As rates rise, "yieldy" stocks require careful consideration. Sustainability/track record key.
Companies: III, ADM, AHT, AGR, CAPC, CARD, CNA, DCG, ISAT, JMAT, PAY, QQ/, TRIG, UBM
I hope you're enjoying all the Trump revelations more than the frosty start to 2017. Last week I examined the implications of Trumponomics and attempted, where I could, to tie it back to companies that may be worth investigating in more detail. This week, as previously highlighted, I am diving a bit further into dividends and bond markets.
As you know, my universe is small to mid-cap (focussing on a mix of value, growth and quality), however, all fund managers need to maintain some wider perspective across asset classes. So here are a few more thoughts around bonds, bond proxies and dividends.
Bond yields have bounced off 20yr lows
Fixed-income assets have generated such extraordinary returns from capital gains in recent years that some have suggested these days you buy bonds for capital appreciation and equities for dividends. There is some truth to this. A broad 10+ year gilt index will have generated capital returns in the double digits this year. Returns for longer duration index-linked gilts have been even more remarkable.
However, it's hard to see similar or sustainable capital returns from fixed income in the near term. Despite UK gilts selling off since the summer, valuations undoubtedly remain at extremely expensive levels versus long-term history and we may be starting to see the beginning of a normalisation of yields.
The above graph plots UK 10yr Gilts over the last 20 years, during which time they have moved from a yield close to 8%, down to a low three months ago of nearly 0.5%. The level has since bounced to c.1.5%, but this remains very close to the recent 20-year lows.
“Yieldy” companies have been in high demand
It is also true that investors have been buying equities for dividends in their search for yielding assets. Indeed, the lofty P/E valuations we see in UK markets have been supported by high dividend yields (with the FTSE100 paying around 4% on average) and high dividend payout ratios.
If interest rates rise, dividend stocks will be less in favour as capital moves from bond proxies back to bonds, and fundamentally as the present value of future distributions falls. However, rates will need to rise above a certain level for this to occur materially.
Dividend payout ratio (DPS/EPS) is, of course, a measure of how much of a company’s annual earnings is being paid out in the form of cash dividends. The dividend payout ratio for larger caps has increased in the last few years, while dividend coverage ratio (EPS/DPS), the inverse of payout ratio (or how many times its earnings cover a company's dividend payments) has declined.
Above is a nice chart which shows the rise in PE multiples for the FTSE 350 index over the last 10 years, and contrasts it with the clear trend of falling dividend coverage over the same period (ignoring that minor, GFC-related blip in 2008).
Dividend sustainability is essential
A low dividend coverage ratio may raise the question of whether the level of dividends suggested by an attractive forward-looking dividend yield may actually be achieved. Unsurprisingly, sustainability of a company’s dividend and a progressive dividend track record are correlated with good price performance over time. Hence it is critical to not just look at high yielding stocks but look at how sustainable a dividend is (in good times and bad) and whether a company has a track record of progressive dividend growth.
Looking again at the FTSE 350, I’ve drilled into its constituents to analyse the distribution of dividend coverage. The below chart plots the consensus-estimated dividend coverage for each of the dividend-paying companies in the index.
As can be seen, for the bulk of the dividend-paying FTSE 350, there is a reasonably broad range of dividend coverage from nearly 0x up to around 5x. There are also some outliers with much higher coverage that I’ve stripped out. These are mainly due to tiny dividends relative to earnings (i.e. likely one-offs that would otherwise muddy the water).
How to analyse sustainability of dividends
To repeat myself, it is important to look at dividends in terms of sustainability rather than just yield. A useful test is to check that the FCF yield is greater than the dividend yield. It is all very well that dividends are covered by EPS but dividends are paid out of cash, not earnings, and EPS can be fudged using accounting assumptions more easily than cash. There are always one-off periods where free cash flow doesn’t cover distributions to shareholders for valid reasons, such as CapEx programmes, or Working Capital swings. However, over time it is crucial that the “look-through” FCF yield exceeds dividends.
Another way of analysing sustainability is to compare dividend and earnings yield over time. Short-term accounting assumptions should have been ironed out when looking at longer-term trends for a business.
Dividend track record and return on equity are other important metrics to consider when investing in yield. The track record, for which we can use a 5-year dividend growth rate, helps identify stocks that have achieved a progressive dividend policy. The Return on Equity, helps us identify which companies have high-quality earnings which should better weather any downturns and hence protect the dividend.
Below I have used a ranking system to illustrate how the FTSE 350 constituents score based on track record, sustainability and coverage. I like using combined ranking systems as they are incredibly easy to put together and they pull out the companies of interest very quickly. These I can then dive into in more detail.
In building the above chart, I ranked the companies for their 5-year Dividend Growth (1 for highest, 2 for next highest, etc.). I then repeated this exercise for the 5-year average Return on Equity, and finally for the forecast dividend coverage this year. I added these ranks together and plotted a scatter graph with highest/best-ranked stocks on the left and lowest/worst-ranked on the right.
There is a case for suggesting that the low-interest rate environment of recent times has supported dividend payouts that may not be sustainable by all as interest rates rise.
I would contend that some companies may have stretched to support their dividends and valuations, possibly at the expense of capital investment. In future, dividends may disappoint. Therefore it is important that companies I invest in for their yield are robust enough to provide a sustainable and growing dividend.
To conclude, this demonstrates that more than ever it is critical to look at the coverage, both in earnings and cash terms, of a dividend and the robustness of that coverage when stock picking.
To read a brief outline of how I think about stocks, and what I aim to achieve in this blog, please check out my first blog where I set out my stall.
Please Note: To be clear, I do not and will not ever give any advice. I will rarely mention individual stocks but when I do these will not be recommendations, instead just my thoughts at that point in time.