This article is part of Morningstar’s Back to School Guide to Investing. Join us every day this week to set yourself on the right path to investment success.
Emma Wall: Hello, and welcome to the Morningstar series "3 Stock Picks." I'm Emma Wall and I'm joined today by John Stopford, Manager of the Investec Diversified Income Fund.
Hello, John.
John Stopford: Hi.
Wall: So, what's the first pick you'd like to highlight today?
Stopford: Okay. So, all of the investments that we look to own, we're building the portfolio from the bottom-up across a range of different asset classes and the key criterion for us is they have to have an attractive yield but ultimately has to be sustainable. It can't be one that's subject to a lot of potential risk. And generally, we want things that are attractively valued supported by fundamentals and also attractive investor behavior.
So, the first example we have is a stock we like, Cisco (CSCO). It's a business that's somewhat in transformation. So, it's evolving from an old tech hardware transactional-based business to one that's relying much more on recurring income which we think is a very valuable commodity. So about 30% of the business now is an annuity stream. It's pretty attractively priced. It's a moderate yielder. We don't want to chase yield. It yields about 3.25%, but it has growing free cash flow, improving margins.
Free cash flow yield of about 8% and it's only paying out about 40% of its revenues in terms of dividends. So there's plenty of scope to support and grow dividend over time and it's generally a business that we think has got good quality, good value and where we can see a decent return to shareholders which is at least half of the free cash that they generate they look to return to shareholders either through dividends or in addition through buyback. So, it's a perfect company for us.
Wall: And the second pick is a little less well known, isn't it?
Stopford: Yeah. So, we're running a fund that can invest across different areas, different asset types. So we also invest in listed property which we look alongside equity. It's another growth-orientated asset and there a company that we've liked for some time is a REIT called Tritax Big Box (BBOX). So they are in the business of running large distribution centers and there's a trend going on with online retailing growing, et cetera, for companies to centralize their distribution.
So, something like M&S which is a client of Tritax, they used to have about 100 distribution centers and they are now down to three. So that consolidation supports, we think, demand for these big scale sites and Tritax is a leader there. They have very long leases typically well over 15 years on average. They are currently earning a yield of around 4.5% and they are growing at about 3.5% a year. So, it's a pretty stable not hugely exciting business. We are in the sort of defensive area of the market but a decent yield, some growth and relative stability in an area that we think is benefiting from change.
Wall: And how sensitive are they though to losing a key client? I think you mentioned before we started rolling Amazon was a client was of theirs and of course, the leader in the e-retail business. If they lost Amazon would there be a change?
Stopford: Well, at the moment, there's a shortage of these kind of sites. So, it's all about the location, so particularly in terms of things like roads and rail networks. It's about the size of the site and availability, et cetera and there is at the moment a shortage of supply versus demand. There are more companies looking to centralize than there are sites available.
In time, that may change, but at the moment it's a pretty secure business we think. And then also, they are generally locked into pretty long leases, so on average I said over 15 years' lease. So, yes, Amazon might try and get out of it, but it's not obvious why they would. I mean, the bigger risk I guess is that some of their clients might fail. But I think they'd be able to replace them fairly easily.
Wall: And what's the third and final pick?
Stopford: Okay. So, again, the first that we've talked about are basically growth-orientated assets. They will do well when economies are doing well. Portfolios have to have more defensive positions as well. The problem for investors is finding defense and yield at the same time. So, one of the areas we like is the local government funding agency in New Zealand.
It's owned 20% by the New Zealand government and then the other 80% by 30 municipalities and they are committed to maintaining the same rating as the New Zealand government. So they are essentially supported and they are deliberately targeting high quality. They are currently rated I think AA+ by Fitch and S&P in line with New Zealand. But because they are an agency bond rather than the government itself, they typically pay you a yield premium anywhere between 40 basis points to 90 basis points at different points along the curve and so we own, for example, the 5.5%s of 2013.
They will behave like a government bond but they are yielding closer to 3% which in today's world is pretty good and in a market where we think we're going to get rate cuts which is generally pretty good for government bonds and linked bonds like that. So New Zealand rates were cut earlier with a cut last month and they've said that they are likely to ease policy further. So, defensive asset, supported by monetary policy, decent yield, what's not to like.
Wall: When 60% of the market, the government bond market, is yielding less than 1.6%, pretty attractive.
Stopford: Exactly.
Wall: John, thank you very much.
Stopford: Thank you.
Wall: This is Emma Wall for Morningstar. Thank you for watching.
