Thirty dividend income threats

The yield trap

Yield traps are stocks that appear to have attractive dividend yields as a result of extreme falls in share prices but also carry high risk of dividend cuts in the near future.

The tables below list stocks that are most vulnerable to a dividend cut over the next year. The risk is approximated based on four stress factors – forecast earnings revisions, trend in payout ratio, stock price stability and the strength of recurring cash flows (eg. operating cash flows minus capex need to sufficiently cover distributions without the need for external borrowings or share issues).

During the last reporting season, many companies on the high-risk list had cut their distributions (eg. APN News & Media, Fleetwood Corporation and Emeco Holdings). However, we continue to be wary in recommending these stocks for yield given the weak operating conditions inherent within their sectors. Not surprisingly, mining services companies continue to be at risk of dividend cuts from a free cash flow perspective. Those within this sector which appear to have the most sustainable yields are Downer EDI, Orica, RCR Tomlinson and Mineral Resources.

Companies that have yet to reduce their distributions and are considered high-risk include OrotonGroup, GUD and Monadelphous Group. Those that have cut dividends but continue to pose a risk include DWS, Sedgman Ltd and Myer. Note that Boart Longyear, Fleetwood and Emeco did not pay a dividend for the 2H13.

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The high-yield conundrum

It’s also worth pointing out that after idiosyncratic risks, it is well known that high beta (low yields) stocks will almost always underperform in bear markets. The danger with this principle is that it broadly categorises high-yield stocks into one “safe” group rather than separating them into subsets which have a significantly higher information coefficient to alpha, especially in the context of the current market cycle. High-yield stocks can be classified as either defensive high yields (low risk dividends) or cyclical high yields (high risk dividends). By their nature, cyclical stocks are considered growth stocks and usually have low yields in rising markets. Hence, when a cyclical company falls into the high-yield group, it is usually the result of a sharp decline in its share price (negative sentiment) which, more often than not, indicates that its forecast distribution will be cut.

The table below provides a comparison of the average capital gain achieved for various classifications during the GFC and the current market. At the end of 2007, if investors had concentrated on high-yield stocks, they would have underperformed the market significantly. The reason for this is that the high-yield stocks in 2007 consisted of many serial underperformers, especially companies with exceptionally high debt levels eg. Allco Finance Group, Zinifex, Centro Property. This explains why property and infrastructure stocks also underperformed over this period even though the investment mantra misconstrued them as being “defensive”. In the 2007 bear market, high-yield stocks underperformed the market significantly (and this included the dividend component as well).

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By separating high-yield stocks into the “defensive high yields” vs “cyclical high yields” categories, a completely different picture emerges. In the current market environment, defensive high-yield stocks such as those in telecoms, utilities and infrastructure, consumer staples, and property, have done well relative to the cyclical high-yield stocks (retail, media, steel and financials). In contrast to the 2007 bear market, defensive high-yield stocks now are performing significantly better because these companies, especially in the infrastructure and utilities sector, have been able to restructure their debt and are in a stronger financial position than during the GFC.

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The comparison indicates that high-yield investors should seek out defensive high-yield  stocks, especially during periods of weak economic growth, to avoid the risk of significant capital losses from cyclical stocks which have the added risk of future dividend cuts.

The following chart compares the historical trend between 10-year bonds and the industrial dividend yield. The gap has narrowed over the year.

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For Australian banks, valuations remain stretched but dividend yields continue to trade above the market average at ~ 5.5% fully franked. During the reporting season, the banks provided a more optimistic outlook for the sector despite plans for tougher capital requirements. Banks are expecting credit growth to rise 4-5% in FY2014. ANZ is currently the least expensive of the banks on our quantitative valuations while CBA is ranked the strongest for longer-term investors.

Telstra remains a high-yield contender, with the majority of analysts expecting it will pay a 29 cents per share dividend in FY2014. The company reaffirmed its earnings guidance at its recent AGM, with FY14 earnings before interest, tax, depreciation and amortisation expected to grow in the low single digits. The company remains confident that it will be able to safeguard the value of its $11 billion agreement with the government during negotiations with the NBN.

Among the department stores, Myer recently reported flat revenue growth for the  first quarter, with sales increasing by only 0.4%. The first quarter result from Harvey Norman was not much better, with a 2.9% comparable sales growth improvement. Both Myer and David Jones have high payout ratios (at 84% and 91% respectively) and are at risk of future dividend cuts. Last month, Pacific Brands issued a profit downgrade and alluded to the challenging market conditions.

The cyclical companies have continued to outperform defensive high-yield stocks over the last quarter as investors anticipate a recovery in the economic cycle. However, investors need to be extra careful given that earnings within a number of these sectors have not risen to expectations. Major companies with profit downgrades over the last month include Ausdrill, Mermaid Marine and Goodman Fielder.

This is an extract from the newsletter Premiership Portfolio by Sam Fimis of Paterson Securities available here www.premiershipportfolio.com/. Kien Trinh is senior quantitative analyst at Patersons.