Yields are usually for a reason

Yields are usually for a reason

12 Jun 2013

Investment is betting on probabilities, not on outcomes. How can we judge if the probability of an event is over-priced or under-priced? Do not try to guess the probability of an outcome with a view to pricing it. Do ask when the price is telling you about the probability – then ask yourself if this is reasonable.

For obvious reasons, investors are now very interested in dividend yield but they also have reasons to be worried about the stock market. Commentators seem to be evenly split between those who are looking down and suffering vertigo and those who say that equities continue to offer attractive value compared to what else is on offer. According to my own investment rules, you will find me in the second camp for as long as that proposition continues to be true.

Dividend yields are as reliable a measure as any for judging what the market thinks of a company. Then, as the quotation from my fourth investment rule (Probability) says, we can ask ourselves whether this is reasonable.

Below is a table of current dividend yields from shares that I follow. There is a wide range which, if the market is efficient, should tell us that we can choose between relatively safe companies with relatively low yields and relatively risky with commensurately high returns. Before I discuss any individual stocks, I will characterise what these various yields imply.

 

 

Price

Yield

BG

1165

1.4%

Fuller Smith & Turner

925

1.5%

Domino’s Pizza

670

1.5%

Travis Perkins

1520

1.6%

Experian

1175

1.9%

Regus

165.00

1.9%

Home Retail Group

152

2.0%

Diageo

19.15

2.2%

Interconti Hotels

1835

2.2%

Smith & Nephew

755

2.3%

Rentokil

88

2.4%

Millennium

549

2.5%

Cranswick

1120

2.7%

Stage Coach

287

2.7%

Kingfisher

344

2.8%

Hays

90

2.8%

BT

312

2.8%

Synthomer

194

2.8%

Sage

348

3.0%

Rexam

505

3.0%

Micro Focus

659

3.1%

Unilever (€)

31.4

3.1%

Reed

736.0

3.1%

Tate & Lyle

811

3.2%

Greencore

130.00

3.3%

St Ives

160

3.3%

Greene King

750

3.4%

Debenhams

92

3.6%

Morgan Crucible

277

3.6%

M&S

448

3.8%

Pearson

1173.0

3.8%

UBM

690.00

3.9%

Mitie

253

4.1%

Costain

254

4.2%

Tesco

343

4.3%

Marstons

142

4.4%

Halfords

315

4.4%

Dairy Crest

465

4.5%

De la Rue

950

4.5%

Morrisons

263

4.5%

Ladbrokes

198

4.5%

Glaxo

1640

4.5%

Centrica

360

4.6%

Sainsbury

360

4.6%

Morgan Sindall

575

4.7%

BP

460

4.7%

Nat Express

201

4.9%

BAE

402

4.9%

Greggs

400

4.9%

Premier Farnell

210

5.0%

Royal Dutch

2185

5.1%

Vodafone

191

5.3%

National Grid

746.00

5.3%

Astrazeneca

3280

5.5%

Go Ahead

1460

5.5%

Tullett Prebon

290

5.8%

ICAP

375

5.9%

Balfour Beatty

215

6.6%

 

2% is the return from 10 year gilts. Gilt yields, as discussed elsewhere, are secure but punishingly low. Investors are effectively being driven away from safety and encouraged to take risks (though, as discussed in my post on QE, this seems to be prolonging a sense of crisis which is not at all conducive to risk taking).

Shares that yield 2%

By implication, investors really love these companies. They are certainly owned for a reason that surpasses the yield. One possibility is that there is a widely understood growth story. Another is that these companies are considered to be takeover targets.

Shares that yield 3%

The companies should be widely admired. They should be regarded as reliable and highly likely to increase their dividends regularly.

Shares that yield 4%

This is where the averagely risk-averse investor might feel tempted. The companies should be regarded as struggling, perhaps with their business model or the markets into which they sell, but not dangerous in terms of their financial health. Investors should not expect the dividends to be cut but nor are they likely to expect them to be increased.

Shares that yield 5%

The market does not like these companies. They are seen as unreliable. This may be because there are external threats that are beyond the power of management to prevent or mitigate or it may be that management is simply mistrusted. It might also be the case that they are mature businesses that are, rightly or wrongly, thought to be approaching the end of their life-cycle.

Shares that yield 6%

The market does not trust the dividend. It expects it to be cut (or “rebased”, in modern corporate terminology).

Now to the fun part – to test my assumptions of what each company’s yield says about it against what I consider to be reasonable.

The companies that yield c.2%

BG is vaguely touted as a takeover target from time to time. Let’s hope it is because it never generates any free cash flow. Fuller Smith & Turner just raised its dividend by 8% which cannot justify such a low yield. It has just been voted “Company of the Year”. Watch out. Experian, Regus and, in my view, Home Retail Group are growth stories that investors think that they understand. Diageo and Smith & Nephew are widely admired, if mature, businesses with high operating margins. The one low yielding company that I cannot find an explanation for is Travis Perkins, better known to most of us as Wickes.

The companies that yield c.3%

Kingfisher, which owns B&Q, is better than Wickes according to my wife who really knows about these DIY emporia and well deserves its implied reliable rating. Sage, which makes software for small businesses, is also highly reliable and has an usually high yield for a software company, but its organic growth is too feeble for the taste of many tech investors: as an ex tech investor, I like it. Rexam, Unilever and Tate & Lyle are all sound businesses connected to the sale of perishable products into mass consumer markets. They look like typical 3% yielders. I like BT less. It has, through no fault of its own, long been a dinosaur looking for new businesses. If memory serves me, it was largely blocked from the mobile phone market due to competition rules; it then made an expensive failed attempt to run IT systems for the NHS; now it is competing with Sky Sports; good luck with that.

The companies that yield c.4%

As expected, many of the companies here are in sectors that make investors feel nervous. Media related companies like Pearson and UBM are solid cash flow generators but they face questions about their role in the digital age. The same can be said for the supermarkets and other retailers. The same can be said for De La Rue which prints bank notes and for Ladbrokes which needs to adapt to online sports betting websites. There are many very old established names that yield around 4%.

The companies that yield c.5%

This is the most interesting selection full of companies that people dislike for both financial and other reasons. National Express enjoys public subsidies but seems to provide little joy for its public – it is also too indebted. BAE is an arms manufacturer and its earnings and its cash flow seem to come out of one of its black boxes. Greggs is (perceived as) a VAT dodger and it warned on profits recently. Royal Dutch is an oil major that continues to invest vast sums in carbon-based energy (though if this is a popularity contest, the fact that it yields more than BP is interesting). Vodafone is another perceived tax dodger whose management comes in for strong criticism of which this is an entertaining example. AstraZeneca is a dinosaur drug giant with management that has been seen as incapable of addressing the threat of expiring patents. In almost every case, these shares are subject to a double-whammy of being unpopular for two reasons. As an investor, you have to make your own call on ethical grounds but bear in mind that other people’s moral objections may be offering you a discounted entry price.

The companies that yield c.6%

Go Ahead and ICAP are companies that I consider to be misunderstood by the market and have written so elsewhere. Balfour Beatty is a candidate for a dividend cut. Given the constant clamour of media talking heads calling for infrastructure projects, it may seem surprising that UK construction businesses these days seem to be of uncertain quality and to consume cash hungrily – but they are and they do. Avoid.

Here are my picks for a sensible yield portfolio:

De La Rue

Go-Ahead Group

Kingfisher

ICAP

J Sainsbury

Ladbrokes

Mitie Group

Pearson

Royal Dutch B

Sage Group

UBM

W Morrison

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