SIF Folio: Evraz tempts me with 9% dividend yield

I don’t have a rigid policy of sector diversification for my systematic SIF Folio, as I think that runs counter to my policy of buying the top-ranked shares highlighted by my SIF buying screen. But I do try to ensure a reasonable spread of sector exposure across the portfolio’s holdings.

Given that stocks which pass all of my buying rules are still thin on the ground, I’ve decided to take a slightly different approach this week in my hunt for the next SIF stock. I started by taking a look at the current sector allocation profile of the SIF folio, using the Allocation tab in Folios.

To start with, here’s a snapshot of the portfolio’s current holdings by sector:

Next, here’s a second view showing portfolio sector weights versus those of the wider market. This makes it easy to see where your portfolio differs from the market. In this case, we can see that SIF has no exposure to the Telecoms, Healthcare and Utilities sectors. Elsewhere, the portfolio’s weightings are significantly different to the market average:

I would like healthcare exposure, but nothing even comes close to passing my screening rules at the moment and I’m not willing to overpay. I’m less worried about telecoms and utilities. I think there are some good options for income investors in these sectors, but I’m less convinced by the case for growth and total return. 

I don’t try to match the market’s sector weightings, as I think that some differentiation is needed to have any chance of beating the market. However, I wouldn’t be averse to adding more exposure in Basic Materials or Energy. 

Having reviewed some possible options, the stock which comes closest to satisfying all of my requirements is FTSE 100 coal, iron and steel group Evraz (LON:EVR). Stockopedia’s algorithms have a favourable impression of this stock, awarding it Super Stock status and a high StockRank:

Evraz (LON:EVR)

Evraz has Russian origins and concentrated private ownership. I tend to think of such companies as oligarch stocks. 

The group’s largest shareholder is Chelsea FC’s billionaire owner, Roman Abramovich:

I’m normally reluctant to invest in Russia-based firms. My perception is they suffer from political risks and a certain lack of transparency. In this case I’m more relaxed, for several reasons:

• Evraz is a FTSE 100 company that’s been listed in the UK for nearly a decade

• The group has a sizeable steel business in the US and Canada, not just Eastern Europe

• Cash generation appears robust and genuine

• My perception is that the group’s owners are intent on capital preservation and income generation

Before I look at Evraz’s QVM factor scores, there are a couple of points I think it’s worth touching on.

ESG risk: SIF isn’t an ESG portfolio, but as an investor I’m conscious of the growing negative market sentiment towards serial ESG offenders. A particular risk, as I see it, is that borrowing costs may rise for such firms.

As a coal producer and consumer, I’d guess that Evraz could potentially be affected in this way. However, the situation may soon improve. Evraz is considering demerging its coal assets. Nothing is fixed yet, but the coal operations have already been consolidated into a separate Moscow-listed business with a market cap of $1.5bn. 

I wonder whether completing this demerger might accelerate management’s ongoing efforts to cut the group’s borrowing costs, which appear to be fairly high at present.

Does Evraz pass my screening rules? Evraz passes all my screening rules except the dividend growth requirement. In common with many other firms the group cut its payout last year. Payouts have in any case been irregular over the years:

I think this variability reflects the cyclical nature of the group’s profits and its sizable debt burden:

Is this a concern for me? Perhaps. I’ll explain more below as I take a look at each of the stock’s factor scores.

Value: Cheap cash flow?

A ValueRank of 81 suggests a decent level of affordability. I agree with this, with a couple of caveats. Starting with the positives, Evraz looks decent value on most of my preferred value metrics:

• TTM price/free cash flow: 8

• Earnings yield (EBIT/EV): 9%

• TTM dividend yield 8.7%

• TTM P/E: 12

I have two concerns about Evraz’s valuation. The first is that steel and iron ore prices are both close to record highs. Coal prices performed well during the second half of 2020 too. Commodity stocks often appear cheap at the top of the market cycle. This is because high commodity prices boost profits, while forward-looking markets start pricing in the risk of a slowdown.

I guess the bull case for commodities is that a post-pandemic infrastructure boom will boost demand. Evraz’s operations in the US would be likely beneficiaries, I’d imagine.

However, I have to consider the bear case, too. A drop in prices would probably be manageable but the group’s $3.7bn net debt could impact its ability to pay generous dividends. The 2020 half-year results specified a net debt/EBITDA multiple of 1.7. Needless to say, EBITDA would fall much faster than net debt in a downturn. 

A coal exit might help to reduce the group’s leverage, depending on how it was structured. But $3.7bn of net debt is quite close to my preferred limit of four times forecast net profits. I’m not entirely comfortable with the balance sheet here.

Quality: pretty solid

Evraz has a QualityRank of 81, which suggests few serious concerns. That’s broadly in line with my view. I don’t think quality is outstanding, but it’s good enough. 

The stock’s Piotrioski F-Score of 6/9 is within my permitted range. The shares’ five-year average return on capital employed of 15% is also pretty solid.

However, once again I think it’s worth considering the cyclicality evident in this business. Here’s a view of Evraz’s profitability since 2014. Remember, there was a big commodity crash in 2015/16:

This is a useful reminder that to some extent, Evraz profits are dependent on market conditions rather than company performance. 

Momentum: better than I expected

This is the kicker: Evraz has a MomentumRank of 99, with strong price momentum and improving earnings forecasts.

Price momentum: As we can see from the Momentum graphic on the StockReport, Evraz is performing well on most measures of technical momentum:

The only point I’d make here is that buying volumes seem to have levelled out. The 10d/3m measure in the graphic above compares trading volumes over the last 10 days with the three-month average. A reading of -1% suggests that dealing volumes are pretty much in line with averages.

Using the Shareholder Activity tool, we can also see that institutions have been marginal net sellers during the last quarter, while the Stockopedia community have been net buyers:

Evraz’s concentrated ownership means that it’s free float is unusually small for a FTSE 100 firm. I suppose this might explain the limited institutional ownership:

Earnings estimates: Analysts covering the stock have been upgrading their forecasts.I’m particularly pleased to see forecasts for the year ahead (FY21) have recently been upgraded.

Despite my concern about cyclical risk, it’s clear that Evraz scores well on all momentum measures at the moment. It’s hard to find much to fault.

My verdict

I’m torn about this. My gut tells me that this might not be a great time to buy into big commodity stocks. I’m also a little unhappy about the group’s inconsistent dividend history and relatively high debt. 

However, I’m not meant to make too many subjective decisions when picking stocks for SIF. My rules require a systematic approach that delivers consistent choices.

The reality is that Evraz shares pass all of my tests except on dividend growth. I think this can be overlooked given events in 2020. The stock also looks cheap, with a 2021 forecast P/E of 8 and a yield of 9.8%. 

Management are starting to act on ESG concerns and are already working to refinance debt at lower rates. Meanwhile, broker forecasts suggest performance should improve in 2021.

I feel that the correct decision is to buy Evraz for SIF (and for my own mirror portfolio). So that’s what I’ll do this week, after this article has been published.