Stockwatch: Backing this FTSE 100 dividend king

This blue-chip yield stock can withstand Brexit chaos and is now in buying range given the level of payout and profit forecasts, argues companies analyst Edmond Jackson.

Does a 6-7% yield now tilt the risk/reward profile positively for FTSE 100 annuities/investment/insurance stock Legal & General (LGEN), currently around 245p?  

It's tricky to be sure now whether or not financial stocks are in the eye of a storm, and British politics will remain mercurial for months ahead.  A working assumption is that May's deal with the EU will be rejected by parliament this December, then financial market chaos will focus MP's minds in the New Year – effectively into a capitulation to support the deal, otherwise extending Article 50 will result in a yet more costly Brexit and achieve little.

Meanwhile, the income needs of thousands of pensioners, present and future, remain a certainty.  The chief fundamental point supporting Legal & General is its diversification over areas of long-term financial growth, demonstrably able to pursue progressive payouts with strong earnings cover.

While there's a perceived risk behind a "no deal" scenario, with financial firms outside the single market becoming subject to member state rules, HM government has published guidance online in respect of a "no deal", and L&G moved its investment management operation – one of the largest in Europe – to Dublin.  

Further sentiment-based fall-out in UK financial stocks is possible, but this one merits buying for dependable income, and capital growth too given potential for re-pricing once the market judges risks have mitigated – such that a lower yield is required to compensate for the holding risks.  

Both L&G and Aviva are worth watching

Aviva (AV.) is another hard-hit insurance-related stock I'm considering, given the way both groups have seen their stocks hit by Brexit fears and stockmarket weakness in October when, at the month-end, the Financial Conduct Authority declared an inquiry into general (i.e. home/car) insurance pricing.  That said, this represents only mid-single digit percentage profits for L&G overall.  I'd keep both stocks in the frame for averaging in, first evaluating L&G.  

Similarly, L&G shares fell by around 40% from early 2015 highs to the trough marked by June 2016's referendum; more recently Aviva has fallen 25% from its mid-2018 highs while L&G is down only 16% - quite likely due to operations' diversity with less EU exposure.  

Source: TradingView (*) Past performance is not a guide to future performance

It's horses for courses whether Aviva is more over-sold currently, while L&G will mean a less-volatile ride given Brexit issues will drag on potentially for years; hence, it is possible to make a contrarian case for diversifying to hold both.  

The chief downside to L&G is it is substantially weighting to investment operations, thus, if a secular bear market takes shape in financial assets – triggered by a US upset and/or conflation of risk factors – you'd simply watch and wait.  Yet even with monetary policy tightening, bank interest rates are most unlikely to rise anywhere near the kind of income returns these stocks generate.  "The search for yield" continues to guarantee buyers.

Strong income credentials despite variable returns

I drew attention to L&G two years ago at 221p on what proved a 6.6% annual yield, when pensions' growth was up 44% to £406 million as workplace pensions supported annuity sales and L&G's capital investment side was performing well.  But in the first half of 2018, annuity sales nearly halved to £1.1 billion, offset by lifetime mortgages up 23% to £0.5 billion, investment management assets by 4% to £984.8 billion also premiums 3% to £1.4 billion for gross insurance or 12% to £193 million for general insurance.  

So, overall, first-half operating profit rose 7% to £1,059 million, although after-tax profit fell 19% to £772 million due to a 129% jump in the expense for reinsurance recoveries to £1,128 million (as shown in part 2 of the results). 

It's a reminder about how such areas of financial services can be variable; why diversification is essential; and stocks are liable to remain priced for above market-average yields.  

Yet within these interims last August, L&G asserted an "exceptionally busy second half" underway, with over £20 billion pension risk transfers and investment management expanding in the US and Asia.  "We are confident L&G is strongly positioned for growth in the second half year and beyond", it said, as underlined by a 7% rise in the interim payout to 4.6p.  The board re-iterated a progressive dividend policy based on "expected medium-term underlying business growth, including net cash releases".  

They reckon: "We are on track to deliver a similar performance out to 2020 as that achieved in 2011 to 2015 when EPS grew 10% annually" by investment in both organic and acquisitive growth.  Ageing demographics, globalisation of asset markets and reform of the welfare state, exemplify top-down drivers where L&G reckons it can "leverage our expertise, with clear synergies" across annuities, investment management and insurance.   
I'd be cautious, but do consider a quality 6%-plus yield supportive enough, potentially to get lucky with the alleged growth prospects.

'Buffer' to a financial assets downturn

Probably the chief risk to holding L&G is not Brexit per se but whether financial assets have topped out: high US stockmarket values meeting with US monetary tightening, the Trump administration's late-cycle stimulus liable to end up in stagflation.  

As further risks such as trade discord and Italian debt, smoulder away, it's possible all this ignites flames under a mature bull market.  Insurance related shares would then fall due to the impact on their proprietary investment assets and potential risk to dividend payouts in a markets' crash scenario.  That's worse case but has to be recognised and is why the market prices for modest price/earnings (PE) and high yield. 

Management's response is L&G's balance sheet having £6.9 billion surplus regulatory capital, enabling it to withstand such a downturn and, by implication, limits downside in the shares.  

Part 2 of the interim results shows that at end-June, debt comprised £3,489 million core borrowings and £957 million operational borrowings in context of £7,778 million net assets and £20,178 million cash.  This lends comfort to buy-and-hold, income investors, although the 2016 example when L&G plunged to 165p around the EU referendum – representing an 8.5% prospective yield – shows what could happen in a 'no deal' Brexit scenario, which pro rata implies downside to 200p.  

So, if you are pessimistic, Britain will indeed exit the EU next 29 March having rejected this "final" deal, sit on hands.

To me, the net upshot is L&G already being in a buying range given a 6%-plus yield and assuming its guidance for the second half and years ahead is reasonably fair.  It is, therefore, a candidate to "average into" given the variety of possible outcomes.        

Parliament to accept May deal on a second vote?

While it hardly looks likely, the proposed EU deal should get UK parliamentary approval in December (first assuming the EU ratifies it on 25 November). The resulting hit to sterling – and all this simmering over Christmas – suggests a fair chance of approval in a second vote in the New Year, given MP's opposition to 'no deal'.  

As yet, it doesn't appear that Mrs May faces a genuine leadership challenge, a majority of Tories would back her even if 48 letters of no-confidence follow.  The EU's line appears intransigent as regards further amendments and by implication "Canada ++" it is alleged, Barnier previously offered but May turned down.  

It's a fluid situation but I think investors need to focus on the current likely reality: neither Remain nor Leave ideals will be achieved.  Put emotions aside and ready for a scenario where sterling and 'UK risk assets' rebound.  Buy.

*Horizontal lines on charts represent levels of previous technical support and resistance. Red represents trendlines.

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