Stockwatch: Is this 9% dividend yield the UK's best income stock?

After backing this blue-chip before, our companies analyst takes a fresh look at this generous payer. 

Are yield considerations now “at sea” along with earnings forecasts, due to coronavirus disruption on the way?

Moreover, among financial stocks, are de-ratings that have produced higher yields logical due to an extra risk premium required to hold such stocks amid financial turbulence ahead?

And another scenario is where the liberal debt accumulated in the last decade by companies gets a reality check, hence banks suffer and ultimately insurance companies and asset managers holding (equity) investments.

That would appear the rationale for why even big-cap diversified insurers have de-rated sharply in recent weeks, notably FTSE 100-listed Aviva (LSE:AV.) down 15% to 350p on a circa 9% prospective yield, and Legal & General (LSE:LGEN) down 21% to 248p yielding 7.5%.

As a long-term follower of both, I empathise with Aviva holders despair: is this behemoth really back to a 9% yield as fair pricing, or does it already present a buying/adding opportunity?

Source: TradingView Past performance is not a guide to future performance

Vague parallels with 2009 to 2011

Despite storms to trigger home insurance claims and a likely flood also from travel-related claims, these are big beasts with strong records of dividend growth helped also by their investment activities. They’re not quite Berkshire Hathaway but not incomparable either. No loaded guns of dodgy liabilities about to go off.

I recall from 2009 to 2011 how a 9% yield associated with Aviva appeared to be related to fears for a eurozone financial bust, given such assets in its portfolio held, which the European Central Bank averted. So, if you want to join dots between then and now, you could fret that the Italian coronavirus epidemic will promptly tip Italy into recession – taking Germany and France with it as disrupted parts’ supply from China hurts manufacturers.

So, I suspect insurers’ current de-rating is shadowed by the experience eight years or so ago, when it seemed the general financial context – eurozone strains especially – weighed on financial stocks. This time around it is somewhat different, but any disruption could still be early stage, so I’d expect these prices to linger until the extent of viral outbreak is known.

350p for Aviva has historically been a support level

I’ve twice rated Aviva a “buy” in the last year or so: at 410p in November 2018 when, according to the latest declared dividend, 30.9p in respect of 2019, the yield was 7.5%; and, similarly last June at 410p. My idea is struggling in that technically the price at best only hit 430p over this period and was down to 352p last September, reflecting a sideways-volatile consolidation even before coronavirus.

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In April 2009, Aviva shares were down at about 260p, albeit very briefly; and it is fair to say the previous CEO had slimmed the group down, with the current Canadian CEO (previously head of the international division) seen as well-placed to continue improving cash flow and reducing debt. Aviva has a whopping £19.5 billion cash anyway (though needs deciphering as to what extent required by regulatory needs than cash available for distribution) so is not exposed to the possibility of a credit crunch – beyond affecting its investments.

My point being that shareholders can take heart that this current area of equity pricing coincides broadly with past low-points – over a period of time when the Aviva’s underlying risk/reward profile has gradually improved. Aside from the macro context, it looks a better “buy” now than it did at 410p on a 7.5% yield, although there is a tactical dilemma around whether the macro context means a “hold” stance is overall appropriate, or, if a credit crunch materialises, it is even a “sell”.

While steeled for a worse-case scenario, lest a pandemic grips, at current pricing I think both Aviva and Legal & General are at least a “hold” and it will take extraordinary events to exact double-digit yields.

Begs the tactical question: what extent to prioritise yield?

If the stock market prices yield too generously for perceived risks, investors can reasonably expect some mean reversion to happen over time. This is attractive for capital growth also, as price edges up.

I’ll concede the patience of Job seems required with Aviva which has traded on a fat single-digit yield for much of the last decade, its volatile-sideways stock trend arguably why 7%-plus has been exacted. Legal & General has, over the last five years, traded similarly although holders enjoyed an excellent run from 35p in March 2009 to 285p in March 2015 before the see-sawing started.

You would reasonably think such stocks are building blocks for income funds and the like, which can also diversify across other high-yielders to avert specific risks such as a jump in insurance claims. Such a “market technical” prop may help to explain support points in a sideways trend, if hard to pin down.

Reason would suggest therefore that even capital growth-oriented traders might want to consider big insurance stocks for re-pricing in due course, besides collecting any dividends.  

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Right now, however, the dilemma is the old adage, how “the market can stay irrational longer than you can stay solvent” – if you get the drift. I’d argue that insurers are a better risk prospect than banks, and even asset managers, if a global recession ensues (being less exposed to banks’ corporate debt, or fund managers’ equities), yet their stocks aren’t immune to the general de-rating of financials.

Despite Aviva announcing this morning that it has continued its tidy-up by exiting Indonesia, its stock opened down 6p at 344p, clawing back to 348p, on the back of Wall Street’s slide.

Respecting sentiment, therefore, buyers are going to need continued patience, but on the basis that coronavirus is an issue which peaks in months ahead, then yields of 9%-plus and 7%-plus for Legal & General constitute intrinsic support. This assumes 2020 consensus forecasts of 32.2p dividend per share for Aviva and 18.7p for Legal & General.

Low risks for a progressive dividend policy

A chief reason for my alighting on Aviva was the CEO setting out his stall declaring:

“The sustainability and security of our dividend is paramount. We are focused on improving our performance to grow capital generation and cashflow.”

See how the table puts the latest 2019 results in context, in particular how free cashflow per share is rising again and at 147p covers the 30.9p dividend by 4.76x – amply justifying the CEO’s promise.

Moreover, Aviva’s Solvency II ratio of 206% is ahead of previous targets of 150% to 180%, with the bulk of restructuring complete: see from the table also how cash increased by 23% last year (if still below levels of end-2017 and years before). Management also claims its investment portfolios do not have big equity exposure, which offers some comfort as to underlying values if a bear market is getting underway.

Still plenty to prove for capital growth

While I am confident enough to argue “hold” Aviva or “trickle buy” with fresh money for its yield and overall risk/reward profile, there is plenty to do to achieve a growth profile. A £1.9 billion operating profit from the UK Life business is effectively flat, although revenues are benefiting from workplace pensions, so maybe a silver lining.

It is not great how operating profit from the asset management side is down 35% to £96 million, despite a near-5% rise in assets under management. General insurance is down 2.5% to £594 million partly due to costs of going digital (similarly as Life) despite premiums rising, and there’s hope for better underwriting performance. Life business is faring better with Europe up 2.5% to £827 million and Asia up 4.9% to £276 million. I like this exposure to life insurance which should help mitigate Aviva’s overall risk profile versus disruption caused by coronavirus.

Holding Aviva for income

I also like a return on equity that is re-rated from single figure percentages from 2015 to 2018 to near 15%. A prospective 9% yield should be as assured as it is possible to be. Aviva’s narrative is going to need continued patience by investors, however, before “growth” is perceived, and bear in mind the de-rating of financial stocks may persist.

With such caveats clear, Aviva represents one of the best UK stocks for income, which will eventually kick in to support price. Despite it dropping further to 342p this morning, my stance remains: Buy.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.