Income stocks: The road ahead

Excess leverage has tainted income stocks, but companies such as BHP and Telstra could soon offer new opportunities.

PORTFOLIO POINT: Stocks paying a good dividend income are few and far between; those with assets capable of generating an income stream are worth investigating.

During the days of despair earlier this month when the sharemarket was in free fall, one stock stood out with a significant rise – Telstra.

The reason why Telstra shares rose on such a dark day was that there was a swing towards income-producing securities and Telstra looked about the best income-producing stock amongst the leaders on the market.

Yet as the market was boosting Telstra shares, a dark shadow appeared over the company, at least from the point of view of those Telstra shareholders who want income from the stock rather than growth.

There is no doubt that the NBN agreement with the federal government provides Telstra with an income that will stretch out for some years and takes a lot of the speculative activity away from its dividend stream.

But Telstra has been eyeing the Channel Nine Group. Nothing may come of the Telstra investigation but the Nine Network is a highly speculative, old media stock that is hopelessly over borrowed. I realise that the Telstra management believes they can disseminate the content within Nine amongst Telstra’s various mobile and other outlets, and therefore enhance the penetration of their mobile and other device markets.

Maybe they are right, and remember Telstra under a previous management almost bought the Nine Network from the Packer family. But such a purchase completely transforms the outlook for the company. Telstra would no longer be an income stock but would be a stock that gambled that their management was good enough to make the Nine Network enhance the growth prospects of Telstra.

As you can guess from my tone I think that the Telstra and Nine cultures are so different that a merger would be an incredibly difficult management task, especially when Nine itself is under challenge from new media and of course from the other players in the TV market.

But leaving aside the strategic merits or demerits of Telstra acquiring Nine, the fact that Telstra has actually been looking at Nine underlines the dispute between those who want income from shares and those who are looking for growth.

We have seen this in BHP where shareholders are seeking higher dividends and management has, at least until now, been totally orientated towards providing growth from the company’s asset and profit base. The fall in commodity prices and the explosion in the cost of erecting and operating mines have forced BHP into a dramatic rethink. As Tim Treagold explained, BHP now yields 4% and is starting to look like an income stock but the board still wants to grow if they see the chance.

Currently bank shares are highly favoured amongst brokers as income stocks. The argument, “why should you accept what have become low rates of return in term deposits when there are much higher rates of return available on bank shares?” has been a popular one amongst advisers for a long time.

But without trying to cast doubt on bank profits, there is no doubt that if we have a rise in unemployment or there is a break-up of the euro (which will do major damage to world banking), then the dividend rates will be threatened and of course the stocks will fall sharply.

In my view, while the income from bank shares is good they must remain an equity risk and therefore are not really income securities in the purest sense. Separately, bank hybrids have fallen in price following the decline in interest rates, which have made their yields less attractive.

One of the problems self-managed and even legacy superannuation institutions face is that the market has not been good at producing pure income stock.

It’s true that there are government bonds available and, more recently, corporate bonds. But like hybrids these usually carry interest rates that are very closely linked to the Reserve Bank’s official interest rates. What superannuation investors are looking for is a pure income stock that offers a higher rate of return than bank deposits.

Commercial property trusts led by prime retail stores have been a wonderful source of this income, unless the trusts holding the property leveraged too far. But retail property now has much greater risk because rents have risen too far.

Theoretically the best source of such returns is investing in infrastructure like roads, pipelines, and hospitals – structures where there is stable and rising income.

The problem is that not enough of this sort of stock is available. There are a number of gas pipeline and toll road infrastructure stocks, but all too often they have high leverage and so are vulnerable to the capital markets. What superannuation investors are after is infrastructure stocks with very low leverage where you simply take the benefit of the low-risk income produced by the infrastructure. In essence, it is almost a take or pay situation.

Toll roads after their initial phase-in period have traditionally provided that sort of income. But there has been a tendency for promoters to over-leverage the stocks. Australia has a lot of infrastructure that needs to be built and is looking for the capital.

The money is there for good infrastructure, but superannuation investors do not want to take the construction risk. But when the project is completed and the revenue has been contracted, then superannuation investors are ready and willing to take a slice of the action assuming the income is secure and the yield is attractive to the conditions of the day. It is important that leverage be kept to a minimum.

I think in due course governments and those wanting to build infrastructure will wake up to this situation and begin to provide securities that are attractive to superannuation holders.

In the meantime, the availability of true income stocks is not as widespread as I would like. Companies like Telstra should think seriously about splitting and creating a true income stock. Then, with their high-risk operations, they can go after Nine. Maybe BHP should turn its rail lines into a toll-based infrastructure stock.

I think there is a very good chance that the NBN, in about two or three years time when it has started its network and income is coming in, could devise securities that will be extremely attractive as income stock for superannuation holders. There is a gap in the market.

Meanwhile if you are looking for term deposits, NAB had the best rates as of the time of writing'” but they can change quickly. But for amounts under $200,000 (government guarantee is $250,000) Rabo is hard to beat particularly for the longer terms.