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Stocks

3 shares for income investors

A dividend screen is a jumping off point for further research.

Mentioned: Eagers Automotive Ltd (APE), Aurizon Holdings Ltd (AZJ), Link Administration Holdings Ltd (LNK)


As an income investor I periodically run screens of the local market to see if any shares look attractive. I don’t use these screens as a basis to make a decision. Rather I see them as a starting point to see if further research is warranted.

Most data is subjective and requires analysis to put it into context. And as Warren Buffett said, "The stock market is a no-called-strike game. You don't have to swing at everything – you can wait for your pitch." For those less familiar with baseball he is saying that investors can be patient and wait for the right opportunity.

This weekend I looked at shares under our coverage universe to see if they met the criteria outlined in my investment strategy. I’ve recently covered my strategy in a series of articles that can be found here.

I’ve outlined the criteria I used in the screen and why I believe they are valuable data points:

Morningstar Moat Rating

As an income investor trying to generate a sustainable and growing income stream I’m interested in companies that are successful over the long-term. Competition tends to lead to poor outcomes for companies as they are forced to lower prices, invest in research and development to create better products, and spend on marketing.

I prefer to avoid those outcomes and find companies that earn high margins and high returns on invested capital. That is why I’m looking for companies with Morningstar Narrow and Wide Moat Ratings. A wide moat indicates our analysts view that a sustainable competitive advantage can be maintained for 20 years. A narrow moat is 10 years.

Morningstar Capital Allocation Rating

One of the most important parts of running a company is making capital allocation decisions. A lack of discipline when investing in internal growth projects, empire building through poor acquisitions and excessive employee perks are all examples of poor capital allocation decisions.

As part of their assessment of capital allocation our analysts also look at the balance sheet and appropriateness of the dividend policy. These are both important considerations. Too much debt can put a dividend – and a company – in peril. If a company pays out too much in a dividend there won’t be enough left over to invest in growth. I’m looking for a standard and exemplary Morningstar Capital Allocation Rating which avoids any company our analysts rate as poor.

Morningstar Uncertainty Rating

One of the most underappreciated aspects of assessing a company is that different businesses have different levels of inherent risk. That means that the outcomes of some companies are more predictable than others.

There are numerous factors that influence the predictability of outcomes. Debt levels, the cyclicality of earnings and pricing power are all considerations. I am looking for lower uncertainty as a higher predictability of outcomes means more certainty in future cash flows and dividends. That fits my personality and my goals. I am looking for a company with an Uncertainty Rating of Low, Medium and High and avoid ratings of Very High and Extreme.

Payout ratio

The payout ratio represents the percentage of earnings that are paid out dividends. The higher the payout ratio, the less sustainable the dividend. With a high payout ratio any fall in earnings may cause the dividend to be cut. That is the theory at least.

The payout ratio works much better when looking at US shares as there is more of a stigma about cutting a dividend. In Australia many companies establish a target payout ratio and are comfortable with fluctuating dividends based on changes in earnings. Regardless, I’ve still used 85% as the maximum payout ratio for my screen.

Dividend yield

I want to build a portfolio that balances higher current yields with opportunities for dividend growth. That doesn’t mean that the yield is not a factor in decision making. Beyond a simple measure of the current dividend in comparison to the current price a yield can be the basis for a historical comparison. A higher yield may also indicate that the market is concerned about future prospects.

A dividend yield doesn’t mean anything in isolation. It can be a starting off point for further research – which is the whole point of running a screen in the first place. I took a minimum dividend yield of 4%.

I did not specifically screen for franking credits but that is certainly something I will explore as part of my research.

Estimated future dividends

I am looking for growth over the long-term, but it doesn’t hurt to look at the next two years. As part of their analysis our analysts provide projected dividends and franking credits for the next two years. After the initial screen I eliminated any forecast dividend cuts over the next two years.

Valuation

While I’m primarily focused on income I don’t want to ignore valuation. A great company is one part of the equation. I also want to buy that company at an attractive price. I’ve eliminated shares that are rated 1 and 2 stars which indicates our analysts believe they are overvalued. I’ve focused on fairly valued shares with 3 stars and undervalued shares with 4 and 5 stars.

A ran the screen and three companies met all the criteria that I outlined above. I will take that as a good sign that the screen is fairly stringent. 

 Investing Compass: Can you retire on dividends

Link Administration (ASX: LNK)

I own Link. I wish I was buying it now instead of years ago. Link is down close to 40% YTD. Over the past 5 years it has fallen 84%. The company has clearly had a rough run. The question of course is what does the future hold.

Our analyst Shaun Ler believes that Link is finally on the right track as management works to reprioritise by focusing on growing its core retirement and superannuation solutions, and corporate markets businesses.

Link will exit its lower-returning businesses like fund solutions and banking & credit management by the end of fiscal 2024. These businesses, which were inherited from past acquisitions under previous management, are being divested to free up management resources and redirect capital toward more productive businesses.

Ler assigns Link a narrow moat rating. He believes the firm’s diverse set of services facilitates cross-selling opportunities and establishes switching costs for its clients.

The group's ability to cross-sell also builds volume and scale that establishes cost advantages. These attributes underpin future earnings and returns on invested capital. Additionally, interest earned on client-owned cash balances, which are exposed to interest rate movements, supplement excess returns.

Ler assigns Link a High Uncertainty rating. He sees the primary risks as uncertain interest rate movements, subdued capital market activity, integration, and legal risks, and stronger-than-expected competition in its retirement and superannuation solutions, or RSS, and corporate markets, or CM, businesses.

He assigns Link a Standard Capital Allocation Rating. This reflects our assessment of fair investment efficacy, a weak but potentially improving balance sheet, and appropriate shareholder distributions.

The shares are currently yielding over 7% with a payout ratio under 70%. Ler expects dividends to grow from 8.5 cents a share to 9.5 cents a share in fiscal 2024 and 11.1 cents a share in fiscal 2025. The shares are currently trading at a 20% discount to Ler’s fair value.

Aurizon Holdings (ASX: AZJ)

Aurizon operates rail haulage of coal, iron ore, and freight, and owns a regulated rail network in Queensland.

Morningstar analyst Adrian Atkins believes Aurizon has a narrow economic moat, underpinned by cost advantage and efficient scale. He believes the firm is more likely than not to generate excess returns over the next 10 years.

The core rail-haulage and rail network businesses hold significant cost advantages over road transport for bulk commodities, particularly coal. Additionally, the limited market size and high capital costs for a new entrant act as formidable barriers to entry.

These traits give substantial bargaining power in contract negotiations with powerful mining customers and should allow the firm to make reasonable returns unless Australia's major coal mines—in particular the metallurgical, or met, coal mines—enter a secular decline. This is not our base case.

Australia is one of the largest exporters of coal in the world, accounting for around a third of global coal exports. While difficult to predict accurately, Morningstar forecasts relatively flat global demand for met coal as China's investment spending tapers off and as it starts recycling more scrap steel.

Higher cost supply is likely to come under pressure but as a relatively low-cost producer, met coal volumes exported from Australia should be relatively flat, given cost advantages from high-quality mines and short distances to port.

Atkins assigns Aurizon a High Uncertainty Rating. The future profits of Aurizon are heavily reliant on global demand for coal and specifically steel production which requires metallurgical coal. Thermal coal use in power generation is harmful to the environment and a continued focus on lower emissions may impact demand. However, 95% of Australian coal exports go to Asia which has a young and growing coal power station fleet.

He assigns Aurizon a Standard Capital Allocation rating based on a sound balance sheet, fair investment efficacy and believes shareholder distributions are appropriate. Aurizon targets a dividend payout ratio of 70% to 100% of net profits after taxes and currently has a 75% payout ratio.

The shares are currently yielding over 4% and Atkins expects them to increase from 15 cents per share to 17.9 cents per share in fiscal 2024 and 19.8 cents per share in fiscal 2025. The shares are currently trading at a 23% discount to Atkins’ fair value.

Eagers Automotive (ASX: APE)

Eagers Automotive is the largest automotive retailing group in the Australian market, with an estimated share of over 11% of new vehicle sales. The company offers a range of products and services, including the sale of new and used vehicles, vehicle repair services, and parts, among others.

Morningstar analyst Angus Hewitt believes Eagers warrants a narrow economic moat. The firm's scale affords a cost advantage in new vehicle retailing, and new-car warranties provide intangible assets over independent workshops' work in the service and parts businesses.

Eagers' car retailing segment, which generates most of group earnings, is Australia's largest automotive retailing business. The firm boasts an estimated market share of over 10% following the merger with Automotive Holdings amid a highly fragmented industry.
The firm's extensive size and scale afford a durable cost advantage over smaller peers. As the largest dealer in the market, Eagers can centralize back-office operations and amortize these fixed costs over a significantly larger volume and revenue base.

Parts and servicing, around 20% of car retailing revenue, is also a vital source of the firm's competitive advantage. New-car warranty logbooks give larger dealerships like Eagers an intangible advantage over independent and smaller chain workshops that allows dealers to charge a premium for vehicle servicing, with the hourly labor charge upward of 50% more than an independent workshop.

Hewitt assigns Eagers a High Morningstar Uncertainty Rating. The business operates in a cyclical industry, and vehicle affordability relies on several factors, including interest rates and exchange-rate fluctuations on imported vehicles.

He believes the primary risk for the firm's automotive retailing business is a decline in new- and used-vehicle sales, which depend on the health of the broader economy, vehicle affordability, and car ownership rates.

Hewitt assigns a Standard Capital Allocation Rating based on a sound balance sheet, a history of accretive acquisitions and a sensible dividend policy.

The shares are currently yielding over 5.5% with a payout rate of 65%. Hewitt expects the dividend to increase from 71 cents a share to 79 cents a share in fiscal 2024. The shares are currently trading as fairly valued.



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