Stockwatch: A Woodford-backed 7% yield

It's easy to write off investing in the financial sector amid the Deutsche Bank sensation, with fears it will leave no bank or insurance company unscathed if it goes down. But the Lehman experience implies that authorities won't let this happen to a "systemic" bank again.

Here, the chief risk of a "bail-in" transformation of its capital base is specific to Deutsche Bank investors. This has smouldered for some time due to Deutsche Bank's under-capitalisation, poor profitability, inadequate capital, high costs, and litigation costs/penalties for various offences. The US Department of Justice has simply brought matters to a head.

Certainly, banks are also under pressure from the ultra-low interest rates that affect the returns insurers generate from low-risk assets and make it harder to sell annuities.

Yet Legal & General shows it is possible to adapt to this environment. It's currently priced for a dividend yield near 7% as financial shares remain under a cloud. Events need only prove slightly less bad than expected for stock prices to rise, with current buyers having locked in a high yield.

38% upside

At 221p, the stock offers a prospective yield near 7%, about 1.5 times covered by forecast earnings. The five-year table and projections show consistent growth in earnings and dividends. Although the table doesn't include cash flow, net cash generation had risen 16% to £727 million by the 9 August interims, relative to adjusted operating profit up 10% to £822 million and post-tax profit up 22% to £667 million.

These essentials flag "good quality" for income, likely a key reason why Woodford Asset Management owns a 5% stake - a £750 million holding is very substantial for one stock.

A PE of 14x isn't unprecedented, but reflects 2015 being a peak year when the price hit 294pConsensus forecasts include Shore Capital and Panmure Gordon's recent 'buy' notes, with Panmure targeting 305p a share.

This assumes a 12-month forward price/earnings (PE) multiple of around 14x compared to the current 10x and isn't out of line with recent experience.

Company REFS shows an annual average historic multiple of 10x for 2012, rising to 14.6x during 2015 and now 11.2x this year. So a PE of 14x isn't unprecedented, but reflects 2015 being a peak year when the price reached 294p.

On that big yield however, the PE only needs to improve to about 12 times to capture upside of over 25%.

Wider trends at work

The stock is currently at the lower end of the 220p to 240p range that has prevailed for much of this year, save the spasm to 165p after the EU referendum.

Legal & General then issued a 28 June defence of its balance sheet in terms of solvency capital and diversified asset portfolio, which saw the stock rebound. A focus on such volatility misses wider influencing trends, however.

On a strict chart basis, L&G remains in a medium-term downtrend unless it betters around 250pThe five-year chart shows a strong bull market from 100p to near 300p from early 2012 to 2015, a period of loose monetary policy in response to late 2011 fears of US/eurozone debt issues, with financial and cyclical stocks soaring the most.

This self-reinforcing uptrend eventually encouraged consolidation among cyclicals but morphed into a similar self-reinforcing downtrend among financial stocks, who are seen as the losers from interest rate cuts.

On a simple and strict chart basis, therefore, Legal & General remains in a medium-term downtrend unless it breaks through, say, 250p. This poses the dilemma of missing pricing opportunities when the fundamentals are sound, however.

Firm drivers

The 9 August interim results revealed strong pensions growth, the group's main source of earnings, with operating profit from the retirement division up 44% to £406 million.

The retirement division is on track to double new business sales this yearFreeing people from annuities and introducing "workplace pensions" has created new marketing opportunities, although sales of annuities still more-than-doubled to £3.7 billion as a result of being tied to such workplace deals. An acquisition from Aegon also helped.

The capital investment side had another good performance despite low interest rates, with operating profit up 17% to £135 million.

Investment management slipped 3% to £171 million, however, savings were down 11% to £49 million and insurance fell 26% to £138 million, as strong competition limited car and home insurance sales.

The retirement division is on track to double new business sales this year amid strong growth in pension de-risking and lifetime mortgages. Quoting on over £13 billion of buy-in/buy-out deals and over £16 billion of longevity deals, Legal & General's wide investment management capabilities ought to offer some competitive advantage.

Building rental properties and infrastructural projects are two examples of this, representing new initiatives amid low interest rates. Despite a mixed operational story, the net result for interim return on equity was a rise from 19.1% to 20.4% like-for-like, a robust score for capital protection and growth, also dividends.

The stock should rise as a 7% yield becomes less vital for perceived risksOperational cash generation edged up 5% to £665 million and net cash generation by 16% to £727 million.

With £19 billion cash in the bank, as required by regulation, £589 million of dividends were distributed in the first half, up 19% like-for-like.

In March 2016 the board adopted "a progressive dividend policy reflecting the group's expected medium-term underlying business growth, including net cash generation and operating earnings".

Buyers should therefore benefit from an attractive risk/reward profile at current prices, and the stock should rise as a 7% yield becomes less vital for perceived risks.

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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.