I am not a fan of traditional dividend investing, as it often focuses an investor on the wrong outputs and favours companies creating value in a tax inefficient manner.
This style of “dividend aristocrat” investing leans towards businesses who have paid their dividends in a metronomic manner over long periods of time, often using high payout ratios to achieve it.
Growing up in Australia, I have seen a whole market wagged by the dividend tail with dividend yield often quoted as the only number you need to know when buying the big four Aussie banks or, from time to time, even the large Aussie miners.
Proponents of this style are often in critical need of the income their investments pay out and run for the hills when if it is compromised.
Instead, I much prefer companies with high normalised yields resulting from a newly fallen share price. These often take on a special situation-type profile, as the income in question may be temporarily jeopardised and the investment too uncertain for a typical institution.
When the outlook is murky, it is often better to calculate for a total shareholder yield (dividend + buyback), as you should be able to see this value accrue on the financial statements, even if it is temporarily prevented from reaching your bank balance.
Of course, there is one absolute necessity in practising this alternative form of dividend investing and it is the main source of the strategy’s advantage- you can’t need the income today. You are investing to receive strong future yields.
Often companies enter dividend uncertainty for a variety of company-specific reasons, but last year due to Covid-19, we saw whole markets experience this condition, with almost no permanent disruption to the company-level cash flows these will be paid from.
One sector leaps to mind- energy (my recent piece here). The sector has been in a bear market that has ground on since 2014. Many thought a bottom had been reached in early 2016, but that proved to be a walk in the park compared to 2020’s implosion.
The outlook has remained so uncertain that dividends have been withheld or slashed across the industry. In most cases, I welcome this sort of prudence. There is no point maintaining your dividend policy, only to risk the solvency of your business, and for many companies the economic benefit of this cash will accrue behind the scenes, through retained earnings and stronger balance sheets.
A great example are many mining services companies, which were never considered dividend investments until their prices fell around 80% over the last seven years. For example, Schlumberger was a 2% dividend payer when it was a $100 stock, but due to the Covid slump, the yield on its 2019 payout reached as high as 15% and is now closer to 8%. This won’t be paid for 2020 of course, but it must be remembered that 2019 was already five years into the energy bear market and I don’t think it is expecting too much to see those levels restored over the next couple of years.
By the time the recovery is clear and a traditional dividend investor might be interested again, the price opportunity will likely be long gone.
Other similar opportunities in the space include Technip FMC and Enerflex, which trade on 5% and 6% yields of their 2019 dividends respectively.
My favourite energy play on future yield is the Russian major Lukoil. Due a higher political risk, Russian investments are those where I am quite happy to see large payouts reach my account and not solely build on the balance sheet. Many Russian companies have been stepping up in this regard and Lukoil is no exception.
The company passed a near perfect dividend policy for an energy company in late 2019, whereby they will pay out all cash flow after capex as either buybacks or dividends, without wedding themselves to any particular number. This formula, applied to 2019 results, would give a 20% shareholder yield on today’s price.
I’m agnostic to whether this is achieved for 2020 or 2021. 2019 was a low bar, as discussed earlier, and will be attained again in time. In the meantime, the business has moderate leverage with debt/equity of 15% and offers a high level of safety for the wait.
I don’t expect Lukoil to see the same octane of price appreciation as many energy investments whose survival was in question until recently, but I believe the stock is a reasonable and safe 5x over the next cycle. Safety and a potential 5x rarely go hand in hand, but apart from an outstanding shareholder yield, Lukoil is the meeting of the two most loathed and cheapest sectors in global markets- Emerging Markets value and energy. It is also priced in an extremely cheap currency.
As distant as it may seem today, EM and energy have both had periods where they were priced at a premium to the market over the last decade. I believe we will see reversion some way towards this over the next 5-10 years and am happy with the terms to wait. This is why Lukoil and Gazprom make up 11% of my portfolio today.
Another market that was already very cheap entering 2020 and is now littered with outstanding opportunities is the UK.
UK financials have been particularly hammered by multiple headwinds since the GFC. First were the waves of reparation payments made for predatory PPI (Payment Protection Insurance) schemes, which have hamstrung their ability to return capital to shareholders for years.
Then the Brexit nightmare, which shredded the pound and created a cloud of uncertainty impossible to shake. Covid-19 was the final straw, when the regulators ordered these companies to halt shareholder returns out of prudence. Final capitulation set in through the year, with Lloyds Bank trading as low as 40% of book value in September.
The great irony is that just as Lloyds reached its GFC lows again in September 2020, all these pressures appeared to be reaching their worst. The PPI payments are close to run off and while further claims are possible, it seems reasonable to say the worst is long behind. Brexit will be resolved one way or another in the coming months and we have reached a vital milestone with the pandemic, with the successful development of several vaccines.
All of this is incredibly prospective for Lloyds ability to reward its long-term shareholders. When I normalise Lloyds earnings and Return on Equity, I estimate an ability to make 42c per share, giving a current yield of 14% (assuming a 60% payout ratio). Once again, there can be no guarantee these returns resume this year and it is exactly this confusion which provides the opportunity.
Similar cases can be made for Barclays and Standard & Chartered, but my preference is for Lloyds, due to its sheer cheapness in relation to normalised earnings power.
Also in the UK and one of my largest holdings is Micro Focus plc (my write up is here), an IT and enterprise software business. The company paid out $1.10 in 2019 and has so far maintained the cash flow stream to do the same in 2020, if it chose. Despite this, the shares fell as low as $2.77 in October.
The business has struggled since their shocking purchase of HPE Software in 2017. The resulting share price fall of over 90% reached its (hopefully) final capitulation last year, when the dividend was pulled out of caution for the Covid situation.
Short sellers had been circling the company, claiming a broken business model, but I blame the HPE deal for the company’s performance. On the contrary, the business has been successfully transitioning customers towards a subscription model, with now over 70% paying this way.
The market appeared to expect the worst as the company went several months without a trading update, but paid back the precautionary draw-down of its revolver, indicating no liquidity issues.
When Micro Focus finally released an update in November, the stock rocketed on what was really just a reiteration of previous guidance. Further good news came in early December, when Amazon mentioned Micro Focus as one of four preferred partners for transitioning its customers onto the AWS platform.
The company has shown good capital return policies in the past (absent HPE) and I believe they will do so again, with a lot of levers at their disposal. If the company can return to growth, it will prove a sensational investment. But even at a steady state, the return of the 2019 dividend would give a yield of around 20% on today’s price. 2020 free cash flow appears strong enough to allow this, with room for buybacks and debt pay-down left over. There are many ways to win, as long as you don’t need the income in the immediate future.
I hope these examples have made this strategy clear and shown why I believe a flexible approach and analysis of total shareholder yield is a path to superior returns. Investing into uncertainty now will likely give a higher yielding portfolio by 2022 and see better capital gains as traditional income investors join the party when the dust has settled.
I have a 6% position in Lukoil, 5% in Gazprom, 6% in Lloyds Bank and an 11% position in Micro Focus.
Guy
PS. As always, these are my own thoughts regarding my own decisions and situation. Please don’t take them as advice and seek a professional if you are unsure.
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