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19th January 2016

Evenlode’s Yarrow: Three income stocks that can ride short-term pain for long-term gain

Hugh Yarrow, Evenlode Income

Hugh Yarrow, co-manager, Elite Rated Evenlode Income

In the unpredictable world we live in, even the most predictable business will not necessarily grow its earnings upwards in a straight line. Problems crop up – at the macroeconomic, industry and individual stock level. As a result, earnings tend to bump around in the short-term.

So instead of short-term earnings, we consider what long-term free cash flow (and thus dividends) we think a company is capable of generating. Our estimates on this basis tend to be much less volatile, and we often find earnings set-backs are a good opportunity to buy fundamentally attractive businesses on attractive initial dividend yields.

Below are three examples of companies we hold that are experiencing tough market conditions, but in our view remain well placed to generate healthy cash flow and dividends in coming years.

1) Spectris

A global leader in the precision instruments and controls sector, Spectris’ products typically represent a small part of a client’s cost base but can have a material impact on efficiency and product quality. Relationships with customers become highly embedded and more than 80% of sales come from repeat customers. Spectris consistently invests approximately 7% of revenue in research and development. Management are currently investing in a new wave of innovative products to help drive future growth.

Over the past seven years earnings and dividends have both grown at more than 10% per annum. However, as industrial production around the world has slowed the knock-on effect has been that this year, organic sales are down 1% so far and earnings will therefore fall in the short-term, as management continues to invest in the business.

Analysts have been downgrading earnings forecasts over the past two years and the share price has underperformed as a result. We initiated a position last summer in Spectris and have been adding to this position over recent weeks, at a dividend yield of more than 3% (more than twice covered by free cash flow).

2) Jardine Lloyd Thomson

JLT has a strong position in the global insurance broking market, specialising in sectors such as aviation, healthcare and construction. This capital-light business enjoys strong customer relationships and a reputation for client advocacy. It takes no insurance risk and profits are consistently converted into cash flow. The business is moving increasingly to a fee-based model, but approximately 40% of fees are still commission-based. As a result, JLT has faced a tough backdrop over recent years from a significant decline in insurance rates. This year’s earnings are also being burdened by JLT’s significant organic investment in its new US insurance business, and the impact of regulatory and policy change in its UK pensions business.

However, JLT is taking market share in this downturn, taking advantage of lower insurance rates to increase coverage for clients, and driving growth in new sectors such as cyber insurance. Looking ahead, the US business will begin to generate and grow profits, and when the insurance cycle ultimately turns, I believe JLT will see a significant benefit to cash flows from its portion of sales that are still commission based.

JLT’s annual dividend growth over the last five years has been 7% and the latest increase was 5%. The potential for healthy dividend growth over coming years is good, and the current dividend yield is 3.5%.

3) Fidessa

Fidessa is a global market leader providing mission-critical software to investment banks, brokers and asset management firms. 85% of revenue is recurring and renewal rates are more than 99%. Long-term growth potential is good as customers look to improve efficiency, cope with regulation and compliance, and bring down costs.

However, Fidessa’s markets have been difficult over the past two years, as its customer base has faced its own problems, spending has slowed and, in some cases, customers have merged with each other. Meanwhile, Fidessa is making a very significant investment in its new derivatives offering. We estimate that current earnings would be approximately 40% higher if Fidessa stopped this investment and just focused on its existing equity platform, but we’d rather they continue to burden current financial results with this project, as we feel the long-term potential for the product is excellent.

Fidessa operates a very prudent balance sheet with no debt and a strong net cash position. As the company is capital light, it needs little of its cash flow each year, so free cash flow is regularly returned as ordinary and special dividends. Including the special dividend, Fidessa’s current dividend yield is 4.5%. We added a position in the company in October.

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Hugh's views are his own and do not constitute financial advice.

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