Under the Radar Report is all about investing for the long-term. We look in depth at companies balance sheets because we realise that growth needs to be underpinned by solid foundations. Income is important, but the balance sheet is where value is ultimately derived. Join today and access this report and take advantage of our Christmas Special with a bonus two months for free!
Blue Chip Stocks provide stable income
Blue Chips generally provide stable income because they are established businesses that are not looking for high growth, but more for consistency. But this can be a trap for investors, as we’ll discuss in this article.
The stocks we are talking about include:
- Bapcor (BAP)
- Fortescue Metals (FMG)
- Healius (HLS)
- Rio Tinto (RIO)
- Transurban (TCL)
Sustainable yield is the key
The average forecast yield before you include franking credits on the S&P/ASX 200 Index is in the region of 3.4%, which is less than our Blue Chip Portfolio’s 4.6%. We are more confident in our Portfolio’s maintainable yield, which is a key reason why we believe that it will be less volatile than the index and provide greater security over the long-run (5 plus years).
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What is the level of income you need?
The level of income that’s appropriate for you of course depends upon your situation. If you’re younger you can tolerate a lower level; a more mature person might have a bigger appetite. But generating income from an equities portfolio is important, because it reduces your risk by realising a profit on your investment.
There has always been an appetite for income and yield
In Australia there has always been an appetite for income and yield, driven by franking credits, also known as the imputation system. The domestic system encourages low tax payers like retirees to invest in high yielding fully franked dividend paying stocks such as major banks and Telstra. This enables them to monetise franking credits via a cash refund from the government.
What's the "Clientele effect"?
Not surprisingly, some Australian based listed corporates cater to this more than they should, which is where investors have been caught out. Economists call this the “clientele effect,” where listed companies pay dividends on the basis of sacrificing capital gains.
In the Modigliani-Miller world of economic theory, it shouldn’t matter if a company delivers returns in income or capital gains (share price) – setting aside taxation. But investors get caught out when companies undermine their balance sheets in order to cater for this income demand, which is a uniquely Australian situation because of the franking credit effect.
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Finging companies that are paying out income sustainably
Finding companies that are paying out income sustainably means not just looking at the dividend yield and payout ratio. The analyst needs to think holistically: can the balance sheet withstand this payout of dividends given an exogenous shock like COVID. In the event many big ASX listed companies were forced to suspend dividends and in some cases not pay them at all and in many cases they raised equity capital to fortify their weakened balance sheets. This tells us a great deal about dividend sustainability under stressful conditions.
Balance sheet sustainability vs. high dividends
You would rather be investing in a company that is thinking carefully about balance sheet sustainability than one that is paying out high dividends without regard to future protection. Factors to consider revolve around the various company’s business model and their balance sheet. You need to look carefully at things like their customer base; the duration in debt repayments and the duration in income from assets. Does the company have short term income but long-term liabilities?
Balance sheet fragility typically reveals itself during times of stress, which is why these considerations are difficult to analyse. Putting effort in is crucial, but there is no silver bullet in the form of a killer ratio some banker might talk about. Moreover, in the go go world of broking the humble balance sheet often gets overlooked. It goes Under the Radar because the income statement often drives short-term stock returns.
A good example of what I’m talking about in this issue is the medical services group Healius (HLS). Our decision to buy back in during July after it announced the sale of its medical centres to private equity for $487m is paying dividends, with its shares up almost 30%. Last week the company upgraded earnings, has boosted its dividends and is about to do a share buy back of 10% of its stock for $200m.
If you look at the stocks in our Blue Chip Value Portfolio you will see that what they have in common is strong balance sheets. Our big weighting in the banks reflects this.
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