Wednesday, 14 August 2013

The Dividend Yield Trap

And Tesco PLC

Mousetrap, courtesy Wikipedia 

Income is a key requirement of an investment portfolio for pension funds, life insurance companies and many private investors. Bonds and short-term deposits once provided a secure source of income that more than compensated for the going rate of inflation. No more. Bank Rate has been stuck at 0.5% since March 2009, banks offer almost nothing for demand deposits and the yield on 10-year Gilts has been below the rate of inflation since January 2011. And no let up is in sight. 

As a result, investors have been concentrating their attention more than ever on company dividends. In response, companies have been increasing their payout. At 23 billion pounds, the dividends paid by FTSE 100 companies in Q2 2013 set a new record. 

Looking at the last 28 years, the return on the FTSE 350 Higher Yield Index (in green) has outperformed the FTSE 350 Lower Yield Index (in blue) in capital terms. Include the additional dividend that has been collected by the investor in the higher yielding portfolio and the long-term investor, who has stuck to higher yielding stocks, has outperformed the lower yielding portfolio by a country mile:  

Courtesy Yahoo, click to enlarge. 

But, according to the two indices, the position reversed itself in the post-Financial Crisis years 2008-2013: 

Courtesy Yahoo, click to enlarge.

What happened? In 2008 and 2009, many high yielding stocks - mainly in the banking, housebuilding, property and financial services sectors - stopped paying dividends entirely. Their share prices collapsed and then they were moved into the lower yielding index, from where their share prices recovered. Many stocks, which had a good history of dividend payments, collapsed in this short period. They stopped paying dividends and their price collapsed. Investors, who were focussed mainly on yield, were caught in a dividend yield trap.  

Nevertheless, an investment strategy based on dividend income makes sense for the long-term investor - see the article at  

However, investors should be wary of the dividend yield trap. A number of stocks with a seemingly good record for dividend payouts are at risk of disappointing investors. They include some of the UK's biggest companies that have fallen on hard times: 

1. Vodafone: yield 5.2%; dividend cover 0.97% on the average of the last 3 years earnings. The cash shortfall on its 2012 dividend was 1.7 billion pounds. (See Competitive pressures and a stagnant economy in its main markets mean that Vodafone's own business is barely profitable. Vodafone relies on its 45% stake in Verizon Wireless and dividends that are determined by Verizon to keep going. The current share price of 197p is buoyed by hope that Verizon will buy Vodafone's share in Wireless for $100 billion or more and that those funds will go straight to Vodafone's shareholders.

2. BP: yield 5.2%; dividend cover 1.9 times on the average of the last 3 years earnings. The gargantuan capital expenditure requirements of BPs' business mean that, in the last 3 years, operating cash flow failed to cover capital expenditure by 3.1 billion pounds. The dividend was paid from debt and asset sales. BP is a shadow of its former self. To pay for the liabilities arising from the Deepwater Horizon disaster, BP has sold assets leaving its oil and gas production 42% below 2009 and its oil and gas reserves 44% below 2009. And its liabilities and contingent liabilities continue to rise. (See BP's current share price of 445p is buoyed by the hope that BP will emerge from the ruinous costs of the Deepwater Horizon disaster and return to trading approaching pre-2010 levels. 

3. GlaxoSmithKline (GSK): yield 4.6%; dividend cover 1.03 times the average of the last 3 years earnings. Free cash flow covered the 2012 dividend 1.6 times. But GSK has been accumulating debt. In 2003, GSK held net cash of 1.6 billion pounds, in 2012; this had turned to a net debt of 14 billion pounds. Meanwhile, 2012 earnings were back at the 2003 level. Generic drugs have destroyed GSK's business based on research and development. (See The current share price of 1683p is buoyed by the hope that new drugs in Phase II and Phase III trials with the US Food and Drug administration will bring GSK back to growth.  

Utilities are another mainstay for income investors. However, the high valuation on water and energy utilities is difficult to justify on their trading results and, perhaps more importantly, on their trading outlook post their regulatory reviews in 2014. For both Ofgem and Ofwat, in response to the present mood of austerity, have said that they will be expecting more from energy and water companies. All these companies are heavily indebted. 

1. Centrica: yield 4.1%, dividend cover 1.4 times is on a P/E ratio of 18. A solid business has been marred by capital misallocation on nuclear energy and wind farms. (See  

2. SSE: yield 5.3%, dividend cover 1.1, is on a P/E ratio of 16. Though sound management has consistently brought an increase in dividends, the thin dividend cover means this must come to an end. (See 

3. The water companies Dee Valley, Pennon, Severn Trent and United Utilities yield between 4.4 and 4.8% and all are on a declining dividend cover (1.2 to 1.3 time). P/E ratios between 16 and 18 do not discount the inevitable disappointment of the inevitable rights issues and more difficult pricing regimes that are on their way. (See 

Long-term investors seeking a growing income stream would do well to look at other sectors and companies. Unilever, Reckitt Benckiser, Pearson, Royal Dutch Shell, Sage, Interserve, N Brown, Cranswick, Personal Group Holdings, James Halstead and British Sky Broadcasting all seem to offer better income prospects. But only buy at the right price. (Earlier articles on this blog cover these 11 companies). These stocks can be supplemented by income-orientated funds covering companies in foreign markets that are difficult for the individual investor to research, value and trade. Earlier articles on this blog cover BNY Mellon Newton Asian Income OEIC and the J P Morgan Global Emerging Market Income Investment Trust.

The wise long-term investor will have a 'buy and hold' strategy, but he or she will avoid the dividend yield trap by reviewing the portfolio regularly:  

1.  Companies are subject to sudden shocks that drastically reduce or improve their value. Think Deepwater Horizon, the banking crisis or, on the plus side, a takeover bid. 

2.  The trading outlook is rarely stable.

·         Macroeconomic changes (economic growth/recession, currencies, and interest rates) affect some companies more than others.

·         Regulators or governments, by imposing new conditions on companies, can significantly damage or benefit a company's trading outlook.

·         The business climate, via competition, new technology or a change in the market place, is constantly in flux.

·         Stock market fads can cause companies to be mispriced. This can bring stocks into the buying range for a patient investor or, conversely, push up the value of other stocks in a portfolio to the point where they are a screaming sell.

3.  Management can take decisions that have a long-lasting impact on a company's earnings. Big acquisitions, mergers, big disposals and demergers are sometimes the product of restless management. Sometimes they are the product of inspired management.

Tesco PLC


WPA poster, 1937, courtesy Wikipedia


Tesco has been through the wars. A withdrawal from its US venture at a cost of 1.8 billion pounds, the cessation of its Japanese venture and the recent merger of its stores with a Chinese retailer, leaving it with a 20% share of a business run from Beijing (the company is state-owned), have removed Tesco from any controlling interest in the world's three largest markets. 

Tesco, with 71% of its operating profits coming from the UK, remains heavily dependent on the UK consumer. In its UK home market, Tesco has suffered from a loss in market share, shrinking margins and a 0.8 billion-pound property write-down for land it no longer plans to develop. The year ending February 2013 saw the company barely in the black with large impairments and reduced trading results in the UK, Europe and Asia and in its banking subsidiary.  

Tesco's share price (in blue) has underperformed its largest rival, J Sainsbury (in green), by 30% since January 2012, when its difficulties became apparent: 

Graph courtesy Yahoo, click to enlarge 

Yet Tesco has undeniable strengths. Consider: 

1. Tesco, with 30% of the UK grocery market, is almost twice as large as its next largest competitors (ASDA and Sainsbury).  

2. Net debt, at 6.6 billion pounds, is 3 billion pounds less than in 2009. This reflects good capital management. Net debt is 40% of equity. Standard & Poor gives Tesco a long-term credit rating of BBB+. This is the lowest but one investment grade. 

3. UK revenue increased by 5% p.a. between 2009 and 2013. Per square foot, revenue was stable in a period when consumer demand has been flat. 

4. Underlying earnings per share (and for once this is more than a cosmetic number) were 36p in 2013, about the same as in 2012. 

5. The dividend was covered 2.4 times by underlying earnings in 2013. 

6. New management has a clear plan for putting the company back into financial health:

·         The net margin in the UK has been 'reset' to 5.2% to allow for better customer service. It has already employed an additional 8,000 staff in the UK.

·         Investment criteria are strengthened for its investment in online selling and international sales.

·         Capital expenditure is to fall from 4.2% of revenues to 3.5 to 4% of revenues.

·         Financial objectives are 'mid-single digit increases in profits', a return on capital employed of between 12 and 15%, and dividend payout to be around one-half of earnings per share. 

It is a sign of the change from the previous management's attitude that the Chairman, in the 2013 Annual Report, should write, "One of the greatest challenges for a business is to face itself honestly." And the Chairman promises "rigorous capital discipline." 

At the current price of 369p, Tesco shares are rated on a P/E ratio (on underlying earnings) of 11 and yield 4.0% (Sainsbury shares are rated on a P/E of 12 and yield 4.3%). My valuation model values Tesco shares at about 430p.*

The prudent investor will consider: 

1. Tesco is a massive company with over half a million employees. It could take years to turn around. 

2. The international operations that remain could still cause more impairment charges. 

3. Though Tesco claims to make money on its online business, it is very likely that margins here are lower than on store sales. No one else seems to make money from selling food online. 

4. The smaller grocers (Waitrose, Aldi and Lidl) are still taking business away from the larger retailers in the UK. 

5. The company's defined benefit pension scheme required a further provision of 735 million pounds in 2013. This is one-fifth of Tesco's regular annual pre-tax profit. And further provisions are likely. 

*Assumptions: Earnings per share growth 5% p.a. Equity per share growth 6% p.a. Return on equity of 16%. Average P/E valuation by the market 13. Dividend payout 50% of earnings. All discounted 2014 - 18 at 12.5% p.a. (5.5% is Tesco's weighted cost of debt, plus 2% for operational risk and 5% as a margin of safety). 

NOTE: The next article will be posted on 4 September.

Wednesday, 7 August 2013

Investing in Cyclical Businesses

And Braemar Shipping PLC

Economic cycle, courtesy Wikipedia

All businesses are influenced by the economic/business/stock-market cycle. Consider Dignity PLC, the UK quoted funeral service company. In its 2004 Annual Report, Dignity predicted its market for 2005:
"Historically, fluctuations in recorded deaths have tended to be self-correcting and the Board’s view on death rates continues to rely on government forecasts. Based on these forecasts, we expect 579,700 deaths in 2005."
The actual number of deaths in the UK in 2005 was 582,639. No other business I know can forecast demand a year in advance with 99.5% accuracy. And, from one year to the next, the number of deaths never varies by more than about 5%. Yet Dignity's share price (in blue) has fluctuated with the movements in the FTSE 250 (in green).
Graph courtesy of Yahoo, click to enlarge
Opposed to industries like Dignity's, what are normally considered cyclical industries - property, house building, engineering, mining, banking, shipping etcetera - present a difficulty for the long-term investor. Their irregular earnings, coupled with the threat of bankruptcies, ruinous 'schemes of arrangement' or desperately priced rights issues at the cycle's bottom, make them hard to value. The FTSE All-Engineer Index (in blue) compared to the Gas and Water Utility index (in green) illustrates the opportunity of investing in cyclical businesses:

Courtesy Yahoo, click to enlarge

And the FTSE Banks Index (in blue) compared to the same Gas and Water Utility Index (in green) illustrates the risks:

Courtesy Yahoo, click to enlarge

Long-term investors will prefer the steadier income streams from non-cyclical industries - utilities, food, personal care, healthcare etcetera (see companies valued in previous posts). And from those companies that have established a private market among consumers and/or professionals; these include the online and catalogue clothing retailer N Brown, the accounting software provider Sage, the education materials provider and financial publisher Pearson and British Sky Broadcasting, all valued in previous articles on this blog.
But there are times, and now is one, when many non-cyclical industries are valued too highly by the stock market. For instance, the funeral services company Dignity, at 1500p a share, is priced on a multiple of 22 times earnings and yields a scanty 1.1%. The long-term investor can sit on his or her cash or venture into cyclical companies. 
The cautious investor will want to:
1. Assess whether the cyclical industry is growing or not from one cycle to the next.
2. Understand what the causes of the cycle are. It helps to quantify the most relevant factors. Cyclical companies often refer to industry standard statistics when presenting their results.
3. Know at what point of the cycle the industry is in now. Timing is very important. Industry sources (trade journals, company news and reports) help.
4. Be prepared to sell when there is evidence the cycle has entered the boom phase. Here a target price and a stop loss are most useful.

Braemar Shipping Services PLC

Unloading at port of Mumbai, India, courtesy Wikipedia

Shipping volumes depend on international trade, and international trade grows - and falls - at about twice the rate of world GDP. Since 2000, merchandise exports have grown at a cumulative 5% per annum. This includes the 19% fall that occurred during the financial crisis. Since then, merchandise exports have been growing at over 9% p.a.

Graph courtesy of Wikipedia, click to enlarge
While trade and shipping volumes have recovered, shipping rates have not. The standard measure for shipping rates that exclude oil and containers, the Baltic Dry Index*, recently shows the most alarming volatility:
Graph courtesy of Wikipedia, click to enlarge
*The Baltic Dry Index provides an assessment of the price of moving the major raw materials by sea. Taking in 23 shipping routes measured on a time-charter basis, the index covers dry bulk carriers carrying a range of commodities including coal, iron ore and grain.
The Harper-Peterson Index for transporting containers and the Baltic Dirty Tanker Index for transporting oil also boomed in the years preceding the financial crisis. Prices have yet to recover. Ship owners ordered too many ships in the boom years preceding 2009 and, as two years pass between order and delivery, ships were still coming onto the market when international trade had crashed. Fleets are young and it will take years for shipping rates to recover.
However, shipping volumes continue to increase and shipbrokers that provide services for shipping have benefited. Braemar Shipping Services (BMS) is one. Braemar's share price (in blue) is more volatile than the FTSE Small Cap Index (in green) to which it pertains:
Graph courtesy Yahoo, click to enlarge
But Braemar's earnings and dividends are more stable than one would expect from the above chart or from the volatility in shipping prices:

Per share pence
Per share pence

 The relative stability in Braemar's results is thanks to management's role in reducing its dependency on ship broking. In 2007, 84% of the company's operating profits came from ship broking and only 16% from its other activities - technical support, logistics and environmental services. In 2013, ship broking accounted for only 40% while technical (25%), logistics (15%) and environmental services (20%) contributed 60% to operating profits. Ship broking profits fell by 39% from 2007 while the contribution from shipping services increased by almost 5 times. Braemar operates in all parts of the world.
Braemar is in good financial health. Consider:
1. The company has held net cash for every one of the last 10 years. At February 2013, net cash, at 23 million pounds, was almost a quarter of Braemar's market capitalization of 95 million pounds.
2. The balance sheet is clean of pension scheme liabilities. Braemar only offers a defined contribution pension scheme to its employees.
3.  Operating cash flow (after deducting capital expenditure) of 40 million pounds these last 5 years covered the dividend 1.6 times. Braemar has built up its newer businesses through acquisition.
4. Return on equity for the last 3 years has averaged 12%.
In Braemar's 2013 Annual Report, management expect continued decline from ship broking, an improvement in the technical and logistics business and a decline in environmental during 2103/14. There are no broker forecasts for this small company.
Braemar's nearest London-quoted competitor in ship broking and services is Clarkson PLC, a constituent of the FTSE 250 Midcap. As such, Clarkson attracts the interest of analysts. Braemar and Clarkson have a similar recent trading history, but Clarkson's shares (at 1900p) are rated much more highly than Braemar's (at 458p):
P/E Ratio
Dividend yield
Price:Book ratio
Net cash as % market value

Compared to Clarkson, Braemar looks to be good value at its current price of 455p. But the investor will want to consider the following:
1. Braemar's main business continues to be ship broking, which is still in recession.
2. While shipping volumes are increasing, there is still an excess of ships of all kinds and there is no sign that rates are recovering.
3. When it comes, the increase in shipping rates, as measured by the Baltic Dry Index, is likely to be sudden. And this will be reflected in Braemar's share price.
4. As the stock market anticipates cyclical recoveries, the investor is seemingly left with the option of buying in early, in the hope of anticipating the market anticipating the recovery. The risk is that the cycle has not reached bottom.