Income stocks globally are becoming too hot to handle with the potential to burn those who touch them.
The flood of buyers chasing high-yielding income stocks is driving up prices. Analysts are beginning to sound warning bells about income stocks reaching valuations that are “stretched” beyond their fundamentals.
Equity income investing involves the risk of dividends being reduced or eliminated. The most common reason is declining or negative earnings. Investors who buy high-yielding stocks at high prices that have poor growth prospects are at risk of losing, and losing a lot.
If growth is the issue, why not look for income stocks with good growth prospects? Let’s take it a step further. Why not look for income stocks with growth potential at reasonable prices? Why not apply the principles of GARP (Growth at a Reasonable Price) to income stocks?
When searching for income equities some investors start with yield. Instead, let’s focus on historical and future earnings and dividends growth. Companies with a solid track record of dividend payments and earnings growth over the last five years have proven they can reward investors. What investors want is total return – the combination of dividend income and capital appreciation through rising stock prices. Here are the metrics we will consider:
• Total Shareholder Return
There’s no point buying high-yielding stocks if the share price falls over time leaving you with a negative total return. Dividend income is only half the investing picture; the other half is capital appreciation.
The last five years have been challenging for share markets. Companies that returned high positive total shareholder return over 1, 3 and 5 year periods provide a reasonable picture of a company’s medium term outlook.
• EPS Growth
Companies with positive earnings over the past five years are in a good position to repeat performance. This does not absolve investors of the responsibility of investigating further, however. Classic examples of risky stocks include miners that profited handsomely from the mining boom.
• Forward Looking Price/Earnings Ratios
Some financial websites like Yahoo Finance Australia publish forward looking P/E and P/EG ratios. Seek out companies with forward earnings growth forecasts that will enable the company to sustain or increase dividends.
• Earnings and Dividend Growth Forecasts
These are analyst based predictions of a company’s expected growth over the next two years. Forecasts can get revised up or down, usually preceded by a warning. Some more cynical investors love to point out when analysts get things wrong but remember they also get things right.
• Dividend Yield
Dividend yields are calculated by taking the total dividend payment for the prior fiscal year divided by the current share price. The pitfall is that yield is a function of share price. Two companies that made identical dividend payments can show dramatically different yields depending on share price. This means that dividend yield must be put into context of other metrics, such as share price changes over time.
Below is our table of seven stocks:
Total Avg Annual Shareholder Return (1Yr//3Yr//5Yr)
5 Yr Historical Growth (EPS)
Forward P/E (2014)
(5 Yr Expected)
2 Yr Growth
Silver Chef Ltd
Northern Star Resources
0.22 (1 Yr)
Forge Group Ltd
Retail Food Group
Most of us move to the right of the table to check the yield. The final share in the table, Kingsgate Consolidated Ltd (KCN), has the highest yield and provides us with a classic example of why yield alone can be a dangerous metric to base buying decisions. Gravitate to the right of the table and you will see KCN is the only share with negative total returns for shareholders on an average annual basis, regardless of the time frame. Here is a 5 year chart for Kingsgate:
At the peak KCN traded at around $12 a share and its hefty dividend of $0.35 a share saw a yield for FY 2010 of 3.7%. The current share price is $1.64 and the company paid an interim dividend for 2013 of $0.05 a share, unfranked.
Kingsgate is a gold miner with mines and exploration projects in Australia, Southeast Asia, and South America. The company has suffered not only from volatility in the price of gold and higher production costs, but also from the kind of sovereign risk all investors fear. The expansion of its mine in Thailand had regulatory hurdles aplenty. Over 5 years 31.2% EPS growth was not enough to shield investors from price falls.
The first stock in the table, M2 Telecommunications Group Limited (MTU) shows the highest total shareholder return; the highest historical EPS growth of 45.7.% over five years; plus, the highest 2 year earnings growth forecast of 40.8%. In addition, the analysts expect a healthy 20% growth in dividends. Over five years dividends increased 44%. The company began paying dividends in 2005 and has increased dividends every year. The current 2.9% yield is fully franked and needs to be put into the context of the company’s share price. Here is a five year chart for MTU:
Is it too late to get into this stock? The Forward P/E of 14.53 is below the current sector average of 17.73 and all the forward looking measures, from the 5 Year expected P/EG to the 2 Year earnings and dividend forecasts suggests this company has room to grow. Historically, M2 has focused almost exclusively on the small to medium business sector (SME’s) but two recent acquisitions indicate management is committed to penetrating the retail market. This diversification has not been universally hailed by analysts as only Citi currently has a BUY rating on MTU while expressing a “wait and see” posture as to whether the new retail focus will distract from the company’s successful business model. Both CIMB Securities and Macquarie have UNDERPERFORM and NEUTRAL recommendations, expressing surprise at the company’s movement into the retail space. The current share price is $6.29.
With a current share price of around $7.65, Silver Chef Limited (SIV) is an interesting stock to watch. The company rents commercial equipment to the Hospitality sector and small businesses across various industries. Innovative funding approaches, allowing customers to “try before they buy,’ means businesses purchase equipment outright from Silver Chef rather than lease.
Silver Chef is off the radar, with only Macquarie initiating coverage of the company on 13 April 2013 with an OUTPERFORM rating, citing the company’s outstanding growth history. The numbers suggest Silver Chef has been outperforming for some time. The forward P/E of 15.39 is significantly higher than the current sector P/E of 8.35 but the growth estimates would seem to support a higher valuation. Silver Chef began trading in 2005 and has increased revenue, earnings per share, dividends, and NPAT every year with the sole exception of small declines in FY 2007. The market cap for Silver Chef is small, at $226 million. This one may be a hidden gem and is definitely worth watching. Here is a five year price chart:
With a market cap of $308 million, junior miner Northern Star Resources (NST) is proof junior gold miners can survive and thrive. Perth based Northern Star is a gold production and exploration company operating in resource rich regions of Western Australia. Right now the company’s best producing asset is its Paulsens Gold Mine. No major analysts cover the company.
Northern Star paid its first dividend in FY 2012 and the dividends are not franked. Look at the table and this company’s numbers do not speak for themselves. Note the P/EG is based on one year. The company did not turn a profit until FY 2011. NPAT went from $16.3 million in that year to $22 million in FY 2012. In short, while the numbers look good, the time frame of profitable performance is short.
If you believe the price of gold has bottomed, Northern Star might merit a place on your watchlist. Here is a 5 year chart for NST compared to another Perth based junior gold miner, Silver Lake Resources (SLR):
Codan Limited (CDA) is another high performing stock with no major analyst coverage. Just two analysts cover the stock, both with STRONG BUY ratings. Codan makes sophisticated electronics equipment and components for a variety of industries; one of them being the beleaguered mining sector. Here is its 5 year chart:
The share price is up 135% year over year, with the average annual total shareholder return for one year of 152.5%, second only to Silver Cher’s 158.8% total return. The 3.5% dividend yield is fully franked. The company began paying dividends in 2004 with a payment of $0.055, increasing every year to $0.095 for FY 2012. Although revenue, net profit, and earnings per share all fell in the wake of the GFC in FY2008, the company did not cut its dividend. That alone makes it a possible hidden gem, with the forward P/E and P/EG certainly qualifying the shares as reasonably priced.
Forge Group Limited (FGE) provides a wide range of engineering and construction services to the oil and gas, minerals and resources, and power and infrastructure sectors throughout Australasia and Africa. Forge paid its first dividend of $0.03 per share in 2009 which has more than quadrupled to $0.14 in FY 2012. Revenues and net profit after taxes have increased every year since 2007, without exception.
Three major Australian analysts cover Forge and all three – Macquarie, Citi, and CIMB Securities – have BUY and OUTPEFORM ratings on the stock. After the company’s Interim Results release in February, all three increased target prices on FGE and the analyst at Citi called the stock “cheap.” That was on 13 February when the stock was trading at $6.21. As of 16 May, FGE closed at $4.42. This one sounds like a bargain. Here is the company’s price chart:
The final stock in our table, Retail Food Group (RFG), has more modest numbers but has the highest dividend yield at 4.5%. The 2 Year earnings growth forecast of only 9.5% is solid, but below the other stocks discussed. The dividend history, however, is rock solid, increasing 23% over five years. RFG paid its first dividend of $0.062 per share in 2007 and has increased its dividend payment every year to an outstanding $0.175 per share in FY 2012.
Retail Food Group is known for the brands it manages and franchises such as Donut King, Michel’s Patisserie, Brumby’s Bakeries, bb’s cafe, Esquires, Pizza Capers, Crust Gourmet Pizza and The Coffee Guy.
RFG is another company that doesn’t attract much attention but posts solid numbers. The company’s Half Year Results released in February drew not a single recommendation note response from the three major analysts covering the stock. Although revenues posted a strong 20% year over year increase, net profit rose only 0.7%.
Analysts may have been unimpressed, but share market participants reacted differently. The six month chart for RFG shows the price climbing with few interruptions since the release. Here is the chart:
With a closing share price of $4.19 on 16 May, RFG is trading near its 52 Week High of $4.26. Yet its growth numbers suggest this income payer is still reasonably priced. The Forward P/E bests the current Sector P/E of 17.39 as does the 5 Year P/EG of 1.69 against a Sector P/EG of 2.36.
Investing in income stocks like those in our table is no guarantee you won’t get burnt, but the numbers certainly seem to increase the odds of staying safe.
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