For those who've missed it, Li Keqiang, nowadays vice-premier but back then still head of the Communist Party in northeastern Liaoning province, candidly told then-US Ambassador to China Clark Randt, at a dinner meeting that economic data in China are nothing but "man-made" and "for reference only". Funny that is. I have a feeling this is one slip of the tongue that is going to stick and will hunt the next political leader in Beijing for many years into the future. Just like that one description by Ben Bernanke instantly turned him into "Helicopter Ben" ever since he replaced Alan Greenspan at the Federal Reserve.

As most of you would know, FNArena has a long history of interpreting official data from China with more than just the usual pinch of salt. Still, according to the leaked documents on WikiLeaks, Li "reference only" Keqiang also provided a guide as to how one should gauge the real growth in China: by focusing on electricity consumption, rail cargo volumes and bank lending. Li is widely expected to succeed Wen Jiabao as premier in early 2013. Get ready for "man-made" jokes and references in spades by then.

Hot on the heels of my recent stories about Market Beating Dividend Stocks, analysts at Bank of America-Merrill Lynch have released a sector update on Australian Infrastructure stocks, and the similarities between my own research and theirs is too much to leave unmentioned. The team at BA-ML has picked three candidates that each should generate a return of some 15% annually from a combination of high dividends and relatively steady growth over the years (plural) ahead. This seems like a brave call given this type of stock tends not to perform very well when interest rates are rising, and don't we all know the RBA is not finished yet? Also, with more and more market strategists projecting 20% returns in the year ahead from global growth leveraged cyclicals and resources stocks, who'd be genuinely interested in defensive exposure with 15% tops in projected return?

In other words… the ideal environment for astute, patient investors to pick the next Market Beating Dividend Payer, while Mr Market is looking in the direction of China and the US dollar.

Note the team at BA-ML excluded two groups of companies in their selection: one is the group that trades on high multiples and only pays a dismal dividend, two is the group that seemingly pays a much higher dividend, but has no genuine growth prospects. Group one consists of one stock only, Asciano ((AIO)) which is currently trading on a forward P/E multiple in excess of 20 (consensus forecasts). Group two includes the likes of Australian Pipeline Trust ((APA)), DUET ((DUE)) and Challenger Infra ((CIF)) who each offer high dividend yields of up to 13%, but no growth.

As I wrote on Monday (see bottom of today's story), the art is to find a high dividend paying stock at a cheap valuation, but with growth ahead. Add the element of "time" and before you know it you're enjoying annual returns in double digits, from dividends only, with the rising share price providing the extra-bonus. (You've effectively turned the standard investment approach on its head). I didn't exactly spell it out on Monday, but it was there nevertheless; this type of share market strategy outperforms in downturns, in upturns and in sideways moving markets. The only time when it appears this approach is like playing the wrong game is often during the early beginnings and during rampant market rallies, but we all know by now, those rallies do ultimately come to an end.

The analysts picked Transurban ((TCL)), Macquarie Airports ((MAP)) and Australian Infrastructure Fund ((AIX)), while it appears that ConnectEast ((CEU)) only narrowly missed the cut.

Projected dividend yields (on BA-ML's forecasts) for the present financial year are 5.3%, 6.9%, 5.7% and 4.5% respectively. The market average, on FNArena's calculations, currently stands at 4.8%. This immediately explains why CEU missed the cut: the dividend is below market average. There simply is no room for any violation of the rules, so CEU drops out. Thumbs up to BA-ML.

From here onwards the theme becomes less obvious, though. On current consensus estimates, Macquarie Airports is likely to experience a dip in earnings growth in FY12, while Australian Infra's earnings per share are to remain in ongoing decline. The only one showing strong growth ahead, in EPS terms, is Transurban. So where does BA-ML's conviction come from?

The analysts at BA-ML have based their selection on projected growth in free cashflow (FCF), which, they argue, should be a reliable guide for the years ahead. The reasoning is that the industry in Australia has finished the balance sheet clean-up act post the GFC and at present dividend pay-outs are closely aligned with free cashflow generation. With free cashflow to grow further on the back of ongoing solid economic momentum in Australia, and elsewhere, dividend pay-outs are thus expected to grow too. On BA-ML's projections, the combination of both should result in total annual investment returns of 15% for the next five years.

As such, these three selected stocks should significantly outperform the ones in group two. Asciano is expected to do better, but projected returns will come through volatile price movements and assume no bumps in the road otherwise. (Always remember: high multiple stocks cannot withstand any deceleration in growth – an observation I have explained many times over in the past).

Other indicators seem to justify BA-ML's choices. On consensus price targets, AIX is trading at a discount of nearly 11%, with P/E ratios for this year and next both in single digits and the prospective dividend yield expected to grow from 5.4% this year to 5.9% next year (all on consensus forecasts). But, and as indicated earlier, AIX does not meet the EPS growth requirement.

Macquarie Airports is trading almost 12% below the consensus price target, with strong growth projected for FY11, followed by a dip in FY12. But then again, Macquarie Airports is one of those stocks that carry a special warning signal in R-Factor because analysts' projections are all over the place. It is for this reason the stock should be regarded higher risk. Combined with the projected drop in FY12, this doesn't appear to make for a rock solid investment story.

Which leaves us with Transurban. Relatively mature tollroads. So not sexy. But EPS is expected to grow at very high pace in the years ahead, and prospective dividend yields are 5.1% this year and 5.6% in FY12. The only minus is what appear to be ridiculously high PE ratios, but then the consensus target at $5.58 (8.1% above the share price) seems to indicate the shares are currently cheaply priced.

The latter observation probably means Transurban still qualifies for our search for Market Beating Dividend Stocks. After all, this is not about remaining faithful to the religion of Price-Earnings Ratios, this is about buying quality growth when it is cheap, securing ourselves from growing dividends and a growing share price. If current consensus forecasts are correct, then dividend yield should surpass 6% in FY13, which while a full 100 basis points above this year's expected yield, also indicates Transurban might find it hard to replicate the example of GUD Holdings ((GUD)) I used on Monday.

Which just goes to show that buying strong growth in combination with cheap valuations and higher-than-usual dividend yield is easier said than done. Which again proves why this strategy requires both discipline and patience. (No crowds allowed).

The above story should be read in conjunction with three of my recent analyses:

This Is How You Beat The Market (from Monday)

The Widening Gap Between The Haves And The Have-Nots

It's A Bubble! (But Not The One You Think)

P.S. I – All paying members at FNArena are being reminded they can set an email alert for my Rudi's View stories. Go to Portfolio and Alerts in the Cockpit and tick the box in front of 'Rudi's View'. You will receive an email alert every time a new Rudi's View story has been published on the website.

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