Income investing is extremely popular at the moment, but the concentration of income in the UK stock market causes a potential problem. The largest 10 income producing stocks produce 53% of the total market’s income1. These are typically the mega-caps like Royal Dutch Shell, Vodafone or AstraZeneca. However, as a group, they have been disappointing investments. They typically operate in challenging industries like oil & gas, banking or mining. Even previously fast growing industries, like pharmaceuticals and mobile telecommunications, have seen increasing competition and greater pricing pressure. In recent years the FTSE 100 index has lagged the mid-cap FTSE 250 index considerably, partly due to the poor performance of the mega-caps. So many investors have, understandably, reduced exposure to these large businesses.
This poses a challenge for income investors, as only around one in three companies in the FTSE 100 Index offers a yield above the average2, leaving limited choice outside the big 10. The mid-cap and small-cap areas also have relatively few high yielding stocks, especially if an investor wants to stick to relatively stable and secure business franchises. So how should a genuine income investor balance the need to earn a dividend income with the desire to buy attractive companies?
Sometimes the answer can be in plain sight, but takes a change in perspective to see it. I believe that several of the mega-cap companies appear to be very attractive investments. The fact that they have been poor performers in the past does not mean that they will continue to be so in the future. It is often said that past performance is not a guide to the future. I think that this will prove to be the case for some of the mega-caps3. Although I was too early in calling for these stocks to out outperform in Mega Value? last year, their continued underperformance has brought valuations down to even more attractive levels.
Here are a few mega cap stocks, which, in my view, currently look interesting4:
The oil majors BP and Royal Dutch Shell which looked cheap a year ago have been hit hard by the halving of the oil price since then. They are now offering dividend yields above 6%, a rare c.60% premium to the UK average. However the oil industry has proved adept at managing through a tough environment before. Industry costs are deflating dramatically as companies shelve investment plans, buy less equipment and lay off workers. The oil majors are postponing or cancelling projects to protect their cash flow. This can be seen at Royal Dutch Shell, which has recently announced a 10% cut in this year’s capital expenditure to $30bn. These spending cuts should balance the books at a much lower oil price and allow both BP and Shell to continue to pay their current dividends. Lower spending by the industry will, in due course, also lead to a tighter demand / supply balance which should support the oil price again as my colleague Chris Wheaton argued in Barrels? Texas holds-em!
The pharmaceutical company, GlaxoSmithKline, has come through a difficult period as profits have fallen due to generic competition to some of their blockbuster drugs and aggressive pricing pressure in their large asthma franchise. However the company has not been standing still. The recent asset swap with Novartis means that 40% of their sales now come from world leading vaccines and consumer health businesses. I believe both of these have strong and sustainable competitive advantages and good growth prospects. Glaxo’s pharmaceutical business is also far less dependent upon large blockbusters than previously and has a rapidly growing HIV franchise. Overall the quality of the business is far higher than it was a few years ago and yet the valuation is at a large discount to food and consumer health products companies that it is increasingly competing with.
HSBC, the large multinational bank, has also had a difficult few years. Like many banks it has had to restructure its operations since the global financial crisis, shrink its assets base and build up capital. This has led to pedestrian profits growth. However HSBC retains an enviable franchise in the faster growing Asian region, with profitable and valuable banking operations in many other countries, not least the UK, a strong balance sheet and a global network to service multinational corporations. HSBC has a modest valuation, trading around net book value with a 5.7% yield5. Furthermore it stands to benefit from rising interest rates, in particular in the USA, which should position it well for the forthcoming interest rate cycle. In summary it is a well positioned and modestly valued business that is being restructured to improve financial returns.
Favouring the mega-caps is a contrarian call today when investors have re-rated mid-caps and companies with high returns and relatively stable earnings. However I believe that the prospects for the four companies above are better than commonly perceived and their valuations are attractive in absolute terms and, even more so, relative to the valuation of much of the rest of the stock market. It is possible to invest in companies offering a good dividend yield and potentially a superior total return, but this may mean going against conventional wisdom and buying unpopular businesses.
1, 2, 5. HSBC Forecasts – Based on Prospective Yields on FTSE 100 Index companies
3,4. This is no recommendation to buy or sell any particular security