Interactive Investor

Stockwatch: are these dividend shares worth buying as a play on tax cuts?

6th September 2022 12:01

Edmond Jackson from interactive investor

If you firmly believe in Team Truss’s agenda, then put both these stocks on your buy’ list, argues companies analyst Edmond Jackson.

The new prime minister’s agenda for deregulation and tax cuts – if implemented – would certainly benefit Britain’s financial services sector.  

Key questions, however, are whether such benefits might be offset by lower demand for credit, also bad debts, as would affect banks during a recession. A persistent bear market in financial assets would hurt investment portfolios that are a key element of big insurers’ asset base. 

Here, I compare FTSE 100-listed Aviva (LSE:AV.) and Legal & General (LSE:LGEN) as key examples – and explain why their stocks have whipsawed lately. 

Bullish updates clobbered by a bear market resuming  

Shareholders may be excused exasperation, how a month ago both these companies issued strong interim results and outlook statements – pushing Legal & General equity up around 13% and Aviva by nearly 18%. 

Yet prices have plunged right back as financial markets resumed their 2022 fall – especially after a 26 August speech by the chairman of the US Federal Reserve, who reinforced the central bank’s intent to achieve 2% inflation, even if higher interest rates trigger a US recession. That, we can reasonably assume, would spread globally. 

The big insurance/pension providers run huge investment portfolios to meet their liabilities, making their equity sensitive to overall trends in equity and bond markets.  

Long-term charts show the extent both were hit by the 2008 crisis, and this is worth bearing in mind amid growing risks of a stagflation-driven debt crisis globally and a sterling crisis domestically. 

High yields mean sensitivity to changes in risk profile 

If the incoming Truss government sticks to its agenda – to ditch a planned rise in UK corporation tax and deregulate – this would likely de-risk what are already high yields, hence stocks would rise. 

A month ago, Legal & General raised its interim dividend by 5% to 5.4p, where the track record implies a final pay-out being at least twice the interim. 

Legal & General - financial summary
Year-end 31 Dec

 201620172018201920202021
Operating profit (£m)1,5172,0612,1292,1561,4992,632
Net profit (£m)1,2581,8911,8271,8341,6072,050
Reported EPS (p)19.626.329.930.421.032.6
Normalised EPS (p)19.926.330.031.220.033.2
Earnings per share growth (%)9.532.214.04.1-35.865.9
Return on capital (%)0.30.40.40.40.30.5
Operating cashflow/share (p)68.774.0-18.9-6068.5-2.7
Capex/share (p)0.83.96.71.52.63.3
Free cashflow/share (p)67.970.1-25.6-61.865.9-6.0
Dividend per share (p)14.415.416.417.617.623.9
Covered by earnings (x)1.41.71.81.71.21.4
Cash (£m)25,71718,91917,32113,92318,02016,487
Net debt (£m)-22,302-14,978-12,393-8,496-12,131-11,045
Net assets (£m)6,9457,5168,5809,0389,99710,981
Net assets/share (p)117126144152169185

Source: historic company REFS and company accounts

This came after 8% growth in first-half-year operating profit near £1.2 billion and most vitally, cash generation up 22% to £1.0 billion.  

Mind, the table shows quite varied levels of free cash flow despite minimal capital expenditure needs. While big insurer balance sheets have strong cash buffers, a key element of this is to meet regulatory requirements (so as to meet liabilities in adverse times). 

Assuming consensus for a 19.4p total dividend rising to 20.3p in 2023, a current stock price around 260p implies a prospective yield of 7.5% rising to 7.8%, with earnings cover around 1.7x.    

Operationally, management remains confident of achieving its five-year - 2020 to 2024 - financial ambitions.  

If Truss’s new chancellor implements her promises, Legal & General would be one financial services stock likely to rise – unless this all coincides with markets taking another leg down. 

I believe the same applies to Aviva, which declared an “excellent six months” for the first half of 2022, its operating profit up 14% to £829 million and the interim dividend up 40% to 10.3p. 

Consensus for a 32.6p total dividend in respect of 2022 implies a 7.5% yield at the 435p current share price, rising to 35.8p hence 8.2% for 2023 – with earnings cover also rising, from 1.3x to 1.5x. Assuming forecasts are reasonably dependable. 

Barring a profits plunge, Aviva’s free cash flow record looks more consistent than Legal & General’s, although both are inherently strong – with free cash flow often at a multiple of earnings. 

This enhances reliability of dividends, despite their stock charts being long-term volatile for overall capital return.  

Aviva - financial summary
Year-end 31 Dec

 201620172018201920202021
Operating profit (£m)1,8332,3741,7343,9161,895877
Net profit (£m)7031,4971,568 2,548 2,7981,966
Reported EPS (p)19.945.049.782.443.78.3
Normalised EPS (p)23.646.648.083.447.28.2
Earnings per share growth (%)-46.597.13.273.6-43.4-82.7
Return on capital (%)0.40.50.40.90.40.2
Operating cashflow/share (p)153249177200-82.87.4
Capex/share (p)6.05.75.04.04.63.6
Free cashflow/share (p)147243172196-87.43.8
Dividend per share (p)30.736.139.520.427.629.0
Covered by earnings (x)0.61.31.34.01.60.3
Cash (£m)29,83413,3778,35511,17110,3457,011
Net debt (£m)-17,858-2,3602,359-1907801,412
Net assets (£m)16,80316,96916,55817,00819,35419,002
Net assets/share (p)544557559571649666

Source: historic company REFS and company accounts

Moreover, Aviva has said its capital position is strong enough to embark on another share buy-back programme, which is likely to lend support in the short to medium term. 

“Trading has been encouraging across all our major businesses in insurance, wealth and retirement” and “our strategy to transform performance continues to build momentum”.  

Will the Truss tax cuts mantra face a reality check? 

I was in the Rishi Sunak camp, in the sense that material tax cuts are unviable now that UK public net debt as a percentage of GDP must now be cruising past 100%. The interest cost on such debt is rising and further rate rises are the only tool for central banks if they are serious about restoring 2% inflation. 

The Truss camp has argued that economic growth is the way to get out of this mess, and lower taxes are the way forward. Time will tell if the foreign exchange market wears that, or the UK limps towards renewed sterling crises – which import further inflation by way of dearer imports. 

Will Truss therefore have “iron lady” resolve, to follow through what was promised to the business community and Conservative Party members? With another furlough-type rescue scheme suddenly mooted for energy bills, I do not see how tax cuts equate with fiscal responsibility. 

I tend therefore to look past the current tax cuts story but admit I could be unduly cautious. If you firmly believe in Team Truss’s agenda, then put both these insurers on your “buy” list. 

Barbell’ balance sheets are a risk if markets slump  

Call him a perma-bear, but Jeremy Grantham – the Briton who emigrated to Canada and co-founded GMO Asset Management – has doubled down, with a 31 August paper about how a bear market rally is giving way to the bursting of a “superbubble”. 

If true, any equity related to asset management is a value trap. 

Legal & General’s 30 June balance sheet had £462 billion financial investments, down 11% year-on-year, already reflecting valuation-changes. They constitute over 88% of total assets, nearly all offset by liabilities, chiefly investment and insurance contracts.  

So, while £11.6 billion net assets may sound substantive, it is quite finely balanced amid a “barbell” of assets versus liabilities. A book value of 199p a share can therefore shift dramatically. 

This would not normally present much of a problem, unless you think the current economic scenario is bad like Grantham portrays. 

Better regulation since the 2008 crisis should mean fewer rotten loans like the US “sub-prime” mortgage scandal, but risks of a stagflationary debt crisis are growing. 

Similarly at end-June, Aviva had £230 billion financial investments comprising 72% of £318 billion total assets, offset by £304 billion liabilities – leaving £14 billion net assets or 514p a share.  

That would appear quite firmly to support the stock, albeit less so if financial asset values fall while liabilities remain constant - or even rise. 

I simplify, but consider this an Ockham’s razor-type explanation – i.e. the simplest is often the best and explains why big insurer equity currently looks “cheap” versus its yield.  

A “buy” case may further exist along a rationale that markets cannot be timed, hence you should accumulate equity when attractively priced, especially in companies well-structured to make payouts. That applies to both these insurers right now. 

It therefore depends how dire you reckon things can get and to what extent you believe in Truss’s agenda. I am cautious, hence apply a “hold” stance to both stocks. You may see grounds for optimism both in the short and longer term. 

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

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