Dividend Strategies: Not All That Glitters Is Gold

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

By Rudi Filapek-Vandyck, Editor FNArena

****

Three types of Australian listed stocks have proved an absolute boon for loyal shareholders and investors in the post-2008 era: reliable dividend payers such as Telstra ((TLS)) and the Big Four Banks, All-Weather Performers such as Woolworths ((WOW)), Amcor ((AMC)) and CSL ((CSL)) and stocks experiencing an operational sweet spot, generating strong profits and shareholder returns along the way.

All three categories have one key characteristic in common: they are able to generate satisfactory returns even when risk appetite retreats or economic momentum wanes.

At the basis of all this lays research by FNArena Editor Rudi Filapek-Vandyck since late 2007 which earlier this year led to the publication of "Make Risk Your Friend. Finding All-Weather Performers", an eBooklet which to date is exclusively available to paying FNArena subscribers (if you haven't received your copy as yet, send an email to info@fnarena.com).

The eBooklet argues that successful investing is closely correlated to minimising and managing risk. Hopefully the framework we are creating with these regular updates will assist subscribers in executing successful, long term investment strategies.

****

Two important events happened this week and I doubt whether anyone else has noticed or realised their relevance.

Yesterday, analysts at Deutsche Bank downgraded their rating for mining services provider NRW Holdings ((NWH)) to Hold from Buy while slashing their price target to $1.50 from $2.25 previously.

The move would have been broadly seen as Deutsche Bank simply catching up with the share market as NRW's share price sits around $1.30, but that would miss the really important move that came along with the downgrade: Deutsche Bank analysts also slashed their earnings forecasts for the years ahead and, in the slipstream of that decision, their projected dividend payouts to shareholders.

At least one commentator on Financial TV had been pointing out that NRW Holdings shares looked ridiculously cheap with an implied fully franked dividend yield of 14% last week. The 14% was incorrect and must have been based on some outdated (or plainly incorrect) source for the dividend spiel, but the underlying message nevertheless would have caught the attention of some investors looking for an alternative to the Big Four banks and Telstra ((TLS)) in the Australian market. Let's face it, 14% plus franking looks like a real bargain.

The problem with such assessment is that it ignores the risks surrounding the implied yield on offer. The easiest way to show the risks involved is to remind investors that seriously struggling retailer Billabong ((BBG)) once upon a time also offered an implied forward looking yield of the same magnitude. That was not a signal that a bargain had been left unattended in the share market, it merely proved a warning that the share price was about to fall a lot lower, and the dividend scrapped altogether.

At this stage there's no suggestion NRW Holdings will share the same fate as Billabong, as a matter of fact those analysts at Deutsche Bank made an extra effort in pointing out how well-run the company is and how good management is in steering the company through challenging times. Sometimes nothing that haunts a quality company is of its own making, but that doesn't remove the fact that challenging times are here to stay.

This is the position NRW Holdings finds itself in and Deutsche Bank is now convinced that investors who may have jumped on the (incorrect) suggestion the shares represent a fully franked yield of 14% for the year ahead will be disappointed. Every analyst covering the company seems to be equally convinced the outlook is now for a negative trend in earnings and simple logic leads to the conclusion that dividends to shareholders will thus suffer too.

As always, there is at this point no consensus about how far earnings will fall and thus how sharply the fall in dividends will be. On Deutsche Bank's latest update, next year will see dividends fall by 50% from the 18c paid out in FY12. Now that's something to think about, also because it still implies a fully franked yield near 7%. Does this mean NRW Holdings shares will find their bottom around present levels?

The second important event happened in that same sector of pick 'n shovel services providers to the energy and mining industry and this time the subject was Monadelphous ((MND)), the absolute benchmark for the industry without equal. Monadelphous is apparently trading on an implied forward looking, fully franked, dividend yield of 7.3%, which is a juicy attraction, in particular given its admirable performance over the past decade. Monadelphous has probably been the best performer in Australia over that period, and consistently too. This will have lured in many investors on perception of lower risk and consistent performance.

It's probably fair to expect that management at Monadelphous will do a better job than any other team elsewhere, but that still doesn't remove the fact that sector dynamics have become increasingly challenging, and they are likely to become even more challenging in the years ahead. UBS updated its projections and views on Monadelphous on the same day Deutsche Bank issued its downgrade for NRW Holdings and the underlying theme is the same: don't bank on the fact that yesteryear's dividends won't be cut, it's more likely than not there will be cuts.

Current consensus estimates (see Stock Analysis) already reflect this, but UBS is now suggesting the negative news will flow sooner and be worse than anyone had been expecting until now. Obviously, this can explain why the share price has fallen from $28 only a few weeks ago to around $21 this week.

To put UBS's epiphany in perspective: the new dividend forecast of 120c for FY14 is only marginally below what the company paid out in FY12 and still represents a fully franked dividend yield of some 5.7% at today's share price, but this is ignoring the fact that FY15 could again prove worse than next year?

Combining prospective dividends with negative pressure on a company's earnings can be a dangerous strategy as many an investor has experienced through traditional media companies and retailers in years past. The two downgrades this week for NRW Holdings and Monadelphous suggest mining services providers and engineers are about to repeat that exact same lesson in the years ahead.

Which is why a general review and update this week on sustainable dividends in the Australian share market by analysts at Credit Suisse can only be labelled as timely. In particular because the report looks into many of today's strugglers in the share market, such as retailers David Jones ((DJS)) and Myer ((MYR)), ex-OneSteel Arrium ((ARI)) and All-Weather Performer post profit warning, Coca-Cola Amatil ((CCL)). They all offer sustainable dividends finds Credit Suisse. The solidity of the research received extra support this week as Coca-Cola Amatil is still expected by all and sundry to lift its dividends this year and next, despite this week's profit warning. CS's research was conducted before the company's announcement.

So who else is on the sustainable dividends list? Qantas ((QAN)) is, as is Metcash ((MTS)), and Toll Holdings ((TOL)), UGL ((UGL)), as well as Adelaide Brighton ((ABC)) and Regis Resources ((RRL)). You know by now I am not repeating the obvious names but instead I am pointing out the ones that seem less obvious.

Investors will probably be surprised to read that Credit Suisse believes most companies in the consumer discretionary space should be able to at least maintain their dividends, and that includes GUD Holdings ((GUD)) whose shares are now trading in double-digit yield territory. Note this is by no means a consensus view (see also Stock Analysis).

The research report becomes more interesting when the focus shifts towards where the potential upside dividend surprises are located in today's share market. CS has selected the following names:

– Fantastic Holdings ((FAN))
– Flight Centre ((FLT))
– Fairfax Media ((FXJ))
– OrotonGroup ((ORL))
– Pacific Brands ((PBG))
– Premier Investments ((PMV))
– Henderson Group ((HGG))
– Insurance Australia Group ((IAG))
– Brambles ((BXB))
– Clough ((CLO))
– Qantas ((QAN))
– Adelaide Brighton ((ABC))
– Rio Tinto ((RIO))
– AGL Energy ((AGK))

Note that for some of these potential surprises to occur, company boards may have to change strategy. Rio Tinto's surprise potential, for example, is dependent on the board scaling back capex intentions and lifting the annual payout ratio instead. Brambles' potential surprise requires finding a buyer for the Recall business.

History shows positive surprises with dividends translate into outperformance for those equities against the broader market.

Within this context, CS analysts have also discovered there's a lot more positive surprise potential from reduced capex programs than one would be inclined to think. Here's the full list:

– David Jones
– Myer
– Fantastic Holdings
– Harvey Norman ((HVN))
– JB Hi-Fi ((JBH))
– OrotonGroup
– Pacific Brands
– Premier Investments
– The Reject Shop ((TRS))
– Metcash
– Wesfarmers ((WES))
– Woolworths ((WOW))
– WorleyParsons ((WOR))
– Australian Pharmaceutical ((API))
– Asciano ((AIO))
– Alliance Aviation Services ((AQZ))
– Brambles
– Downer EDI ((DOW))
– Leighton Holdings ((LEI))
– NRW Holdings
– Qantas
– Royal Wolf Holdings ((RWH))
– Adelaide Brighton
– Rio Tinto
– AGL Energy ((AGK))

Amidst all the talk about a yield stocks bubble in the Australian share market of late, this report shows that if we are experiencing the beginnings of a true bubble, there's a lot more potential to take the present yield focus a lot farther still. Whether companies ceasing to invest in future maintenance and growth in order to please investors in the short term is a viable longer term strategy is a complete different matter. US companies seem to be getting away with it for years in succession!

Bottom line: there's a lot more that can be done with dividends in the share market and there's a lot more Australian companies can offer shareholders in the years ahead, if they wanted to.

See also: Dividend Strategies: Not All About Franking, April 5

****

DO YOU HAVE YOUR COPY YET?

At the very least, my latest e-Booklet "Making Risk Your Friend. Finding All-Weather Performers", which was published in January this year, managed to accurately capture the Zeitgeist.

All three categories of stocks mentioned in the booklet are responsible for the index gains post 2009 and this remains the case throughout 2013.

This e-Booklet (58 pages) is offered as a free bonus to paid subscribers (excl one month subs). If you haven't received your copy as yet, send an email to info@fnarena.com

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms