This week, I was mildly surprised to see Centrica (which I’ve owned since 2012) cut its final dividend as part of a plan to rebase the dividend some 30% below its previous level.
It wasn’t a complete surprise given the recent collapse in the price of oil, but it’s the sort of event that demands some sort of reaction.
As I see it, shareholders have three main options.
- Panic sell: Break out in a cold sweat, curse Centrica’s management and place a sell order immediately
- Do nothing: Be mildly miffed, but do nothing because you like to hold shares “forever”
- Weekend review: Wait for the weekend and then review the company again in order to decide whether to keep holding, start selling or perhaps even buy more if the price drops enough
Reaction option 1: Panic sell
If you’ve been reading this blog for a while you’ll know that I am not a fan of panic selling, especially when it relates to an established, successful company like Centrica.
Sure, panic sell an AIM-listed micro-cap mining company that operates in some country you’ve never heard of, but Centrica?
I’ve written about this before, but in my view panic selling a defensive dividend payer like Centrica is like selling a buy-to-let property because its rental income drops for a year or two.
Typically rent will drop because there’s a void period, i.e. a period where one tenant leaves and another can’t be found immediately. The property sits empty for a few months so rental income for the year is lower.
Panic selling in that situation would mean putting the house up for sale immediately at a knockdown price, perhaps 20% below its true market value, just to get rid of the place.
To me, that is just crazy. It locks in a massive capital loss just because income has dropped a little bit for a little while. The property is still there, its basic ability to generate an income is no different, and in time the income may well bounce back to where it “should” be. The same could easily be said of Centrica or any other defensive dividend payer.
The same sort of situation led investors to sell Aviva after it cut its dividend in 2013, causing them to miss out when the share price rebounded massively shortly after (a roller coaster ride that I went through myself).
Reaction option 2: Do nothing
Now this is much closer to my heart. I like to be efficient, i.e. to minimise the amount of work I need to do (which my wife describes as “lazy”).
The minimum amount of work in this situation is to simply do nothing at all. In fact, this is a popular strategy which generally falls under the banner of “buy and hold”.
A good example of the buy-and-hold approach is the High Yield Portfolio strategy (HYP) developed by Stephen Bland, which has its spiritual home on the Motley Fool bulletin boards.
With HYP, defensive dividend payers are bought with attractive yields and then left untouched for all eternity, and “tinkering” with the portfolio is a definite no-no.
While this sounds more attractive to me than panic selling and is for the most part a fairly sensible strategy if you’re buying the right sort of companies, it isn’t for me.
I don’t like the idea that I would buy a company in 2010 and still be holding it in 2030 without ever having thought about whether it was worth holding on to.
When a company is first bought it is analysed to make sure it’s a defensive dividend payer. At the same time, its share price is analysed to make sure the yield is sufficiently good. So if it makes sense to check those things when the shares are bought, why does it make sense to never check them again?
What if the company goes down the pan, never to recover? Surely at some point, it makes sense to move on and buy another company that is far more successful?
Or what if the company does okay, but the share price doubles or triples, dropping the dividend yield to well below the market rate? Wouldn’t it make sense in that case to lock in those excess capital gains by selling? The proceeds could be reinvested into another, equally solid company but with a more attractive valuation and dividend yield.
That’s not to say buy and hold isn’t a good strategy. It can be, but only for those who really do never ever want to make any investment decisions ever again, or at least no more than once every few years.
For me, that is far too boring and leaves far too many potential returns on the table. So while I think doing nothing is probably much better than panic selling, I’m not going to stick with Centrica forever, regardless of how it performs. I want something in between those two extremes.
Reaction option 3: Weekend review
And so we come to my preferred approach, which is the weekend review. The idea with a weekend review is to take the middle path between an emotionally driven knee-jerk reaction on the one hand and a complete absence of reaction on the other.
It may seem odd to wait for the weekend, but there are good reasons for doing so:
- The markets are closed so you can’t see the price ticking lower every few seconds and you can’t execute a trade immediately, which means you can concentrate on doing a good review without distraction
- It will usually be a day or so since the original unpleasant results were announced so you will have had time to calm down (although if you get upset by bad news you’re probably not diversified enough), which should help you to think more clearly
Once the weekend rolls around you would just sit down and do a thorough review of the company (Centrica in this case) using its latest results and its latest share price (using this investment spreadsheet if you like).
In my case, as a defensive value investor, I would be looking to see:
- Defensiveness: Is Centrica still a relatively defensive dividend payer (despite the dividend cut), with reasonable medium and long-term growth prospects?
- Value: Is the valuation still attractive, given the company’s slower growth rate and reduced dividend?
Here are Centrica’s results up to and including the dividend cut:
The profits are a bit jerky but the general trend is upward, although of course there are no guarantees for the future. At 255p the company and its shares have the following metrics, which I have compared against the FTSE 100:
- Growth: 10 year revenue/earnings/dividend growth rate = 8% (FTSE 100 = 1%)
- Quality: 10 year growth quality (consistency) = 79% (FTSE 100 = 54%)
- Value: PE10 ratio (price to 10 year average earnings) = 11.3 (FTSE 100 at 6,850 = 14.4)
- Income: Dividend yield = 4.7% (FTSE 100 = 3.4%)
- Profitability: ROCE = 12.4% (using post-tax profit) (FTSE 100 = 10%)
By those metrics, the company still has a better track record than the market average and its share price is still more attractively valued than the market, by a considerable margin.
After looking at the numbers I reviewed the company’s operations and its market and I think it is by no means clear how Centrica will perform in the medium to long term. The oil price is uncertain, the political situation is uncertain and the economy is uncertain.
However, this degree of uncertainty is entirely normal as the future is almost always uncertain. Rather than try to predict an uncertain future, my approach is to defend against it instead.
I think the best way to defend against an uncertain future is to build a highly diversified portfolio of successful, established, dividend-paying companies, and then for the most part to let them get on with it.
On that basis, I will be holding on to Centrica for now, despite the dividend cut.
I think this told everyone that there was a looming problem back in May :-
I would have thought the biggest worry here, and one that should also apply to other utilities, is the rising level of debt. The last 7-10 years have an Alice in Wonderland period of ultra low and rigged interest rates.
Centrica is actually probably one of the better examples, but even here it’s sports some £20Bn in total liabilities and a pre-tax profit of (oh wait it’s a loss for this year), averaging about £2bn but trending down. With a post tax profit significantly below this, Centrica is sitting on some many years of servicing.
One better hope that the FED doesn’t start to wind up interest rates anytime soon or this and other utilities are going to look pretty sick around the gills.
LR
Hi LR,
Yes but £6b of the £20b is trade payables which net off against trade receivables, more or less, plus a billion or so in price hedging and so on. Generally I focus on borrowings, which are at £7b, which is about 3.5 times the company’s recent post-tax profits.
For defensive companies like Centrica I like that ratio to be below 5, so the company’s fine by that measure. The dividend has been cut because management want to maintain an investment grade credit rating, so they’re being very cautious, which again is fine by me.
I guess we’ll find out if the sellers or the holders were right over the next few years.
Hi John — I see your point, but trade receivables have to happen. Even if you discount the trade receivables £20bn – £6bn – £1bn = £13Bn or another £6bn unaccounted for if you then exclude the £7Bn borrowings.
If you ignore the pre-tax loss of £1.4Bn last year as a blip, the next three years pre-tax profits are forecast at £1.5bn per annum, and that’s assuming oil and gas don’t continue to decline.
So on current trends you have debt ratio of 4.7X (close to your target of 5) against just borrowings and 8.7X against net liabilities.
I’m sadly a shareholder in Centrica too and didn’t heed the warning when all the directors sold in May. I’m not in the frame of knee jerk reaction selling now, so will wait, but things don’t look quite so rosy for Centrica and some of the other utilities (fortunately non of which I hold – having sold Drax at £7 and SSE at 16XX).
The sector is going through a change, having now exposed itself to increasing debts. (Interest rates could be the game changer)
I don’t know what your views on Drax and SSE are, but Drax looks very unstable with a business model smashed by coal carbon taxes rising 15% per annum and is now reliant on subsidies to make biomass pay. In the case of SSE, they have been increasing debt and reducing margins and ROCE for 5 years in a row, at a time when money has never been cheaper.
Food for thought I guess (no pun intended, but we could be looking at another supermarket type story, no?)
LR
Hi LR, I own SSE as well and that one definitely has more debt than I like to see. Also ROCE isn’t anything special, but I wouldn’t expect it to be in such a capital intensive industry. I agree that they’re all in a tough spot, but let’s see how things pan out over the next few years.
As for the supermarkets I think the war there is just getting started…
Agreed. Would you buy more?
Hi Andrew, I might buy more if I had new capital to deploy, otherwise I wouldn’t. If I only had existing cash or new dividends to invest I’d put it into a new company as I prefer to make one buy and one sell decision per stock.
But as I say if I had a large amount of new capital to put to work then I probably would buy more Centrica, along with any other existing holdings that I thought were especially good value.
Regulation and very poor management are the problems for this stock.
I cannot own a stock which future depends on the results of the next elections. Why would I?
Hi Eugen, possibly, but as a value investor I often find myself in stocks that are having problems, otherwise they wouldn’t be attractively valued. Of course whether or not that attractiveness was real or illusory only becomes clear in the fullness of time!
As for the elections, I’m agnostic on such things as there are a million and one external factors which affect each and every company, most of which I can’t even imagine, let alone factor into investment decisions. That’s why I stick to rule number 1: Diversify, diversify, diversify.
There is a study somewhere, I believe from Fama and French showing that utility stocks do not offer ‘value premia’ and if I remember the reason was regulation.
I read the study somewhere in 2009 and so far it seems right. Utilities are easy targets for the Governments through price regulation, green energy investment pledges etc.
To own an utility stock based on that, it needs to offer a deep discount which is not the case for Centrica now, which in my opinion is well overvalued on several metrics.
However, the main problem remains the management, which to be honest they do not what they are doing it. If you ask them, they cannot even tell you how many retail clients they’ve got.
I don’t adhere to this strategy (wait until the weekend and review the situation calmly). If you do that, you will always be able to rationalize and justify holding onto a dog. Instead, write a plan with ‘rules’ in advance. One of my rules is, ‘If they cut the dividend, they’re history.’ No debates, no second guessing. No speculation about how quickly they will recover. Centrica may recover in a year, but it could just as easily be six. They have violated a fundamental premise of investing by cutting the dividend. There are many more attractive opportunities out there. (Disclosure: I sold my Centrica investment the day after the cut.)
Hi PCL, even though I don’t like to automatically sell dividend cutters I do like your commitment to stick to your pre-defined rules. If only more investors would.
With fixed and diligently applied rules you know what you’re doing, and over time you can see if they are working or not and change them as need be. If someone invests in an ad-hoc manner, with no fixed rules or a lack of discipline in applying them consistently, few lessons will be learned and success will be more down to luck than anything else.
So if selling dividend cutters is working for you then that’s good, and I wouldn’t try to persuade you to change.
Hi John
Would you have any thoughts regarding the use of energy derivates for the past few years? Lost £1160m last year due to this. Do you think the directors of Centrica are hedging or speculating?
Thank you for sharing your views.
Hi Caffrey, that’s an interesting question, but I don’t really have an opinion on it. My assumption would be that the company is hedging to smooth out its input costs, but of course there is the possibility that it could speculate for profits, at least to some extent. I might do some research on this point and have a stronger opinion if the company continues to underperform.