Not all high yielding stocks are equal. Here's three that deserve second-thoughts

It's easy for investors to be allured by high-dividend yields, particularly in the current low interest rate environment; but it pays to be wary.

Tuesday, September 24th 2019, 3:09PM

by Pathfinder Asset Management

By: Hamesh Sharma

Too often, investors seem to ignore weak business fundamentals and uncertainty and cling to the hope of an “attractive” dividend pay-out when justifying a stock investment.

Three companies which look attractive are; Z Energy, Sky TV, and Fonterra Shareholders' Fund. But there are question marks around each one.

A recent example of a stock we have avoided and continue to avoid across our portfolios is Z Energy (ZEL). A number of brokers and fund managers have been holders and buyers of ZEL given its 8%+ dividend yield, which at face value is very attractive.

However, as we saw earlier this month, that dividend yield doesn’t provide much comfort when the share price falls by close to 20% after a profit downgrade and dividend cut.

ZEL is facing a number of headwinds, most notably from what the company described as "unprecedented" discounting and competition among petrol retailers. Ironically this comes at the same time the Commerce Commission market study into the fuel industry suggested that the sector was generating excess returns, partly due to a lack of competition.

So, it feels to us like Z is in a “lose-lose” situation, as if the competitive landscape improves the threat of regulation increases, and vice versa. We find it difficult to envisage a scenario with large upside for ZEL at the current juncture.

At the same time, oil prices, the NZ dollar, and margins remain volatile, creating uncertainty around pricing and volumes and hence ZEL’s profitability. Finally, long term there are massive question marks around how ZEL will respond to the proliferation of electric vehicles – a key reason behind Infratil’s divestment of the business from their portfolio.

Overall, while the current dividend yield may provide some downside support, we believe there are better risk/reward investment opportunities in the NZ market.

ZEL is not alone, and two other major New Zealand companies we continue to avoid are Sky TV and Fonterra Shareholders' Fund, these are no longer dividend traps as management have recently suspended dividend payments, the usual end-game for a “dividend trap”.

While the weekend’s news that Spark Sport’s stream struggled with the load of the All Blacks game is marginally positive for Sky TV (question marks on the suitability of the internet as a broadcast medium will add weight to arguments suggesting Spark is unlikely to be a meaningful competitor for incumbent Sky TV on key broadcast sports rights), we still see Sky TV as fighting an uphill battle.

Sky TV continues to bleed high-value satellite subscribers, despite adding more streaming subscribers, which at the margins will cannibalise existing higher-value customers as the streaming product offering quality improves.

Sky has been struggling for some time now with the age of “digital disruption”. The latest on this front being news Disney+ is entering into the New Zealand market meaning Sky TV is set to lose a significant chunk of its children programming – losing its one-stop-shop appeal for families that in the past helped justify its higher pricing.

Sky can still bid for Disney content, but as with other bidding processes the cost of quality content is increasing as new players enter the market, and at a time when average revenue per customer is declining it does not place Sky in an enviable position.

Finally, Fonterra has been a classic dividend trap, recently cutting its dividend after writing down the value of under-performing assets. Fonterra has failed to deliver on its promised “value-add” strategy to date and as a result its share price continues to be punished – with the dividend cut likely the final straw for many investors, adding to inherent issues with the company structure.

While there is potential for a turnaround and restructure over the medium term, we are happy to watch from the side-lines for now.

Pathfinder is an independent boutique fund manager based in Auckland. We value transparency, social responsibility and aligning interests with our investors. We are also advocates of reducing the complexity of investment products for NZ investors. www.pfam.co.nz

Tags: Commentary investment Markets Opinion Pathfinder Asset Management