A high-yield portfolio constructed (Pt 3)

Following up on my recent construction of a 25-share high-yield portfolio this update expands out to smaller shares in order to improve the range of companies and overall yield

Introduction

This is a follow-up to my earlier high-yield portfolio construction articles located here: Part 1 and Part 2.

The motivation for this update is that I received some very interesting feedback from investors on the Motley Fool website. The gist of the discussion was that by restricting my selection to the very largest of companies I was potentially missing out on smaller firms with better histories and dividend growth profiles. So I decided to test this hypothesis by reducing the minimum size for consideration down to £500mn (which is small in the HYP context!) to see what would happen.

In practice this meant scrutinizing each of the original constituents and looking for one of two reasons to change:

• I could find a better, smaller candidate in the same sector, or
• the original share wasn't of high quality and a share in a new sector looked stronger

The end result of this filtering is that I've identified 8 substitutions; six of these involve direct, like for like replacements while two are new companies that provide improved income and yield security. In this piece I cover each of these eight companies and give my reasoning as to why these are sensible picks in their own right and, in addition, why they are better than the shares that they replace.

For reference the spreadsheet of candidate shares is available here.

Changes to the original portfolio

1) Imperial Tobacco [Consumer Defensives - Food & Tobacco]

The first portfolio change that I'm making is to switch from British American Tobacco to Imperial Tobacco. A few months ago BAT yielded more than Imperial and with twice the market cap of its competitor seemed like a decent choice. However Imperial now offers more, with a forecast yield of 4.7% for 2016, at a higher cover level and dividend growth rate (around 10% compared to BAT's more pedestrian 5%). That said there's very little to choose between with these companies and I'd be happy to buy both and split the sector allocation between them.

What's important though are future prospects for the dividend and there are two good reasons for feeling positive here. Firstly the dividend policy is clear and beneficial: Our current dividend policy is to further increase the payout ratio with dividends per share continuing to grow steadily ahead of adjusted earnings per share over the long term. Secondly Imperial has an excellent dividend history with almost 20 years of steadily rising dividends. Over this period the CAGR (Compound Annual Growth Rate) comes in at 13.2% and only dips slightly to 11.9% and 11.4% over the last 5/10 years respectively. This is an excellent growth rate for such a large company and well worth having.

2) Marks and Spencer [Consumer Cyclicals - Speciality Retailers]

The next change is to move from Next to Marks and Spencer for one simple reason - the former's reliance on special dividends to achieve a high yield. The problem with these discretionary top-ups is that they're not reliable and may dry up at any time; a concern if you're fully dependent on the income. So in this sector Marks and Spencer offers a more secure, and quite comparable, income although with a few caveats. In the past twenty years the payout has been cut twice, in 2001 and 2009, and that's not a great record despite subsequent recoveries in the dividend. However with cover of 1.8 this doesn't look like an imminent threat unless earnings take an unexpected turn south and the recent trading statement is positive on this front: We continue to make progress against our key priorities. Our Food business did very well in a difficult market. In General Merchandise, sales were broadly level on last year and we are on track to deliver the planned increase in gross margin.

From a dividend policy perspective this is all laid out in the 2015 Annual Report: Our dividend policy remains a progressive one, with dividends broadly covered twice by earnings. We intend to pay a final dividend of 11.6p this year, taking the total dividend to 18.0p, up 5.9% on last year. In the context of our increased free cash flow, we are also pleased to announce an ongoing programme of returns of capital to shareholders, starting this year, with a share buyback programme of £150m. This is all well and good but I despair of any firm buying back its shares when there's debt on the balance sheet (gearing of 63% is acceptable but hardly nominal) and no clear rationale. I'd far rather see a hike in the dividend, or a focus on debt reduction, but of course neither of these help you reap a bonus for increasing the earnings per share figure!

3) Amec Foster Wheeler [Energy - Oil & Gas Related Equipment and Services]

This oil services provider isn't a direct replacement for any previously selected share; instead it's a choice based on 'strategic ignorance'. What this means is that while we all 'know' that the crude oil price has halved in the past year, and that the oil sector has been decimated, we're going to put this to one side and take a long term perspective. In the case of Amec Foster Wheeler this is that there's a 25-year history of paying dividends here with the last cut occurring in 1992. Since that point the CAGR has been 15.1% with this stepping up to 19.6% over the last 5 years. Even with this growth the cover is a respectable 1.7-1.8 and gearing isn't too onerous at 66% despite last year's hefty acquisition of Foster Wheeler.

Looking forward a recent trading update indicates that market conditions are challenging, which is no surprise, but that the company is more or less coping with this: Continued customer pricing pressure, particularly in the Oil & Gas market, is expected to generate a further modest reduction in the 2015 Trading Margin, compared to previous guidance. Taking into account the timing of expected contract close outs and milestone achievements, and the non-recurrence of a favourable contract settlement of $32.5m in GPG in H1 2014, we are expecting Trading Profit to be more second half weighted than in 2014. That said profit forecasts have already been reduced by around 30% over the past year, to reflect the known knowns, and projected cover is still close to that outlined in the dividend policy: Going forward, the board expects to maintain a progressive dividend policy whilst maintaining dividend cover at around two times adjusted diluted EPS from continuing operations. So I see this company as a good fit for the portfolio despite all of the gloom surrounding it at present!

4) UBM [Consumer Cyclicals - Media & Publishing]

With UBM, the marketing and events company, it's same-sector heavyweight Sky that has received the boot for the sin of yielding too little. The latter was always a marginal choice, for this reason, and moving down the size scale allows us to access a yield 40% higher with identical cover and a similar forecast growth rate. Looking back UBM exhibits a decent 25-year track-record of paying dividends although the company came badly unstuck in the 1998-2002 period with heavy losses leading to a repeatedly slashed dividend. Since then growth has been steady with a CAGR of 2.5% over the last 5 years (compared to 12.1% since 2002) although you have to be careful with the data generally available; a rights issue last year led to a proportionate re-scaling of the dividend (to maintain the same total cash cost) and in many sources this presents as a cut.

All of this ties in with the cautious tone adopted when discussing dividend policy in the 2014 Annual Report: We understand the importance of dividends to our shareholders and pursue a progressive dividend policy targeting 2x cover through the economic and biennial cycle. I don't get the sense that management are about to put these payouts at risk although last years $972mn acquisition of Advanstar is certainly at the more adventurous end of the spectrum. This venture appears to be paying off though with the integration proceeding and existing debt being refinanced: The integration of Advanstar is progressing well with synergies in line with expectations. In March we brought together UBM’s and Advanstar’s US medical, dental, veterinary, nutrition and pharma brands into a single business unit, UBM Life Sciences. So UBM feels like a good choice to beef up the portfolio income stream.

5) HICL Infrastructure [Financials - Collective Investments]

HICL Infrastructure is a rather different beast to the other stocks in the portfolio as it's a closed-end investment fund rather than a trading company. That said it's not vastly divergent from a REIT such as SEGRO in that both are invested in real-estate, get valued on the NAV of their holdings and seek to pay out a decent income. In fact this is a key aim (HICL aims to distribute the majority of underlying investment returns to its shareholders and without the accumulation of profits offshore) and since incorporation in 2006 the fund has delivered a steadily rising dividend at a yield of almost 5%. Unusually the fund doesn't have a dividend policy but instead sets out an annual target that they hope to achieve: New guidance of a target dividend per share of 7.45p for the year to March 2016 (up from the previously published guidance of 7.40p). The reason for the broker forecast being higher than this is probably because the fund beat its own target last year: Four quarterly interim dividends declared totalling 7.30p per share, exceeding the stated target by 0.05p per share), a 2.8% increase on the prior year.

From the perspective of comparing HICL to SEGRO the most obvious distinction is that the forecast yield is over 30% higher with a much better level of cover (1.5 vs 1.2). Unfortunately it's not possible to compare debt levels as the fund holds no debt itself - it's the fund's investments that are typically leveraged and this is all off of the balance sheet. Looking ahead a very recent trading statement indicates that the managers aren't getting carried away by the current buoyant market: Despite strong investor appetite for exposure to infrastructure generally, and for the Company's equity in particular, the Board and InfraRed Capital Partners believe that investment discipline is key to delivering the long term yield and inflation protection to which we aspire. This level of caution is certainly warranted given historical boom and bust cycles but, equally, from the evidence of the last 10 years HICL appears to be a decent SEGRO replacement.

6) Carillion [Industrials - Construction & Engineering]

Carillion is a support and construction services company employing over 40,000 people worldwide. Pretty impressive for an outfit that only demerged from Tarmac Group in 1999. Since that time the dividend has grown each and every year with a CAGR of 10.4% (slowing to 4.0% over the last 5 years). A decent result given recent economic conditions and the forecast is for a yield of 5.4% that is reassuringly 1.9x covered. Quite impressive and while gearing of 74% is a little on the warm side the debt load did reduce last year from £215M to £177M despite spending £38M on acquisitions; so the business is generating enough cash-flow to handle its fiscal responsibilities.

It's a little annoying that Carillion don't provide a dividend history on their investor relations site but it is available in full from Investorease. They do, however, reference a rather anodyne dividend policy in the 2014 Annual Report: Carillion has a progressive dividend policy that aims to increase the dividend per share broadly in line with growth in underlying earnings per share, subject to the investment needs of the business. The Board’s decision to recommend an increase in the dividend, despite the reduction in underlying earnings per share, reflects its confidence in the Group’s resilience and ability to achieve its medium-term growth targets. So the board have reasonable faith in the firm's prospects and in the construction sector Carillion is clearly our top pick.

7) BBA Aviation [Industrials - Transport Infrastructure]

In the original portfolio EasyJet was always a slightly unusual choice due to its short history of paying dividends. As it turns out by looking at smaller outfits we can locate a related company offering both a higher yield and a much longer track record: BBA Aviation. This is more of a picks-and-shovels affair that offers aviation support and aftermarket services. It's been around, as a mini-conglomerate, for over a century but only since 2006 has the focus been purely on aviation. Over this key period the dividend has increased steadily although the history is a touch confusing as the company switched to reporting in dollars a few years back (which adds in complexity from exchange rate variations and begs the question of whether a fall in the GBP dividend is a cut when the USD dividend remains unchanged).

Nevertheless the dividend has risen steadily, apart from currency shenanigans, with a 5-year CAGR of 6.5%. Broker forecasts suggest a future yield over 4% with excellent coverage by earnings (almost 2x); the only fly in the ointment is a high gearing ratio of 74%. On the dividend policy front I can't find an explicit statement from management but they do allude to one in the 2014 Annual Report: The Board is proposing a final dividend of 11.58 cents per share, taking the full year dividend to 16.20 cents per share. This is a 5% increase and reflects the Board’s progressive dividend policy and continuing confidence in the Group’s medium-term growth prospects. So it appears that the re-focus applied a decade ago is working out; if the company can maintain its 25-year history of dividends going forward then it deserves a slot in the portfolio.

8) PayPoint [Industrials - Professional & Commercial Services]

The final replacement share is relative minnow PayPoint weighing in at a mere £680mn - a third of the size of low-yielding Berendsen. A relative newcomer, established in 1996, PayPoint is a specialist payments company responsible for the ATMs that you find in local shops amongst other things. Upon listing in 2004 the directors laid out a clear dividend policy and have stuck to it: Given the cash generative nature of the Group's business, it is the Board's intention to pursue a progressive dividend policy taking into account the Group's capital requirements, cash flow and earnings whilst maintaining appropriate levels of dividend cover. The Directors anticipate adopting a dividend policy under which initially dividends are covered approximately 2 times by after tax earnings. The Board will regularly assess the appropriateness of the dividend policy.

In practice PayPoint has stuck, almost obsessively, to a dividend cover of 1.5 with the dividend increasing exactly in step with earnings growth. At the same time cash generation has remained excellent with the business sitting on an appreciable and growing cash pile. This certainly makes me more sanguine about the limited track-record of the company and the fact that the dividend forecast for 2017 suggests a drop of 4% - which appears rather arbitrary given the prediction of 8% earnings growth at the same time! More usefully PayPoint put out a trading statement just a week ago and appears to be trading normally (although I don't know what the impact of selling their parking division will be): We have had an encouraging start to the year and remain excited about the growth opportunities presented by our retail businesses. The proposed sale of our parking and online payment processing companies is progressing satisfactorily and we will update shareholders further in due course. On the basis of the information that we do have I'm happy to make PayPoint the final new share in the portfolio.

Conclusion

This re-vamp of the initial high-yield portfolio has been an educational experience as it's encouraged me to dig a little deeper for companies over-shadowed by the behemoths of the market. There are plenty of quality companies outside of the FTSE100 and, a priori, there's no compelling reason to exclude them from consideration. That said I've still only ended up with one company, PayPoint, that's less than £1bn in size so we're hardly talking about minnows here.

Nevertheless this update has allowed me to jettison shares that were originally selected to provide essential sector diversification but at the cost of a lower yield (or cover). As it happens I've been able to retain this diversification but with an improvement in both yield and cover across the portfolio: the first 15 shares now offer a blended yield of 4.8% (was 4.5%) which is 1.5x covered while the full portfolio only falls to a yield of 4.4% across the 25 shares (was 4.2%) with an improved cover of 1.8x. I think that this is an excellent result.

For tracking purposes I've set up a demonstration portfolio on Stockopedia to see how the portfolio performs over time. This was initially set up with the original portfolio but I've re-balanced into the shares mentioned above (removing United Utilities and Booker) to reflect the composition of the new portfolio. How this group of shares will look in 2025 I cannot say but they are, at least, well diversified and have proven track-records (and policies) of returning earnings to investors. That's a good starting point.

Disclosure: the author holds many of the shares covered in this article.