High yields too good to be true?
High dividend yields among small cap stocks are generally too good to be true. They are either the result of a share price decline because of trading problems or market concerns, but where the dividend forecast hasn’t (yet) been downgraded. Or they are companies that aren’t reinvesting money into their business, so the cash position piles up. You MUST reinvest in a business or eventually it will suffer.
Ask these questions of any firm expected to pay a dividend:
• Are earnings per share comfortably more than the dividend paid out?
• Look at earnings strength - if trading is poor, this raises the chance that there’s not enough cash being generated to make the expected pay-out. Don’t forget it is CASH that pays the dividend.
• A prospective dividend yield above 8% is rarely sustainable unless there’s significant levels of cash generation and the money isn’t needed elsewhere. (Even then - check to see if the company is reinvesting cash to sustain and grow its business. It if isn’t, then why not?)
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Formerly known as Helphire, at 59.5p Bath-based Redde (REDD:AIM) offers a prospective 10.5% yield based on 6.2p dividend forecast by house broker N+1 Singer (June 2015 financial year end).
While that looks very enticing on paper, there’s an immediate red flag with this expected payout being marginally higher than the 6p earnings per share forecast. N+1 Singer analyst Andrew Watson comments: ‘The balance sheet is strong. It is debt-free and has funds available for acquisitions. It is a cash generative business that is improving internal processes and becoming more efficient with working capital.’ With sufficient funding in place to develop the business Redde plans to return all cash profits to shareholders, adds Watson.
Redde is one of several companies on the stock market offering outsourced services to insurers; sector peers include Quindell (QPP:AIM) and Innovation (TIG). A person involved in a car accident (that’s not their fault) is often offered help from their insurer with pursuing the claim against the driver at fault, and given a courtesy car while their vehicle is being fixed. That’s the domain of Redde which has a car fleet and undertakes the insurance claims work on behalf of the customer’s motor insurer.
N+1 Singer’s forecasts look very impressive with pre-tax profit of £17.5 million forecast for the year to June 2015, versus a £4.1 million pre-tax loss three years earlier. Redde has diversified into legal services which looks a sensible move. It has also increased the mix of courtesy cars financed on lease agreements rather than direct ownership, to reduce exposure to swings in residual value on its balance sheet.
The improvement in cash collection is good but there’s most definitely a catch to the story. The Competition and Markets Authority (CMA) has announced plans to reduce the cost of insurance premiums for motorists including a cap on the costs of courtesy cars. In a research note following the news, Watson insists there’s no significant impact from the CMA investigation, saying Redde already adheres to the FTA framework under which credit hire prices are moderated.
There’s clear regulatory issues to consider but investors with an appetite for risk may feel Redde is one of the more professional operators in the market and therefore won’t see a massive dilution in profit margins from fee capping. It is also encouraging to see lauded fund manager Neil Woodford buy stock in May via Woodford Investment Management. We take a more bearish view in the belief that earnings cover needs to radically improve for this is to be an income stock to own. (DC)