PORTFOLIO POINT: Buying into a company when its share price is close to “dividend support” is a great way to lower risk.
In early March, I said that given the choice between buying shares in BHP Billiton (BHP) or Perth-based IT services provider ASG Group (ASZ), I would categorically choose the latter option, without thinking twice about it.
That statement caused a bit of turmoil, to put it mildly, and I received many negative responses. To my disappointment, even some of FNArena's subscribers queried whether I had lost my marbles.
Here we are today, less than two months later, and ASG Group shares are up 9.2% since March 9, the day on which I made my statement. And BHP shares? Well, they were trading at $34.71 on the day, fell to $31.46 in between and have now rallied back above $32 – still down 7.8% over the period. Overall, Australian equity indices have nearly given up all the gains achieved earlier in the year.
All of a sudden, I assume, my seemingly crazy choice looks a lot less crazy. Perhaps it’s time for a proper explanation.
When analysts at Goldman Sachs published an in-depth analysis of dividend-oriented sharemarket strategies earlier this month, they emphasised that data analysis from the past 15 years had proven that investing in high-yielding stocks is not a defensive strategy, even though strategies built around sustainable dividends have significantly outperformed the sharemarket index over the past decade.
I fully concur with the analysts’ findings. Too many investors make the basic mistake of assuming that buying stocks purely for capital appreciation is the higher risk approach (which often leads to disappointment during times when the index moves sideways or lower) and that buying dividend stocks with a high implied yield is the more defensive strategy. Alas, this misconception has seen many being punished hard after they bought shares in discretionary retailers and traditional media companies last year, as both sectors offered unusually high dividend yields on beaten-down share prices.
It is thus easily established that dividends do not equal "risk-free" or "defensive", but there is one strategy built around dividends that can seriously reduce investment risks and this is why I selected ASG Group at the time. I had done my homework and was pretty confident in my choice, even though others failed to see my logic.
The whole premise behind ASG Group versus BHP Billiton is built on the concept of "dividend support". BHP pays too little in dividends, so the concept doesn't apply, but when a company such as ASG Group is de-rated because growth has vanished in the face of the multi-speed economy in Australia, its shares tend to find support at a level where future dividends are too high to be ignored. It was my assessment in early March that, having arrived at a share price of circa $0.80, representing an implied forward-looking yield in excess of 8% fully franked, ASG Group shares were in exactly such position.
The same logic applied earlier to Ardent Leisure (AAD) and to the big four banks. Essentially, what happens is these stocks are being de-rated because the companies or the industry as a whole go "ex-growth", but the slide in the share price stops where "dividend support" kicks in. The difference with print media companies and with discretionary retailers is that neither of these companies ends up battling sharply negative growth.
Ardent Leisure, for example, is anticipated to report negative 4% EPS growth for the year to June this year, but FY13 is expected to see a positive growth number, albeit a modest one. Some of the major banks might report negative growth this year or next, but it won't be anything as bad as what shareholders in the likes of David Jones (DJS) and APN News & Media (APN) have endured in recent years.
Most importantly, the banks have enough cashflow and reserves to virtually guarantee that yesteryear's dividend payouts will not be lowered in years ahead (at the very least). The solidity of that promise in combination with the market's perception of the inherent security behind the banks' dividend promise has kept a solid floor under the banks' share prices during times when sellers dominated buyers. Straightforward logic tells us that risks overall can be minimised by buying into these share prices when dividend support levels are near, even if this means buying when other market participants are selling.
More often than not, it doesn't take any hocus pocus or higher forms of market intelligence to find out where such dividend support is located. A random price chart for CommBank shares post-2009 clearly shows support is below $48. CommBank shares fell below $49 last week. A similar price chart for ANZ Bank (ANZ) shares shows a more diffuse picture, but I'd say the closer to $20, the stronger dividend support will come to the fore. On Monday, ANZ shares closed at $20.60 and this translates into a forward yield in excess of 7%, fully franked.
The price chart for ASG Group didn't provide any such clues, with the share price first running up from $0.40 in 2009 to $1.49 in July last year, after which a gradual depreciation left the share price at $0.80 in March this year. With an implied forward-looking dividend yield at 8%, it was my belief that further downside was limited, as long as the dividend payout itself didn't come under threat. Today, I still believe this is the case, but ASG Group shares are now trading around $0.90 (sometimes above) and this means not only has the implied dividend yield now fallen closer to 7%, there's now also more risk that the share price might tumble when risk appetite again leaves the market.
Investors should note local IT stocks in Australia have all been de-rated over the past year and with good reason, as investors correctly anticipated the sector would be facing serious headwinds to growth. Apart from ASG Group, peers including SMS Management and Technology (SMX) and Oakton (OKN) have all seen their share prices tumble. I picked ASG Group after my research taught me some 70% of annual revenues are recurring, providing a high degree of certainty underneath dividend payouts.
It goes without saying this strategy equally requires a healthy balance sheet as well as sufficient cash flows.
As it turns out, I didn't even pick the best option available: Technology One (TNE) has seriously outperformed since the beginning of the year (up by some 20%). Technology One shares have equally avoided being de-rated post-2009. The reason behind this is easily found in the summary table of FNArena's stock analysis: the company's earnings per share have improved by double digits in years past and they are anticipated to do exactly that in years ahead. As a result, Technology One shares are not as cheap as most others in the sector and the implied dividend yield is between 5.5-6%.
What the example of Technology One shows is that picking cheap stocks near solid dividend support won't put a rocket under one's investment returns, unless earnings growth returns at some point. In the case of ASG Group, this won't be the case this year and we'll have to wait and see whether FY13 will deliver on the promise. The same logic applies to the banks, where FY14 might be a safer bet to see growth numbers pick up from low single digits. As long as investors buy cheaply and nothing happens that threatens the payout of dividends, they do have the luxury of sitting and waiting for growth to return.
In terms of finding the next ASG Group, I have come to the conclusion that Thorn Group (TGA) looks like a genuine candidate. The specialist niche lender and provider of consumer credit has equally been de-rated over the past 12 months and with the share price now between $1.40-$1.50 the price-earnings ratio (PE) is only at 7.3x and the dividend yield at 6.9%. The balance sheet seems in good shape and so are cash flows. Highly regarded management is working towards diversification, away from the radio rentals operations that have served the business and its shareholders so well since 2007.
Price deflation for flatscreen TVs and PCs is now hurting growth, while new initiatives are still of insufficient size to fully compensate for this, but analysts (and management) are confident that FY14 and beyond look promising, at the very least. Nothing in the sharemarket comes without risks and it is possible that FY13 might well disappoint in terms of (negative) growth. As shown in prior examples, such risks can be mitigated through buying the shares as close to dividend support as possible, while free cash flow projections virtually guarantee there will be no cuts to dividend payouts.
In case the share price shows no net progress in years to come, the yield is projected to rise from 6.9% this year (until March 2013), to 7.2% in FY14, to 7.5% in FY15.
As far as the proposition of ASG Group versus BHP Billiton is concerned, right now the latter seems like the most promising choice, but only because of the sharp divergence in share price movements since I first raised the question in early March. If, however, growth returns much quicker to ASG Group, I would still prefer to own shares in the IT company. Earlier analysis has revealed that combining growth with sustainable dividends simply cannot be beaten in the longer run. This is why pre-2007, owning shares in David Jones (DJS) beat investing in Rio Tinto (RIO); the only reason why this is no longer the case is because David Jones has seen growth slip away in rather dramatic form.
It's good to remind all investors looking to play the sharemarket from a yield focus: avoid stocks where growth has left, no matter how high the yield. It is simply not worth the risks.
Rudi Filapek-Vandyck is editor of FNArena, an online news and analysis service. (This is an edited version of an article sent to FNArena’s subscribers on Monday, May 28 2012.)
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.