High-voltage yields

Listed utilities are delivering high-yield returns, and strong cash flows suggest there is more upside potential.

PORTFOLIO POINT: A high dividend yield can often equate to high risk, but utility stocks are delivering good returns and investors have the security that they won’t run low on cash.

The month of June saw Australia's ASX 300 Accumulation Index (accumulation indices include dividend returns) rise by 0.5%, underperforming the US, up 4.0%, the World MSCI (ex-Australia) index, up 4.9%, and the regional MSCI (ex-Japan), up 3.5%.

We don’t have to look too far to work out why Australia underperformed, and this graph of the RBA commodities index holds a clue:

The resources sector fell 4.6% over the month while the All Industrials provided a plus 2.4% offset with defensive stocks, and yield, leading the way. Financials were up 4.8% (not defensive but high-yield), real estate investment trusts (REIT) were up 4.3%, healthcare was up 2.5% and telcos (read: Telstra) were up 3.6%.

If we have a look at the June quarter, a 5% fall in the ASX 200 Accumulation Index matched the MSCI World (down 5%) but year-on-year we are down 7% while the world is down 5%.

If you were invested in fixed interest ahead of the June quarter you’ve done rather well, with the 90-day bank bill rate falling 91 basis points (ie price increasing) to 3.27%, three-year government bonds falling 96bps to 2.52% and 10-year government bonds falling 99bps to 3.09%. The RBA cash rate is of course down 75bps over the period to 3.50%. While some bargains are still available from smaller banks, term deposit rates have felt the impact of the RBA cuts.

If you were not invested in fixed interest then it’s worth appreciating bills and bonds are about as expensive as they’ve ever been and not offering yields of much more than the inflation rate. Not much to be excited about there as a longer-term investor or an investor seeking income, other than the implicit safety of such assets. Australia is one of few countries still rated AAA. Capital preservation is indeed an important consideration in this current volatile environment but one would rather not dig into capital to cover the cost of living.

June data from the ASX tells the now-worn tale of little interest in trading the stock market, at least in terms of “risk” equities. Stock turnover value was down 10% in June from May and first-half 2012 turnover was 16% lower than that of the first half 2011. By contrast, derivative volumes were up by 2% on the same half-half comparison, with SFE futures and options (these include interest rates as well as SPI) leading the charge over stock options.

The number of shares per stock option was dropped to 100 rather than 1,000 last year, yet still the general market ignores the value of option strategies (particularly while implied volatilities are surprisingly low). It is the one area of financial markets in which Australia trails well behind the rest of the developed world, particularly the US.

Derivatives aside, where does a longer term investor with a need for income put their money?

If you were to ask the analysts at Deutsche Bank, they would reply that listed utilities are still the way to go. Despite a stand-out 2011 for regulated utilities, Deutsche was still convinced of upside potential as we moved into 2012, believing strong yields underpinned by defensive cash flows would be a key theme for the year. Six months later, the analysts’ call has proved a good one. The question now, given subsequent further share/unit price rises, is: is the theme still valid?

“If anything,” says Deutsche, “this theme has increased since, resulting in continued sector outperformance. While we recognise that capital growth upside potential is limited from here, we believe strong yields will continue to drive sector outperformance”.

Yield is often considered the poor cousin of capital growth, Deutsche notes, which is probably fair in a low-yielding market like that of the US, and hard to deny in boom times such as we saw pre-GFC. But even Americans are now embracing yield as the investment choice despite historically offering a market average 2.25% to Australia's 4.50%.

In Australia at present, regulated utilities (in Deutsche’s coverage universe) are yielding over 7%. Such income looks pretty attractive when set against bonds, yielding under 4%, and given the sheer uncertainty of capital performance from the general equity market. On this basis, Deutsche sees a “compelling argument” to be overweight regulated utilities.

Of course the investor must always be wary of what a high yield implies. In debt terms, high yields imply high risk. In equity terms, a high yield can also imply risk given dividends/distributions are not necessarily fixed and at the discretion of the board, as opposed to coupon payments which are fixed or at least fixed above some floating rate such as the bank bill rate. If a company is short of cash, it can cut dividends – just look at the banks in 2009. Amidst the various infrastructure funds existing before the GFC we’ve even seen some distributions halted altogether. Yield levels are not a given.

Investors must also be very wary of “look back” dividend yields. If a stock price has fallen substantially since the last dividend paid but before the next dividend, “look back” yield measurements such as those often provided in newspapers can show startlingly attractive yields. It is very unlikely, however, the next dividend payment will match, or even come close, to the last payment, in which case that apparent yield will plunge.

It will all come down to cash flow, now that the days of borrowing to pay distributions are mostly behind us. If cash flow dries up, companies will seek to retain liquidity and a simple way to do that is not to hand anything much out to investors. Thus in choosing which yield stocks to invest in, one must look not simply at yield alone but whether the business providing that yield is based on sustainable cash flow.

This is where regulated utilities come to the fore. Note that “regulated” implies government mandated pricing, and the recent mandated indexing of the price of electricity in NSW, for example, which will see price rises of as much as 20%, shows government cannot simply set cheap prices in order to stay popular. There are other sectors in which government price-setting can be a big risk and we’ve seen evidence of that often enough – Telstra (TLS) in its earlier days and healthcare more recently under PBS changes. But utilities tend to be a lot more consistent, and while we can all learn to cut back on electricity, gas or water usage, we will still only be playing around at the margin. Utility cash flows are pretty safe.

Nearer term yields on regulated utilities are running at between 7.0% and 8.5% and Deutsche believes yields are generally sustainable. With the near-term exception of SP AusNet ((SPN)), cash coverage ratios are above 100%. This means the utilities are currently carrying more than enough cash to meet the distributions expected (which are usually based on a pre-set payout ratio).

Utilities must nevertheless spend money on capex, so Deutsche suggests an even more comforting measure of yield sustainability is to look at how much cash a utility will have after distributions and compare that to capex intentions. This will determine whether that utility does need to borrow, thus increasing gearing and threatening yields.

The analysts have concluded, nevertheless, within the universe of utilities they cover, that this is not a problem.

Greg Peel is a journalist forFNArena, an online news and analysis service.

Readers should note all names are mentioned for educational and informational purposes only. Investors should always consult with a licensed professional before making investment decisions.

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