Five income stocks to ‘consider’ in a crisis

A local shop had a queue of people waiting to get in on the weekend. The store was mindful of social-distancing rules, so let in two customers at a time, as two left.

This was not a supermarket, pharmacy, butcher shop or baker. Rather, a board-games store in high-demand, as customers loaded up on puzzles and trivia, to stay occupied. Shelves were emptying and the cashier said trading was “three times busier than Christmas”.

A nearby bookshop was also busy. With local libraries shut, the shop traded briskly as customers stocked up on reading. The shop had extra staff to cope with the demand.

Driving home, I noticed cars lining up at a bottle-shop drive-through. The hotel bar was shut, so customers bought alcohol for home consumption. Who could blame them?

My guess is readers will have similar anecdotes in their suburb. Many stores are closed or dead quiet, and a few are seemingly doing a roaring trade. I know some entrepreneurs who are devising entire new business models and concepts for life after COVID-19.

These anecdotes are not meant to downplay the economic impact of COVID-19 or suggest the share market is about to bottom. Recession is certain. With estimates that up to a million people became unemployed this week, a sustained long-term downturn is possible.

Also true is that elevated consumption in some sectors will ease as hoarders stop hoarding, and people realise their pantry and freezer are full. Woolworths’ management said this week they are seeing an ease in rapid growth in grocery sales.

But these anecdotes are another reminder that some companies are much better placed to weather the COVID-19 storm than others. The few that can maintain earnings and dividends should be the focus for income investors.

To recap, I have repeatedly emphasised in my last three columns for The Switzer Report that it is too soon to call a market bottom. This time last week, I suggested another 10-15% fall in the S&P/ASX 200 index was possible and it almost got there.

My general advice has been to put a small amount of available cash (if possible) to work in the market and “average in”. Nobody knows precisely when the market will bottom, so anybody buying today must be able to tolerate further falls and persistent high volatility.

As I wrote last week: “Keep most of your portfolio on the sidelines and wait until markets show signs of stabilisation. It’s better to miss the first 5-10% of the upswing than rush in too early and watch your portfolio fall by a third or more.” That view remains.

In terms of sectors, my preference has been technology. I know that highly priced tech stocks can fall a long way in market crashes. But the best software-as-a-service companies have high margins, recurring revenue and there are “switching costs” to move between providers.

It’s hard not to think the world’s best tech companies – Amazon, Microsoft Corporation, Apple, Facebook and Alphabet (owner of Google) – will not be significantly higher in three years than they are today. Prospective buyers need at least a 1-3-year view, preferably longer, with these stocks.

Dividend conundrum

My attention this week turns to the income side of investing, partly because some Self-Managed Superannuation Trustees (SMSF) have asked my opinion on the dividend outlook, and also because some high-quality companies, on paper at least, have high yield.

Extra care is needed with dividends on several fronts. Forget about using historical dividend yields as a guide. COVID-19 has skewed several key investment metrics.

As always, focus on the next dividend, not the latest or the previous one. Specifically, the company’s ability to pay the forecast yield. A yield of 14% looks too good to be true, and invariably is because the falling share price has inflated the income return.

More companies this week withdrew their earnings and revenue guidance, such is the uncertainty surrounding COVID-19. Brokers cut dividend forecasts for numerous companies and market chatter suggested several equity capital raisings were imminent.

With balance sheets under immense pressure in some sectors, some boards will defer, reduce or axe their company’s next dividend. Others will approve discounted equity-capital raising to boost balance sheets and those in big trouble will do both, as happed in the 2008-09 GFC.

Don’t be lured by double-digit dividend yield that could go even higher as share prices fall. There’s a lot of dividend pain ahead. Don’t believe traditional yield sources – banks, listed property, infrastructure funds – will be immune; dividend cuts are inevitable.

That said, a small group of Australian companies that can maintain their yield, or get by with a modest, temporary cut, could provide attractive yield for income investors. With wealth falling and bank deposit rates near rock bottom, dividend income is vital.

Balance sheet, business models are key

Every investment decision must start with balance-sheet assessment during such turbulent times. Simply, can the company survive an extended economic downturn? How close is it to breaching its debt covenants? How quickly can it raise equity capital if needed and what type of share-price discount will be needed to attract institutional and retail investors?

Companies should always be assessed on a case-by-case basis, but I would be wary of buying any mid or small-cap stock for yield right now. The market’s best “blue chips” have that description for a reason: they have the strongest prospects when everything tanks.

Then, consider the industry and business models. Avoid companies that have highly cyclical earnings, lower profit margins and greater threats in downtimes. Stick to defensive companies that can maintain most of their performance in good and bad markets.

Valuation is key. Quality companies with highly defensive earnings and capacity to maintain dividends typically hold up better during savage corrections. But in the COVID-19 crisis, most stocks are getting belted. That will be a wonderful opportunity in time.

I’ve narrowed the list to five companies for income investors looking to put fresh capital to work. Some are already portfolio mainstays and the stocks below will not excite readers looking for hot ideas. The ideas are aimed at conservative portfolio-income investors.

The five income ideas are:

1. Telstra Corporation (TLS)

After falling from $3.90 in late January to $3.10, the telco has a prospective grossed-up dividend yield (after franking credits) of 7.4%, on Morningstar numbers. Telstra has a strong balance sheet, resilient earnings and management has maintained guidance, albeit at the low end of its range. That’s a huge tick in this market.

Source: ASX

2. Australian Securities Exchange (ASX)

The financial-markets operator has fallen from $86 in early February to $70.55. At the current price, ASX is yielding about 4% fully franked. That’s low for income investors, but ASX has an excellent balance sheet, strong competitive position, and benefits from elevated market volatility through higher trading volumes.

3. APA Group (APA)

Units in the energy-infrastructure giant have tumbled from $11.70 in mid-January to about $9. At the current position, the grossed-up prospective yield is about 5%. In this market, that’s useful for income investors and APA has good prospects for solid distribution growth in the next few years. And core infrastructure, such as energy, is highly defensive.

4. Woolworths Group (WOW)

I became negative on the supermarket giant late last year, nominating it as a stock to sell in 2020 on valuation grounds. Woolworths has fallen from $39 at the time of that story to $35, but this relatively small fall reinforces its defensive qualities.

At $35, Woolworths has a grossed-up forecast yield of just under 4%. Again, that’s a touch low for income investors, but sacrificing some yield for the safety of a high-quality company makes sense. Woolworths has a better chance of maintaining its dividend this half, notwithstanding challenges in its hotel division.

5. ANZ Banking Group

Dividend cuts from the big-four bank stocks are likely, as interest-rate cuts pressure their net interest margins and as they provision for a higher rate of bad debts as business insolvencies spike. But the market has already priced in the likelihood of dividend cuts and then some, after savage share-price falls.

After years of avoiding bank stocks, I nominated ANZ as a stock to watch last year and see value emerging in the big four.

The aforementioned stocks suit income investors who are prepared to sacrifice a little yield for greater certainty in owning high-quality companies. But there’s no need to buy aggressively yet; this market has further to fall. Beware relief rallies.