Is it time to buy resource stocks

Published in the ASX Newsletter, February 2015 by Dale Gillham

Rising dividend yields on big mining stocks a temptation, but beware the risks.

When asked to write an article about buying big mining stocks for their rising dividend yield, I was not used to hearing the words dividend yield and mining stocks in the same sentence. Buying any stock just to get a dividend is not a good investment, regardless of the return being offered, the current market conditions or the size and profile of the company.

I understand that with the cash rate at historical lows, finding a return greater than 3 per cent is attractive, and some of the big resource companies currently offer dividend returns around, or above, the market average of 4.6 per cent.

Traditionally, investors looking for yield outside cash would invest in banks, which tend to be far less volatile than other stocks. The more volatile resource stocks have typically paid low dividends. For example, in 2010 BHP Billiton paid around 2.7 per cent dividend and even in boom times most resource companies have paid less than 2 per cent.

Currently some big resource companies are paying high fully franked dividends, including BHP Billiton (5.2 per cent), Rio Tinto (4.4 per cent) and Woodside Petroleum (7 per cent). It is a temptation to be avoided, in my view.

Choose resource stocks for capital growth, not income

Resource stocks traditionally are growth stocks, in which people invest for capital growth. Dividends are considered a bonus, not the reason to invest. These companies reinvest profits to create more growth in the share price, which means higher returns for investors, so they do not generally pay out high dividends when the business is growing and doing well.

Resource stocks tend to rise in price when revenues are rising, or when major projects are under way. Now is not the climate for either. Many of the stocks in this category have been falling in price, which means the investment risk is higher. In good times these companies have the potential to produce high double-digit earnings growth, which is a better return than a dividend.

In talking to investors looking for yield, often they do not understand how the dividend yield increases, as does risk, with a falling share price. So too, both are likely to decrease if the share price rises. This is because the dividend yield is simply the dividend amount as a percentage of the last sale price.

Many resources companies have fallen quite dramatically over recent times, and at the same time a few have increased the value of the dividend, which further pushes up the yield and makes them attractive to those chasing dividends. What it does not do is make them a good investment.

Investors in general do not want high-risk investments, but this is exactly what you get if you buy a share that is falling in price just to get a high dividend yield. This presents a real conundrum for some investors, who unfortunately fail to address the most important aspect of investing - to always understand your risk - and instead just focus on the dividend being paid.

Seven suggestions for an investment checklist

It does not matter how much you decide to invest, or what you invest in. What matters is that in order to be unemotional about the investment, your rules for investing should be the same every time. A savvy investor has an investment process, or checklist. Here are seven suggestions:

1. Determine your risk tolerance - low, medium or high. Low generally means an investor will tolerate very little or no risk to their capital.
2. Invest according to your risk tolerance.
3. Research what you want to invest in. Do not just take a hot tip.
4. Understand the risks with all of your investments and the potential return.
5. Determine how much capital you will place at risk.
6. Determine what you are prepared to lose if the investment falls in price.
7. Determine how you plan to manage your risk and preserve your capital.
8. If you have not completed any of these you are not ready to invest, and the more you complete the better.
9. Even having read my thoughts on investing for dividends, perhaps you still have an urge to invest in a resource stock to get a high dividend yield. What do you do? It would be easy to just say read the above again, but history shows that the majority of investors tend to follow the herd rather than good investing advice.

Set stop-losses on every share you own or buy

Sadly, most investors do not know how to determine or minimise risk, simply because they do not know much about setting stop-losses (a pre-determined point at which you sell) or lack the confidence to use them. Ask yourself, if a stock I own is falling in price and I don't have a stop-loss set to limit the risk, what risk am I taking? The answer must be a high risk.

The next question is why would you invest in stocks falling in value that others don't want to buy, simply to get a dividend? Particularly when the share price may continue to fall and often by more than the amount you are getting from the dividend? This just does not make good investment sense.

If you must invest, a stop-loss ought to go hand-in-hand with buying any stock. This is the risk you are willing to take when you invest. As a general rule, I suggest investors allow 15 per cent from their buy price and if the stock falls below that level, exit.

What most people fail to consider is that they might buy expecting to receive a certain return, only for the company to later decide to cut the dividend. Where would this leave you if the share price is below your buy price? It is not wise to buy when those in the know are selling.

I would agree that our market is not the same as before the GFC, but this does not change the basics when it comes to investing in shares. Regardless of whether or not you are looking for an income from the sharemarket, the aim is to always buy shares that are going up in price.

Stocks such as BHP Billiton, Rio Tinto and Woodside Petroleum have been falling heavily, as shown on the chart below. Although this signals to me that there will be a day when they represent good buying opportunities, they will have to jump some hurdles before I would consider them a good buy. The chart shows how much each stock fell before it formed a low in the past six months. It would take years to get this back in dividends.

BHP Billiton 1 month line chart

Source: Market Analyst Click to enlarge

A lower-risk strategy for those wanting a higher return than bank interest is to locate stocks where the share price is rising, by learning to draw proper trend lines on chart. I discuss this in my bestselling book, 'How to beat the managed funds by 20%'. Also, look for stocks paying dividend yields close to the market average, with good or improving earnings prospects.

To learn how you can gain the required knowledge and skill to ensure your success in the sharemarket click here.