Stockwatch: Is 6.3% yield opportunity or warning?

London estate agency Foxtons has been flagged as a "short" sell periodically since floating two years ago, and it is certainly on a high multiple of earnings following the London property market's bull run. Yet various issues appear to explain why the stock is currently falling, and deserve wider attention.

Foxtons' chart shows euphoria expiring with a long plunge from 400p to 148p last year, then a recovery to 285p in the first half of 2015. But despite a robust trading update on 22 October the price continues to drop - currently 189p - as if the market reckons on essential change.

Foxtons is residential London-oriented, yet its revenues/profits from property sales are roughly matched by lettings and there is a relatively small contribution also from mortgage broking - i.e. it's no pure estate agency. The stock slide has continued after Countrywide estate agents warned of a 14% drop in sales on a UK basis and charts for various UK house-builders appear to show "double tops". It's as if the stockmarket is realising the extent to which UK housing can be propped up by taxpayer-subsidised mortgages, and that "prime central London" is over-cooked as an asset class.

London is the most overvalued housing market globally

Two analysts argue it rates 1.88 on UBS's bubble index, where the 1985 to 2009 period shows that, whenever it exceeded 1.0, a real price correction of an average 30% began within three years 95% of the time.

To reckon "it's different this time" needs any interest rate rise to be so small as not to make a real difference; and even if there is a downturn then in due course property will assert itself as a prime asset class. Yet the distortion of values has got so extreme - around 15 times London earnings, versus an average 3.5 historically - despite over 50,000 homes planned or under construction, many being near the £1 million mark and mainly flats. This compares with 3,900 properties sold in 2014 for £1 million or higher.

London has previously benefited from foreign buyers regarding homes effectively as a deposit box, yet with these buyers in retreat there could also be a glut of new flats people can't afford. We shall see.

Estate agents, politicians and the mainstream press tend to emphasise lack of supply, but in Surrey, for example, my next door and opposite neighbours have struggled to sell for as long as I recall. Plenty of home improvements/extensions have taken place, enhancing values as owners seek to profit from the property boom re-ignited by the Conservative Party in government. But where are the buyers at asking prices? Countrywide says its number of new instructions fell for the ninth consecutive month.

The dilemma for investors is having been lulled into complacency by strongly-rising property/share values in recent years, especially house-builders. It is easy to overlook how such industries are cyclical, i.e. a consolidation can morph into downturn.

Latest news of resurging house prices in October compound the problem for anyone trying to trade up - and if the first-time buyer market is pressurised, it can undermine the entire market.

How secure is Foxtons' dividend?

With the stock's price/earnings (PE) multiple in the mid-teens, more likely the 6.3% alleged yield is the crux for valuation. It either makes Foxtons a useful income play if the London housing market shrugs off risks, or over-priced even now if this market faces a disruptive downturn. The brokers' consensus expects about 20% dividend growth on a 12-months' forward basis.

As an agency business with modest capital spending needs, Foxtons' cash flow profile and record of returning cash to shareholders is indeed strong: its 2014 results show £35.5 million net cash generated from operations and £28.1 million returned, with a modest £7.1 million spend on property, plant and equipment. End-June cash was consistent at £20.9 million and there is no debt, hence Foxtons has been able to increase its interim dividend by 5%.

Yet the yield assumes a high element of cash distribution - earnings cover only of about 1.1 times - and the 2015 interims show pre-tax profit down 21% to £18.1 million - mainly the result of property sales down 11%, whereas lettings and mortgage broking rose slightly.

It puts a lot of emphasis on trading updates and other reports about London housing, whether Foxtons' ambitious dividend policy is appropriate. The board has divided total dividends into ordinary and special, as if steeled this extent of payout is according to market conditions. They could, therefore, cut the total dividend via the specials, with the ordinary element maintained.

Stock trends lower despite Q3 growth

The market is brushing aside a 22 October update that included property sales commissions up 12.8%, helped by market share gains and network expansion, despite central London being affected by higher prices and stamp duty. More positively, this is provoking interest in outer London, and a £1 billion overall sales pipeline is well above the same point last year.

Management says third-quarter group revenue rose 8.8% and that it is broadly on track to meet full year expectations. Yet the market is attempting to price in a serious jolt to prime central London sales. If the market is correct - also regarding double-tops taking potential form in various house-building stocks - then this could be a watershed moment, not only for portfolio management but also for government/central bank tactics to boost the UK economy with low interest rates and asset inflation.

I would, therefore, leave Foxtons stock alone for now - but pay close attention to what is evolving. Directors and senior management do not appear to be in any restricted period on share dealings currently, yet they are not using the price fall to add - or, in fairness, cut exposure.

For more information see their website.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.