Look to revenues to help you through

Nov 19 2008 by Iain Laing, The Journal

WHILE economic news remains almost unrelentingly grim and the media has now moved its focus on from the credit crunch to the recessionary impact on the economy, it is worth remembering that there are some investment strategies that equity investors can employ to improve the chances of their portfolio weathering the turmoil reasonably unscathed, at least as far as performance relative to the wider market benchmarks is concerned.

A few weeks ago we looked at lessons from past recessions and showed that, in general, “value” styles of investment generally outperform in the run-up to recessions, while “growth” stocks outperform in the period after.

As we noted, there are a few exceptions to this rule, but generally it seems to hold true. One style we didn’t discuss was income, and specifically the fact that income investing has outperformed in the last three bear markets.

While income investing may seem like an obvious choice in the current climate, it is worth remembering that what looks like an attractive level of dividend income today may become somewhat less compelling should the dividend be cut – or passed altogether. Indeed, while bellwether stocks such as BT trade on an estimated 2009 dividend yield of around 12%, that payout looks rather less enticing if a 50% dividend cut is factored in (which we deem to be a reasonable assumption in BT’s case, given the risk of increased funding requirements for its pension scheme).

So, recognising that income stocks usually outperform in a downturn but at the same time acknowledging that many companies will either cut their dividends or simply forego them altogether, we have screened across our UK and European analyst portfolios and identified a number of companies where we believe the likelihood of a dividend cut is minimal.

The results of this screening identify what could be called the “usual suspects”, ie companies with generally low levels of gearing, well-protected earnings streams and high levels of dividend cover, as well as attractive levels of income.

However, as well as looking at these characteristics, we have sought to refine the list further by identifying stocks with decent total return prospects and at least some upside to our fair-value estimate.

Our analysis suggests that some of the stocks offer very good return potential. In one of the more traditionally defensive sectors, pharmaceuticals, AstraZeneca stands out as offering earnings and dividend dependability and some price upside.

In telecommunications, Vodafone also trades below our estimate of fair value and offers an estimated 2009 dividend yield of 6.6%.

The bottom line is that there are a number of companies that still offer good price upside and decent, relatively secure, dividends – characteristics that we believe will be in demand in coming months, especially if macroeconomic news continues to worsen and equity market sentiment deteriorate.

Of course, income stocks are not without their own risks – some, such as BP and AstraZeneca, pay their dividends in dollars, so foreign exchange (FX) is another consideration as some investors will not want to incur any FX risk.

But overall, high-yielding stocks with well-covered dividends and strong levels of interest cover should provide better returns through the downturn than most.

Andrew Miller is regional office head at Barclays Wealth in Newcastle

A number of companies still offer good price upside and decent, relatively secure, dividends.