Australian Edge was founded in September 2011 on the same approach that guided its companion advisory Canadian Edge: a focus on high-quality stocks of strong businesses with easily understood cash flows, solid financial management and track records of success within their particular fields of operation.

My longtime colleague, mentor and friend Roger Conrad was with me at the creation of AE and is in many ways its spiritual godfather. Roger, as many of you know by now, has moved on to other entrepreneurial pursuits.

In place remains the AE Safety Rating System, the foundation of our analysis and Portfolio selection. Along with my new co-pilot Ari Charney as well as the rest of the Investing Daily research team, we’ll continue to score companies in the Australian Edge How They Rate coverage universe on a set of criteria that help us establish the quality of the underlying business.

The payout ratio remains the cornerstone of the System. It’s basically the dividend as a percentage of profits available to pay dividends.

Two of the six points in the Safety Rating System are determined by payout ratio. If a company’s payout ratio comes in below a certain level required for its sector, it gets a point. If it’s superior for its class, and the payout ratio will likely stay in the safe zone for the next 18 to 24 months at least, the company will score two points.

Two more are determined by debt. Companies get a point for having a debt-to-assets ratio below a certain percentage designated for their group. They get another point if total obligations coming due the next two years as a percentage of total market capitalization (outstanding shares times share price) are less than 10 percent. The result is a gauge of refinancing risk for each company reviewed.

Criterion No. 5 is the nature of the business of each company. Basically, some business models are better suited to supporting dividends throughout the business cycle. Others are more susceptible to economic shocks.

Among the most resilient are pipeline, electric power, select infrastructure and various consumer-focused companies whose cash flows have proven to be steady over time.

By contrast, resource-focused names such as mining companies and oil and gas producers are often subject to wild swings due to ups and downs for commodity prices, which can help or harm cash flows and, thus, dividends.

Companies in economically resistant businesses receive a Safety Rating point on this score, while resource companies do not.

The last criterion under the Safety Rating System is simply whether a company has cut its dividend over the past five years. If it hasn’t it gets a point; if it has reduced its payout it doesn’t get a point. This is a significant factor, as the last half-decade witnessed the worst global economic downturn since the Great Depression.

Companies that endured without reducing their dividends have been tested under the harshest of circumstances.

The Safety Rating System establishes a framework for analysis, one that’s guided selection for the AE Portfolio going back to the original “Eight Income Wonders from Down Under.” I made those selections and every succeeding one using what I learned during my decade working alongside Roger on CE and Utility Forecaster.

I’ll note that the 24 Holdings that comprised the AE Portfolio at the end of the publication’s first full year generated an average total return–capital gain or loss plus dividends paid–of 25.5 percent in US dollar terms in 2012. Including two positions that we opened and closed during 2012 the average US dollar total return was a little lower at 20.8 percent.

By comparison, the S&P 500 Index returned 16 percent for US-based investors, including dividends, while the MSCI World Index was up 16.6 percent.

I’ve very much enjoyed identifying and researching stocks for inclusion in the AE portfolio. The desire to do more research was one of the main reasons I left my career as a broker and turned to financial writing.

Running portfolios boils down to stock selection. But it’s important to understand the big picture as well.

And, as the founder and sole author of CE’s companion e-letter Maple Leaf Memo and the AE complement Down Under Digest I’ve consistently followed the relative strengths of the Canadian and Australian economies versus their developed-world peers, covering extensively the moves made by fiscal and monetary authorities that ensured the Great White North and the Land Down Under would survive and emerge from the Great Recession in better shape than most.

But it all boils down to individual businesses and their ability to generate cash flow to sustain and grow dividends. To this end my approach, as the head of our research team, will be guided by three principles:

• Work the AE Safety Rating System.
• Let winners run.
• Be quick but not hurry to admit mistakes and move on.

The goal for Ari and me, along with the rest of the Investing Daily research team, over the coming months is to continue to provide you the same level of outstanding investment research and advice you’ve come to trust in Australian Edge.

In the end I expect nothing less than to be held accountable for the decisions we make. The standard is market-beating returns, and I intend to meet it.

As of this issue you’ll see Ari’s name on the News & Notes byline, and I’m assuming responsibility for Portfolio Update. Everything else should be seamless.

I look forward to hearing from you in the “Comments” section at the bottom of article pages at www.AussieEdge.com.

Thanks for reading.

Portfolio Update

The S&P/Australian Securities Exchange 200 Index, along with most major global equity indexes, continues to push out to multiyear and, in some cases, all-time highs.

The Australian benchmark is now comfortably above 5,000 for the first time since the second half of 2008, or just before the world almost came to an end on news of Lehman Brothers’ implosion.

Meanwhile, the S&P 500 Index and the Dow Jones Industrial Average are posting all-time highs on a near daily basis, and the MSCI World Index is trading at levels not seen since mid-2008. Yet this remains perhaps the most hated stock-market rally ever.

At the same time, however, valuations appear to be a little stretched, at least compared to what’s historically proven to be a pretty good bright line distinguishing equity market value.

Our focus remains on collecting high-quality businesses that can sustain and grow dividends for the long haul. We establish our value-based buy-under targets on a set of financial and operating criteria–the AE Safety Rating System–that establish the viability of current payouts and incorporate a forecast of potential near-term capital appreciation.

We raise our buy-under targets when Holdings increase their dividends or demonstrate, through organic initiatives or via accretive acquisitions, that a higher valuation is merited.

We’re continually evaluating the companies we select for inclusion in the Portfolio–whether their numbers and performance measure up, whether their business mix fits within the context of other Holdings as well as our long-term objectives.

Portfolio Update has the latest news on our Holdings.

In Focus

Solid runs for oft-recommended JB Hi-Fi Ltd (ASX: JBH) and AE Portfolio Aggressive Holding Amalgamated Holdings Ltd (ASX: AHD) are major factors driving the outperformance of the consumer discretionary sub-sector of the S&P/ASX 200 Index during 2013.

Consumer discretionary stocks as a group have generated a total return in US dollar terms of 22.9 percent through May 3, best among the 10 sub-sectors and outpacing the broader benchmark’s 11 percent total return.

Amalgamated is priced above traditional value levels at present. But there are other solid dividend payers in addition to JB Hi-Fi that are attractive–not just because of price-to-earnings ratios but due as well to solid operating and financial performance.

Several consumer staples stocks, meanwhile, have been bid up as investors chase the Asian-food-demand story. The group has posted a collective total return in US dollar terms of 18.9 percent thus far in 2013, trailing only consumer discretionary, financial telecommunications stocks among the 10 S&P/ASX sub-sectors.

The United Nations’ Food and Agriculture Organization has estimated that food production must increase by 70 percent by 2050 in order to meet global demands, a claim which is continuing to fuel the increased value of agricultural businesses worldwide.

This is the basic rationale behind Archer-Daniels-Midland Co’s (NYSE: ADM) AUD3 billion deal to acquire AE Portfolio Aggressive Holding GrainCorp Ltd (ASX: GNC, OTC: GRCLF).

GrainCorp management recently accepted a new, higher offer from the US-based global agribusiness giant. ADM will pay AUD12.20 per share in cash as well as a one-time AUD1 per share special dividend before the deal closes. The deal has an enterprise value of AUD3.4 billion, including debt.

Another Australia-based food-focused company poised to benefit from maturing Asian appetites is breads, spreads and dairy product manufacturer and marketer Goodman Fielder Ltd (ASX: GFF, OTC: GDFLF, ADR: GDFLY), which could also figure as a takeover target for larger entities in the wake of the ADM-GrainCorp deal.

In Focus has the goods on several dividend-payers attractive on a valuation basis as well as for their solid operating and financial profiles, and we also tout a couple speculative ventures in the consumer staples space that could attract takeover bids.

Sector Spotlight

Both of May’s Sector Spotlights–which should be considered our “best buys” for the month–are joining the AE Portfolio.

Woodside Petroleum Ltd (ASX: WPL, OTC: WOPEF, ADR: WOPEY), Australia’s largest oil and gas producer by market capitalization, is essentially replacing former Aggressive Holding New Hope Corp Ltd (ASX: NHC, OTC: NHPEF) in the Portfolio.

In mid-April the company announced that it would not go forward with the proposed onshore development of the 12 million metric tons per annum, USD46 billion Browse LNG project at James Price Point near Broome, Western Australia.

Woodside also recently ended talks with other owners of gas resources to secure new supplies for an expansion of its Pluto LNG project.

What’s particularly refreshing about Woodside’s moves is the fact that management recognized the environment around it and made a prudent capital decision rather than plowing forward with a project that, based on ample evidence, had real potential to blow well past USD50 billion.

Rather than let its already ample cash pile continue to grow on a balance sheet simultaneously strengthened by recent debt reduction, Woodside announced a plan to share more of its largesse with shareholders.

Woodside Petroleum–a new addition to the AE Portfolio Aggressive Holdings–is a buy under USD42 on the ASX using the symbol WPL and on the US over-the-counter (OTC) market using the symbol WOPEF.

Woodside also trades as an American Depositary Receipt (ADR) on the US OTC market under the symbol WOPEY. Woodside’s ADR is also a buy under USD42.

This month’s first Sector Spotlight has more on Woodside Petroleum.

GPT Group (ASX: GPT, OTC: GPTGF), the second-biggest diversified Australian real estate investment trust (A-REIT) by market capitalization, once again exceeded expectations with full-year 2012 results.  Management continued to execute on its long-term strategy while delivering earnings growth that beat guidance.

GPT is one of the A-REITs recommended in a January 2013 In Focus feature. Based on its full-year 2012 results–which included a distribution increase–as well as management’s measured approach to reorienting its assets we’re adding it to the AE Portfolio as a Conservative Holding.

Execution of its strategy will see GPT well positioned to benefit from growth in the online retailing sector. Adding industrial assets will allow it to profit as well from increasing demand for warehouse space.

GPT Group–a new addition to the AE Portfolio Conservative Holdings–is a buy under USD4.25.

This month’s second Sector Spotlight has more on GPT Group.

News & Notes

What’s Next for Australia’s Economy After the Commodity Boom?: With investment in Australia’s resource sector likely peaking this year, policymakers are trying to spur growth in other areas of the economy.

The Dividend Watch List: The Dividend Watch List includes updates on How They Rate companies that announced dividend cuts during fiscal 2013 first-half earnings reporting season Down Under as well as those that reduced earnings guidance in recent weeks. It also includes those that cut payouts during their most recent reporting period but that don’t report based on a July 1-to-June 30 fiscal year or a calendar-year basis.

The ADR List: Many Australia-based companies that list on the home Australian Securities Exchange (ASX) are also listed on the New York Stock Exchange (NYSE) or over-the-counter markets as “sponsored” or “unsponsored” American Depositary Receipts (ADR).

Here’s a list of those companies, along with an explanation of what these ADRs represent.

How They Rate

How They Rate includes 111 individual companies and four funds organized according to the following sectors/industries:

• Basic Materials
• Consumer Goods
• Consumer Services
• Financials, including A-REITs
• Health Care
• Industrials
• Oil & Gas
• Technology
• Telecommunications
• Utilities
• Funds

We provide updated commentary with every issue, financial data upon release by the company, and dividend dates of interest on a regular basis. The AE Safety Rating is based on financial criteria that impact the ability to sustain and grow dividends, including the amount of cash payable to shareholders relative to funds set aside to grow the business. We also consider the impact of companies’ debt burdens on their ability to fund dividends. And certain sectors and/or industries are more suited to paying dividends over the long term than others; we acknowledge this in the AE Safety Rating System as well. We update buy-under targets as warranted by operational developments and dividend growth.

In Closing

I’m notified almost instantly via e-mail when (or if) you post a comment after you read an article. I can provide nearly real-time answers to your questions, provided the subject matter can be disposed of in such manner.

Thank you for subscribing to Australian Edge. We look forward to hearing feedback about how we can improve the service.

David Dittman
Editor, Australian Edge

Follow @ddittman