I know I’ve written a lot lately about big cap, solid growth companies like Vodafone, BHP Billiton and MITIE, and I guess some people who read this stuff might think, “What sort of value investing is this? Where are the obscure, the unloved and the unfashionable?”.
Well you can relax now as the next company is no world leader or mega-growth story. In fact they’ve barely grown earnings per share in a decade. They operate in a commodity market (where nobody has any pricing power) with barriers to entry that are relatively low and customers that don’t give a damn who they deal with.
I’m talking about UK Mail Group, the leading independent, integrated postal group in the UK. In plain-speak that means they deliver things like mail, parcels, packets and palletised goods either inside the UK or internationally, for next day or not. Take your pick.
So why would I invest in a zero growth company in a market so competitive it looks like a war zone?
The irresistible lure of a high dividend yield
The yield. It’s all about the yield. With a share price of around 200p and a dividend of 18p, the yield currently sits at almost 9%.
Usually when a dividend yield is that high it means the odds of the dividend actually being paid are low. That’s why it can be so dangerous to invest just on the basis of yield. The dividend often gets cut or suspended and all you’ll have to show for your investment is some shares in a crummy business on the road to nowhere.
On the flip-side, the benefits of a high dividend yield (if it actually gets paid) are obvious:
You get a whacking great dollop of cash just for holding the shares
This is really useful, especially in the longer term as you are realising returns all through the holding period. This means you’re not as dependent on the share price (and therefore capital gains) to actually make you any money.
The problem with being dependent on capital gains for all of your returns is that Mr Market is a fickle fellow; there’s no way of knowing how he’s going to value your holdings, regardless of how well the company actually does. For example:
Scenario 1 – Company doubles in size, retains ‘no dividend’ policy and share price halves. It’s possible and more likely than you’d think, especially if you overpaid to start with.
Scenario 2 – Company doubles in size and doubles the dividend. That’s possible too and you’d almost certainly be in profit after a few years if you bought with a sensible starting yield.
For example, if the yield was 5p when you bought the shares at 100p you’ve got a 5% yield. If the dividend goes up to 10p over the next 5 years you’ll have received around 35p in dividends. With the new dividend of 10p the share price is unlikely to stay at the original 100p, let along drop by 35p to 65p, which would be required to negate your dividend profits. At 65p the 10p dividend would be a yield of over 15%, which just isn’t going to happen in a sustainable business.
A high yield helps to support a minimum price for the shares
Most investors love a good dividend. If the price falls the yield goes up and sucks in more buyers which, assuming the company is sound, will help to reduce further falls. Of course the price can still fall off a cliff, but across a diversified portfolio of high yielders the downside protection may help you sleep easier (as will the cash rolling in while you sleep).
The search for a sustainable dividend
I don’t go looking for high yield shares first as that’s controlled by the price of the shares. The first thing I look for is a quality company. “A-ha!” you might say, “where is the quality in UK Mail if they have barely grown earnings in a decade?”.
Good point, but sometimes I like to lower the growth bar and just look for companies that have stood their ground for a decade or more; in other words:
Look for a business which is not declining
This means I screen for companies that have at least the same revenue, earnings and dividends as they did 3, 5 and 10 years ago.
UK Mail just about ticks those boxes.
You’d be surprised at how many companies – especially in the current economic climate – haven’t kept revenues, earnings and dividends above where they were 3, 5 and 10 years ago. Many companies don’t even have a 10 year history.
By starting with just this minimalist standard of quality and durability I can say that any companies making it over the hurdle have been around a while and are at least not going down the pan. Not exactly the glamour of 20% plus growth per annum; more like the dirty foot soldiers of capitalism, grinding out the results through grit and ingenuity.
Check out Game Group. In many ways they could be a good value investment and they’re yielding almost 20%. Will it get paid? Perhaps, but for the last three years revenue and earnings have been on the slide and the expectation (from the ‘experts’) is currently that they’ll keep going down.
Perhaps they can turn things around, but that’s not the sort of company I want in my model portfolio.
Look for a company with low debt
There’s no point buying a high yield share if the company goes out of business 5 minutes later. That’s why it’s important to check the company’s debt levels, the basics of which I covered in 5 Ways To Measure Debt.
If the company has low debt and reasonable liquidity then the odds of it surviving whatever issues have caused the share price to drop are, in most cases, greatly increased.
A defensive industry can be a bonus
Another aspect to a company’s survival is the sort of business it’s in. One problem for game group is that (without having looked into it too deeply) they sell computer games to kids. If the kids haven’t got any money (because they’re NEETs, or because their pocket money dried up) then they can either just stop buying the games or more likely download the things from the internet for free – which I guess would be illegal.
With UK Mail, it delivers mail, parcels, packets and palletised goods (and a few other things besides). People aren’t going to stop sending mail because of the recession. If anything they may send more parcels as they start buying everything on eBay. The same goes for businesses; they can’t just stop posting things out because times are hard. Well okay, they can to a small extent but so far UK Mail has offset any reduction in demand by shutting a depot or two.
Is a 9% yield ever sustainable?
I hope not.
My assumption is that if the dividend is paid next year then by that time the share price will have appreciated such that the yield is back into ‘normal’ territory, i.e. 5% or so. This requires a share price of around 350p which, somewhat handily, is what Investors Chronicle said was fair value back in 2010. It’s also well below the 700p investors thought the shares were worth back in 2004.
It’s my expectation that UK Mail’s market leading position as the low-cost provider of choice, the defensive nature of their industry, their low debts and their ability to keep growing revenue through innovative products (like iMail and their iPhone postcard app) will be enough to keep the dividend in place. Only time will tell.
I have added UK Mail to my model portfolio at 210p (therefore yielding 8.7% – down from 9% due to the bid/ask spread on this slightly illiquid small cap share) as well as my personal pension.
1. Building an income to retire on
John McElligott says
Good post. I am by in large a dividend investor. I would caution, that dividend yield in my opinion is not a measure of value – it is a measure of payout. In many cases, as you correctly point out with Game Group, exceptionally high yields become questionable. My preferred strategy is to find stocks that offer great value on P/B, thru the cycle earning or P/S that have good balance sheets and just happen to offer a god dividend. Experience has thought me that in almost all cases a dividend strategy is incompatible with poor balance sheet – the cashflow cannot serve two masters.
John Kingham says
Hi John. For me the yield IS a measure of value as my valuation is based on yield and growth combined. The going assumption is that both are sustainable and that’s the tricky bit to work out.
I like your point about thru cycle earnings; I value partly using PE10 rather than the current PE, so that I can see how much I’m paying compared to what has been earned over time. I also measure growth over 10 years to look for consistency more than anything else.
Even a 10 year period can be too short, e.g. BHP Billiton. It’s had a good 10 year run and perhaps there are another 10 years in it yet, but it’s definitely a cycle… just a very long one.
Salis Grano says
I suppose there is a question mark over the dividend cover. Never large, it has recently declined, limiting investment opportunity. If the divi were reduced, the sp would fall significantly and that would provide a more comfortable entry point. Good post and food for thought.
John Kingham says
Hi Salis, hope you’re well. The cover is wafer thin, that’s for sure. But it seems they have always run the business like this which I guess means they really don’t have much to spend the earnings on internally.
In fact, this low cover is exactly what they should be doing, given that they have earned something like 2% on retained earnings in the past. That means every pound of shareholder earnings they retain might as well have gone into a cash account – which would be much better as it doesn’t have the same risk.
Of course they have to retain ‘something’ to run the business, but better they give the earnings to me than retain it for a 2% return.
For example, the old Berkshire Hathaway used to gobble up earnings just to keep updating equipment to stay competitive, but it never returned a dime on that invested capital. The only person making any money was the guy selling them new looms!
At least UK Mail pay all the earnings out. I agree that if they hit trouble like in 2005 then they’d cut the dividend as they did back then, but there’s no obvious reason to believe they’ll hit that much trouble (although there wasn’t back then either).
I looked at this one back in March and then it was right at the top end of my valuation range (13x PER) at 305p, so the price has come down somewhat. In hindsight, I should have waited but I still think this is one for a long-term value hold. They key points for me are:
– the large family holding, which supports a strong dividend (plus a declared policy of pursuing a progressive dividend policy and good operating cashflows)
– a strong market position, albeit in a fragmented but difficult market
– some hidden asset value on the balalnce sheet (possibly)
I’ve been averaging down as the price has fallen, but I would certainly agree that now is looking like quite an attractive entry point
All the best
John Kingham says
Hi Yorkiem. I like your “should have waited” comment – if only that would work!
I think you just have to act on what you see in front of you. If you think it’s good value then buy and if it goes lower don’t worry – or buy some more if the investment case is still sound.
I’m a bit wary of averaging down though. Of course, there’s nothing wrong with if it you’re right, but if you buy rubbish (as I have foolishly done at times in the past) then as it goes to zero you could pump in a billion pounds and it would still go to zero.
Having been burned in the past (back when I used to buy the odd basket-case) I like to put in a set amount and have done with it. Most on to the next opportunity.
Ash @ Sterling Effort says
Hi John, nice to see you trudging around in some unsexy businesses 🙂
I’ll take a look at UK mail. I think it’s important to be cautious and make sure you understand the industry. With Game as a good example, if you don’t understand the investment, it will kill you. I don’t think it’s the fact that kids don’t have any money. Also the gaming market is probably older than most people think. It’s the fact that their model is simply outdated. Why listen to the radio when you have TV? Why watch black and white TV when there is colour? And why walk to a shop to buy a physical copy of a digital product when it can be sent directly to your device quicker and cheaper? As far as I see it, this isn’t to do with piracy. I think game piracy is much less common nowadays for technical reasons – other forms of piracy are still rife. This is to do with the platform vendors such as Sony completely displacing the need for physical and even online retailers. It’s about integration. I click a button on my PS3 and Sony delivers the product to me directly and instantly. There is no need for Game in this environment and that is why its end is nigh.
John Kingham says
Hi Ash. I’m not sure I’m as gloomy about Game as you (some people do still listen to the radio and read paper books, or is it just me?), but your point about becoming obsolete is an important one.
That was part of the point with UK Mail. Although mail is declining, parcels are increasing as everyone buys on-line and with eBay. So if you can adapt, you can survive. I don’t know Game well enough, but if they can lever their expertise in some other way there may be a future.
That’s why I try to pick companies where I can’t imagine the core business (or something similar to it) not being around 10 years from now.