Further to my post on what factors I use to pick Compound Income stocks and the value stock selection the other day.
I came across a site recently that explains things in a relatively simple fashion including videos, which may be preferable if you find the academic papers a bit heavy going.
This article looks at the benefits of adding a profitability measure to a variety of different portfolios.
While this one which includes videos and looks at market, value and size risk factors. I particularly like the bit where it explains why buying a seemingly boring value stock which makes Spam over a growth stock involved in Mobile Phones might be a good way to go, enjoy.
Further to my recent post about Cashing in my stamps where I sold one of my stocks on a 20x P/E and a sub 2% yield, this is where I found a more attractive P/E, yield and dividend growth combination.
It is a sligihtly strange one Hargreaves Services (LON:HSP) which describes itself as follows:
Hargreaves Services plc is a holding company. The Company is engaged in the provision of haulage services, waste transportation, mineral import, mining and processing, together with coke manufacture and related activities.
It breaksdown as follows:
Divisions by T/O £m, Op. Pr. £m, Op. Margin %
Production 103.2, 16.7,16.2%
Energy & Commodities 585.0, 31.9, 5.5%
Transport 82.7, 4.0, 4.8%
Industrial Services 149.3 3, 2.0%
This gives an overall operating margin of just over 5%, although in the past it has been over 7%. So probably dull enough to be on a low rating which indeed it is. According to Stockopedia it is on around 6x with a 3% yield on a 12m forward basis and has a value rank of 95 (100 = best) so it ticks the value box.
In their most recent H1 pre close trading update in December they indicated that trading was in line with their expectations and they were well placed for a strong second half. So It looks as though the H1 results due on 11th February 2014 should be OK, but will be interesting to look for any updates on demand for coking coal from their steel customers and the outlook for H2.
In last years results they made an interesting shift in their dividend policy as follows:
In view of the strong underlying performance from Continuing Operations the Board has confidence in recommending an increase of 15.3% in the final dividend from 11.8p to 13.6p. This will bring the dividend for the full year to 20.5p compared with 17.8p in the previous year, an overall increase of 15.2% for the year. The proposed final dividend will be paid on 12 December 2013 to all shareholders on the register at the close of business on 8 November 2013.
The Board believes that the Group's dividend cover remains conservative. The average dividend cover over the past three years has been set at between six and seven times. The closure of Maltby together with the expansion of the Group's surface mining activity reduces the capital intensity of the business and increases the stability and predictability of our operating cash flows. The Board has therefore set a target of increasing the dividend payout progressively over the next three years towards a dividend cover of around 4 times.
So this gives some scope for the dividend to increase nicely if they can also increase the earnings going forward. Taking a look at the estimates I see on digital look that they have an eps figure of around 160p and a dividend of nearly 40p three years out, reflecting the 4x cover target above, I do note however that the historic figures there are on a UK GAAP basis including discontinued activities and are therefore higher than those shown on Stockopedia. However, on the next two years numbers both are in the same ball park. Talking of more tangible historic numbers I note that the dividend has compounded at the rate of around 15% since 2009.
Now this makes looking at historic valuations a bit tricky as the historic PE has either been around 6 to 10x or 8 to 14x. An average of the two is 8x to 11x which probably feels about right for what is likely viewed as a mature stodgy business. Yield on the face of it might be a better way to go on this one and it has traded on relatively low yield which has grown quite nicely in recent years ranging between 1.2% and 3.4% according to Stockopedia, or an average of 2.3%. I guess it might move onto a higher yield as the cover comes down but IF the dividend does nearly double (as suggested by forecasts - but who knows) in the next three years then the shares should do pretty well. It also has some good institutional names on the list as major holders behind the Chief Executive who is the biggest holder at 9.2%. These include Odey, J O Hambro, M & G, Fidelity and finally Hansa, a trust I wrote about recently which prompted me to research this one.
So taking those numbers again of 160p and 40p approximately three years out 8x would give a 1280p target and 3.4% yield on 40p would be 1176p which represents 50% and 40% upside from my recent purchase price. Interestingly the high price in 2012 was just over 1200p. The fall in the price since then I think reflects the fact that they had some accounting irregularities and resultant write off's in a Belgian operation and problems at the Maltby Colliery, both now discontinued and hence the difference in the historic numbers.
If they can deliver the forecast earnings and rebuild their reputation then maybe it could get back nearer to the higher end of the recent P/E range, then the price could double. Or if the earnings disappoint and it stays on a 5 to 6x rating it might just sit there like a pudding or sink further, recent lows have been closer to 600p in 2012 and 700p in 2013.
Financially it is not too highly geared with net debt of £77.9m at the last year end versus a market cap of £287 although they have done a placing and acquisitions since then so will need checking at the results next month. Pension liabilities are also not too bad having reduced last year to £3.6m. Otherwise it is a fairly low margin business but with some good ROE and ROCE numbers with quite a bit of green on Stockopedia screen. I also note it qualifies for a couple of momentum based screens on the basis of earnings surprises, although the recent earnings trend seems to be negative over the last 3 months - not sure how that works - guess we'll have to wait and see if the interim surprise or not? So if you want to get your hands dirty in a boring grubby value stock that has had some issues, it may be worthy of your consideration.
Given the recent (overdue?) shake out in markets I thought I would share a couple more web sites with you. The first one is called Advisor Perspectives which describes itself as:ACTIONABLE ADVICE FOR FINANCIAL ADVISORS: Economic and Market Updates for Investment Planning. Another part of the site by Doug Short (his name not his trading stance) also look quite good for market related indicators etc. This is the best and the most thought provoking of the few I have just looked at and this one might be interesting if you believe wholeheartedly in technical analysis?
This site overall seems to have some interesting stuff on it and is where I came across the piece that the title refers to. Or you can download it here in pdf form as it is quite long. It is from a long time bear Albert Edwards from Soc. Gen. and a bit from one of his former colleagues Dylan Grice. It is quite strong stuff and his on going call for a deflationary bust seems at odds with the current recovery hopes. All I can say is, although he has not be proved right so far, I hope he is wrong in the long term otherwise "We're all doomed" as Fraser used to say in Dad's Army.
If you have the time you could also check out a recent piece from another of his former colleagues James Montier, which looks at valuation and it effects on returns. James is now at GMO and you can find links to some of their other publications and register here if you want.
This is the second of three articles where I explain the why, what and how of my Compound Income investing. In this part I will look at the other factors I consider in addition to yield which was covered in Why Compound Income?
Even though yield cover this to to a certain extent as often higher yielding shares tend to offer value as they have got onto a high yield by being beaten up or neglected. I do however like to check other valuation metrics when considering yield shares, to ensure that I am buying value and not just an expensive high yield stock.
No discussion of value would be complete without a mention of Benjamin Graham and his focus on buying cheap assets or Net Nets as he called them. Other studies of returns to value have also found price to book value to be a good predictor. However, I have always struggled to find many Companies meeting Graham's deep value criteria and while I wouldn't put people off using price to book and I consider it, I prefer to focus on profit, earnings and dividend based measures of value. Nevertheless in certain circumstances I use price to book such as for asset plays like property and investment trusts and for certain financials like banks.
So I consider the basic P/E as buying low P/E stocks is also generally a good idea as shown in the What works research I highlighted last time. The main issue with P/E's is that it does not take the capital structure into account. So sometimes stocks are on cheap P/E's because they are highly geared (debt) which can be both good and bad. I therefore prefer Enterprise value (EV) measures that take the full capital structure including debt into account. While there is probably no one best value measure it seems from research that EV/EBITDA comes close, so I tend to pay most attention to gross profit to asset measures and earnings yield type calculations where EBIT or EBITDA is compared to EV. I then factor these in alongside yield in my screening. However, it can also be argued that a composite value rank composed of several value factors can do an equally good job. See the book Quantitative Value for more details on comparisons of value measures and Stockopedia which has a Composite Value Rank which is probably an easier alternative for most people.
Cover, growth, operating ratios and financial security (or Quality)
Next I want to cover quality and what I mean by it in relation to compound income shares. This comes in three forms, firstly I am interested in the quality of the income and this can be indicated by how well the dividend is covered by earnings and free cash flow. The rationale for this is from this paper by CSFB which showed that cover helped to select better performing shares in the yield space and this seems quite logical and is quite commonly used. The level of cover will also be an indicator of the security of the dividend i.e. scope for it to be maintained or increased, which is what I am looking for in the Companies I invest in. I also want to avoid those stocks that are vulnerable to cutting their dividends, which is pretty obvious, but why this is a good idea is set out in this research paper on dividend omissions.
Another aspect of dividend quality that I am interested in, given that I am looking for Companies that can grow their dividends, is the dividend history or streak, together with forecast dividend growth. This can help me to identify trends and Companies that seem able to offer what I am looking for given the signalling inherent in a dividend policy. Some research has been published on this in the UK and while not conclusive it did show that it worked well in equally weighted portfolios and therefore is useful with smaller companies. The other significant feature of this research was how badly zero yielders as a group have performed in this extract from the research:
"It is observed that a considerable portion of the excess returns available to equally weighted consistent dividend portfolios can be attributed to the avoidance, by definition, of any non-paying stocks during the period studied. Whilst there have been periods of spectacular out performance by zero-dividend firms, over the full period of 1986-2006 they have demonstrated relatively poor returns coupled with markedly higher volatility than dividend paying firms."
Thus as a rule I tend to exclude zero yielders from my investment universe and also tend to use a low yield threshold to act as a sell signal / discipline.
The second aspect of quality I am looking for is the nature of the business which is generating the cash flows to pay the dividends. In this area I have tended to look at Return on Capital Employed and operating profit margins. More lately though, since they developed it, I have also been using Stockopedia's Quality ranking which is a composite measure for this factor, plus a QV rank where it is combined with their Value composite. Research which supports the use of quality screens generally and in income portfolios has been produced by GMO and Soc. Gen. respectively and in relation to value in this academic paper by Robert Novy-Marx.
The last factor related to quality that I address is that of financial security of the Company or essentially the state of the balance sheet and how it is moving. This is also covered in the Quality research from GMO & Soc. Gen. In addition this recent paper from Cliff Asness et al and another one that explored Buffet's performance also highlight its importance and the value of avoiding junk. I also particularly liked the paper also by Asness et al about betting against beta.
Therefore, I prefer lower gearing and further measures that I use to assess financial security / risk include interest cover, the Altman z score and the Piotroski score plus the actual levels of debt to equity. Again this is designed to weed out the financially weaker companies that might be more vulnerable to not growing or cutting their dividends if things don't turn out as expected. Since I am looking for yield and value it would be acceptable to stop there and select quality, value and yield candidates from the above and indeed I do run screens with just those inputs in the score.
However, there is evidence that momentum in various forms such as price movements and estimate revisions can also be predictive of future performance. In addition there is research which shows the benefit of combining value and momentum factors to help smooth out some of the fluctuations in performance between the two styles.
Consequently I also look at rankings including estimate revisions, which if positive, makes it more likely that the forecast growth and trend might be achieved and continued. Or alternatively that a good value / yield stock with poor price performance might be worth a look if the estimates have started to rise and the market still hates it.
While I'm less keen on price momentum it can also help to avoid losers or value traps, especially when combined with looking at earning revisions which if also poor tends to keep me out. Avoiding losers is often just as important as picking winners. The converse is where stocks have performed well, then obviously the value and yield will tend to be less attractive and you then have to watch the momentum factors carefully for signs of trouble. Once again Stockopedia has done much of the work for you here with their combined momentum rank, although personally I prefer to split the momentum factors as discussed above.
In addition, I also screen for three year under performers on the basis of mean reversion (see What has worked paper from Why Compound Income?) to see if I can find any attractive yield stocks that may have recovery potential or seem to be turning around as evidenced by earnings upgrades and or price performance picking up.
Despite my reservations I have found it useful to pay attention to these factors as often it can be an early warning sign. In addition you can get a new stock coming up on yield screens only to discover that it has just collapsed on the back of a profits warning. If this is the first one out of the blue I find it is then generally worth ignoring that stock for up to a year as often more profit warnings or downgrades follow until the Company and analysts adjust to the new reality.
Summary and Conclusion
My approach would probably be categorised as income growth investing. I describe my investment strategy as a Quality Value and Yield based strategy focussing on valuation, yield, dividend cover and growth, business characteristics and financial security. In addition I pay some attention to momentum factors, especially earning revisions and price momentum and utilize quantitative techniques (including Stockopedia) to help identify new ideas and monitor my portfolio.
The bottom line is that I am aiming to grow my capital and income in real terms over time. I therefore look to Compound Quality Growing Income or CQGI, this is the essence of Compound Income.
Just a quick note on Stanley Gibbons International (SGI) a small £100m or so market capitalisation stock. It deals in collectibles like stamps, coins and medals etc. It acquired Noble Investments last year which is a similar business and it is currently integrating this. Allied to this they have also changed their reporting year end, sometimes a red flag that muddies the waters and makes comparisons difficult.
I bought this originally as I couldn't bring myself to buy stamps for their investment value. However, given all the quantitative easing and money sloshing around the system I figured others would be looking for alternative assets like stamps, coins and art etc. So I thought I would tap into this trend via this one.
This has worked well and the shares have re-rated and gone up nicely ahead of the market. They no longer look such good value (like many stocks) on around 20x earnings and now a sub 2% yield, so another red mark in my book. What made me reach for the sell button was the announcement on 22/1/14 that top directors had exercised options and sold a reasonable slug of them. Now I know that these type of sales are not as informative as a crowd of directors buying together but given the rating, where the market is at I thought I would follow them out and redeploy the capital into something more attractive in terms of valuation and yield.