Views at a Glance / Income Report; How predictable are dividends? (CBA, NCK, TLS, SUN, FMG)

By Market Matters 01 November 17

Income Report; How predictable are dividends? (CBA, NCK, TLS, SUN, FMG)

Market Matters Income Update 1st November 2017

The MM Income Portfolio had another positive week adding 0.477% while the ASX 200 was reasonably flat, adding just 0.1%. Major contributors were CNI and NCK, up 3.5% and 8.5% respectively while we’ve also seen a decent bounce in Harvey Norman this morning following confirmation from ASIC that they have no case around the financial reporting of their franchise stores. This has been a big impost for HVN and one key reason why the stock has traded down at such a depressed multiple.

Overall, the portfolio has gained 5.51% since inception. Cash now sits at 9.07% after allocating 7.5% into the new Bendigo Hybrid through the bookbuild which was completed last week. That deal was strongly bid and they didn’t extend it to $350m as they could have.

How predictable are dividends?

With interest rates at record lows many Australian’s are forced into the share market to increase income levels, sustain lifestyles, be able to put fuel in the Landcruiser and enjoy the wonders of our beautiful country during retirement – it’s why we created the MM Income Portfolio a few months ago to satisfy this appetite, but how safe are dividends of Australian stocks?

It’s obviously a broad question but a topical one given 1. The must own ‘yield stock’ Telstra recently cut their dividend and this prompted many in the market to sell the stock, probably right at the wrong time 2. Banks currently have high payout ratios with the added impost of higher capital requirements meaning any reasonable size economic hiccup will likely lead to cuts to dividends 3. Infrastructure assets that carry higher debt levels will likely feel the pinch as interest rates rise, and that could put their dividends at risk.

In terms of our macro view, we know interest rates are going up, we know that’s a headwind for certain dividend paying stocks, and a potential tailwind for others. We have little interest in Infrastructure given their bond like characteristics, so we won’t consider those, we own Telstra in the income portfolio so clearly have a vested interest there. We’re also long the banks and that’s an area that is likely to benefit if rates go up gradually but clearly worthy of some thought, Suncorp is our largest holding so the sustainability of their dividend is important, we covered property stocks last week (click here), concluding that from a sector perspective a lot of the players look too expensive if we consider the current backdrop of rising global interest rates and high property prices, however we are open to the sector if specific stock driven opportunities arise.

We mentioned the consumer facing stocks in today’s AM report commenting that we need to be very selective in our exposures or avoid all together. The Income portfolio currently holds a couple of retailers and a mortgage insurer which fall into this category, however these are stock specific plays more around the markets overly bearish positioning driving ‘cheap valuations’ than an outright call on the macro picture. Importantly, we also have hybrids and a fixed income investment in the portfolio and that helps with income predictability. All up, we’re comfortable with the level of visibility of income in the MM Income Portfolio.  

  1. The Market

Looking firstly at the ASX 200 dividend yield, the market pays 4.31%, while 12 month term deposit sits at ~2.30%. which is a spread of 2.01% . The Index is 76% franked (which equates to a grossed yield of 5.71%) so if we think about things after tax, then the spread versus cash or the risk premium you earn to hold equities is around 3.41%. It’s a much debated topic however looking back in time, a typical risk premium is around 3-3.5%, which is about inline with current levels.

The predictability of dividends really does come down to the predictability of earnings. If we have a handle on earnings and we understand the proportion of those earnings that are paid in dividends, then we can determine how predictable dividend payments will be.   

Looking at the earnings for the ASX 200 using Bloomberg Consensus, we see a positive earnings trend even though the index is leading those earnings – clearly the market is expensive from an absolute P/E perspective however that’s because interest rates are low.

The long term average PE of the Australian market is 13.8 and the current PE is 15.6. The same is true for American stocks with the long term PE there of 15.4 versus the current PE of 18 which renders them 13% and 17% overvalued in terms of their earnings, HOWEVER, when considered in the context of low rates , we actually see the Australian market about 7% ‘cheap’.

ASX 200 Monthly Chart versus Earnings Expectations

  1. Portfolio stocks

Banks; the earnings trends here are improving and despite high payouts (~70%), the outlook for future earnings also seem sound as long as interest rates are lifted gradually. Banks are very much exposed to the ebbs and flows of economic momentum and right now, this is flowing through to better earnings and therefore we remain comfortable holders here for yield.

Bank sector monthly chart versus Earnings Expectations

Commonwealth Bank (CBA); The decline in share price recently following reputational issues is all about a PE re-rate, not the reduced outlook in terms of earnings as the chart shows. In fact, CBA should be earning more now than they did when they were trading at $96.  This simply means that market sentiment has changed, which caused a drop in the stock and we should take advantage of it. We have 7.5% of the Income Portfolio in CBA.

Commonwealth Bank (CBA) monthly chart versus Earnings Expectations

Nick Scali (NCK); One of the most beautiful trends in terms of earnings and share price is shown below from Nick Scali, a stock we own in the Income Portfolio which is up around 13% since purchase. They recently upgraded guidance and continue to kick goals. Despite the headwinds in retail, the consistency of earnings is clear which drops down to a very consistent and growing dividend, which we purchased into market weakness. It’s hard to fault this trend. Stay long NCK

Nick Scali (NCK) monthly chart versus Earnings Expectations

Telstra (TLS); we own in the Income Portfolio from $3.48 so we’re only marginally up on the holding. From 2006 onwards the company paid a FY dividend of 28cps or above. Specifically they paid 28cps from 2006 to 2013, increasing to 29.5cps in 2014, 30.5cps in 2015, 31cps in 2016 & 2017 before cutting their guidance to 22cps for FY18, and the market has become incredibly bearish the stock.

We’d argue that the dividend cut is a prudent measure, the first time TLS has actually implemented a sensible policy for more than a decade. It looks to us that recent weakness is more a function of shareholder churn with retail investors dumping the stock due to the dividend cut.  We expect that while retail investors were attracted to a strong dividend, institutional investors are more likely to look past the dividend at earnings and valuation – which to us now seem reasonably attractive, hence our purchase in the income portfolio.

In terms of dividend predictability, there are some clouds here, however we think that they’ve been aggressive in their dividend guidance and because of that, there is a wider margin for error in terms of earnings.

Telstra (TLS) monthly chart versus Earnings Expectations

Suncorp (SUN); our largest holding in the Income Portfolio so clearly relevant here. The earnings trends outlined below are volatile however that is typical of an insurance stock. Importantly, SUN have excess capital of their balance sheet, are very conservative in terms of risk management, and are likely to supplement regular dividend payments with special dividends as time goes by. We remain bullish SUN targeting above $16. 

Suncorp (SUN) monthly chart versus Earnings Expectations

  1. Opportunities on the radar

We penned a note a few months ago discussing the miners as potential yield plays, suggesting that underlying earnings are dictated heavily by what commodity prices do, and as such, volatility in earnings will play out and will feed some volatility in dividends. If we buy resource stocks solely for dividends, then this reality must be acknowledged. The miners dividend policies revolve around a payout of earnings with varying ranges. This might seem simple however cast your mind back to the ‘progressive’ policies of the past, which in hindsight seem ludicrous. Because they pay a percentage of earnings, we should simply focus more on earnings, the outlook for those earnings and the dividends will look after themselves.

Take Fortescue for instance -this was touted as an income stock after they produced a great result in August and importantly, blew past all expectations in terms of the dividend paying 25cps in September. Annualise that and we get a yield on the price at the time of 8.5% plus franking – clearly attractive. Since then the price of Iron Ore has tumbled more than 25% dragging down the price of FMG by around $1 or a similar amount in percentage terms.

The result in August was a cracker however the prevailing trend in the Iron Ore price since then has highlighted the vagaries of their earnings. This is a stock to buy into weakness and clearly we’ve had weakness. Interestingly, at the time of the report they announced an average Iron Ore price for the period of $US53 a tonne compared to US$45 tonne in FY16. Right now, the Iron Ore price sits at $58.52 yet the price of FMG is now down ~25%. FMG is firmly on our radar as an ‘Income Stock’. A panic move below $4.50 would get us interested, bearing in mind that resource stock detract from income predictability.  

Fortescue Metals (FMG)  monthly chart versus Earnings Expectations

Conclusion (s)

The income portfolio continues to perform well, however importantly, balancing the level of income achieved  and the predictability of that income remains our core focus 

We think Telstra is oversold and we remain buyers here for income 

Fortescue is not your typical Income Stock, however it is now on our radar as a buy into weakness

Disclosure

Market Matters may hold stocks mentioned in this report. Subscribers can view a full list of holdings on the website by clicking here. Positions are updated each Wednesday.

Disclaimer

All figures contained from sources believed to be accurate.  Market Matters does not make any representation of warranty as to the accuracy of the figures and disclaims any liability resulting from any inaccuracy.  Prices as at 01/11/2017.  09.00am

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