Income investors face a substantial opportunity in the likes of BP, Shell and Rio Tinto where dividend yields are at least 7 per cent, according to John Baker, manager of the JPM UK Dynamic fund, thanks to falls in their share prices.
These three stocks, which all sit in the top 10 largest holdings of Baker’s £160m fund and make up more than 11 per cent of the portfolio, have seen their share prices suffer large falls over the past year or so.
According to FE Analytics, over the past 15 months these three stocks have fallen hard while the FTSE All Share has chugged along and gained 2.99 per cent. Rio Tinto has lost 27.33 per cent, Shell 23.31 per cent and BP 12.92 per cent.
Performance of stocks and index since August 2014
Source: FE Analytics
However, these falls means their yields have leapt up. The falls in the share prices have lifted the dividend yield of Rio Tinto to 8.75 per cent, Shell’s to 6.96 per cent and BP’s to 6.75 per cent.
But some have also suggested that the companies are at risk of having to cut their dividends, as their revenues continue to be hampered by low prices in underlying commodities.
“We have to acknowledge as investors that if the oil price and commodity price stays here for the next three or four years, it is logical to start to fear that the dividends for these companies could be threatened but as it stands at the moment they are safe,” he said.
“Each of those companies whether it is BP, Shell, Rio Tinto or BHP Billiton have all come out in the strongest terms to reiterate that the dividend is their very first priority. The position they are starting from is a position of strength because they are not highly indebted companies.”
“Even if their cash flow doesn’t cover their annual dividend payment, they have more than enough capacity to increase levels of gearing to cover those payments. At least on 12-month view those dividends are pretty secure. Whilst we acknowledge longer term there’s is a risk, over the next 12 months we are fairly confident.”
The stocks have all come under the pressure of falling commodity prices, which in the case of miner Rio Tinto has been a broader trend for several years and in the case of BP and Shell – both oil producers – the oil price plunge ongoing since June 2014.
Performance of indices since 26 June 2014
Source: FE Analytics
Duncan Goodwin, head of global resources in Baring Asset Management’s equity team, agrees that the glumness of the market on oil has opened up a buying opportunity.
“Pessimism toward the oil sector is so widespread that the market is pricing in virtually zero growth in the price of oil or any improvement in the returns that the oil industry can deliver in the future,” he said.
“We believe this dismal assessment is overly pessimistic and that many may be overlooking one of the greatest potential opportunities in resource equities today. This is not the first time the market has been through an oil price cycle. It has happened before and the price has not perpetually remained at crisis levels.”
“Furthermore, forecasting no improvement in equity returns into perpetuity at lower oil prices assumes that oil companies themselves will do nothing to better their situation in response to current market conditions.”
Indeed, companies have been cutting costs hard and shelving expensive capital projects which is freeing up cash, he adds.
“Shell’s acquisition of BG Group is one of the more noteworthy examples. The deal, which is pending completion, will help realise cost synergies and give Shell access to a more efficient production base through BG’s assets in Brazil.”
Chris Beauchamp, senior market analyst at IG, says miners have been holding up well in recent days despite data from China that suggests a further slowdown, the primary cause of their longer term falls. However, he warns that the coming months could see a new pressure on their profits.
“With the full effect of rate cuts yet to be felt there is some reason to hope that this performance may be reversed in the coming months,” Beauchamp said.
Over the past three years the JPM UK Dynamic fund, which Baker co-manages with Jonathan Ingram and Blake Crawford, has doubled the FTSE All Share’s 27.06 per cent gain with a return of 54.1 per cent. The average fund in the IA UK All Companies sector returned 37.26 per cent over this period.
Performance of fund, sector and index over 3yrs
Source: FE Analytics
While Baker thinks Shell, BP and Rio Tinto are screaming value – Shell is his largest position at 4.8 per cent – he says it is currently a short-term expectation and after the next 12 months the pessimism is harder to dispute as things stand.
On a longer term view he is also backing domestic stocks in the mid-cap part of the market where he says there is particular amount of value.
“There is still valuation attraction in the UK equity market. Particularly if you adjust for earnings on a cyclical basis. Notwithstanding weakness in earnings for oil and gas and mining companies, there are [also] loads of areas where you can still make money from,” Baker said
“At the moment most of those companies tend to be domestic ally focused such as house builders, general retail stocks and domestically focused banks,” he added.
JPM UK Dynamic has a clean ongoing charges figure of 0.93 per cent.