Low-growth companies plodding their way to the top

There's a derogatory term given to low-growth companies - they're called plodders. They are utilities, ports, property trusts - the kind of investment you would happily put your granny into because they pay reliable dividends, thanks to their predictable cash flow. But you don't expect the share price to go up much because that simply is not the nature of the investment.

That has been the long-held belief. But boy has it been turned on its head. If you had walked into a stock broker two years ago and insisted he/she cobble together a portfolio of 10 of the most boring companies in New Zealand, you would have produced returns that would shame the returns on the NZX50 index.

In fact, the irony is that many of the conservative shares have outpaced the high-growth darlings, without any of the risk inherent in a high-growth strategy.

Your 10 shares might have included the likes of Ports of Auckland, Lyttelton Port, Capital Properties, Kiwi Income Property, New Zealand Refining and Contact Energy.

One of the world's most famous fund managers, Peter Lynch, described plodders as large, well-established companies that are very dominant in a single industry. Because of this dominance they have little room for expansion and their growth rate depends on the economy's growth. The share price is more or less tied to the country's GDP.

They pay excellent dividends, though, because they often don't need cash for expansion so they return it to shareholders.

In the past couple of years, however, plodder share prices have boomed while dividends stayed high, making for some extraordinary returns. Why?

There are three reasons, related to P/E ratios, bottlenecks and takeover activity.

Most conservative shares trade on low to moderate price to earnings ratios, below 13, say, reflecting their limited opportunity for growth. In other words, you get what you pay for and most investors will not pay a big premium for a share price that is likely to only reflect economic growth.

The advantage of a low P/E, however, is that because not much growth is expected from the share, any surprise is likely to be a pleasant one; that is, when a low-growth company delivers moderately better earnings than expected, that causes the share price to jump.

The situation is just the opposite for a high-growth company trading on a high P/E ratio of, say, over 20, such as Pumpkin Patch. That implies that the company must deliver double-digit earnings growth to satisfy the market's demand. This is an excellent company but heaven help the share price if the reality falls short of the expectation.

Low-growth infrastructure and utilities are often by their nature quasi monopolies. Many of these companies have been well situated to take advantage of bottlenecks occurring as the global economy rockets ahead.

AMP Office Trust, for example, owns a portfolio of top-quality CBD properties in Auckland and Wellington, which have been in demand as the economy has grown. Its usually staid shares have lifted over 20 per cent in the past year.

But no bottleneck was better exploited than the oil industry's, turning NZ Refining from a $15 share in February 2004 into a $60 share late last year (before it split). Between February 2001 and February 2004, the NZR share price did not increase by 1c. The only reason you held it was for the annual cash dividend.

While demand for refining was steady, the problems that accompanied it were enormous, including expensive breakdowns and low international margins.

But demand from China and a booming global economy took the world by surprise. Refineries were barely able to meet demand for their services. It is not easy to bring new refineries on stream, and the refining margin leapt taking NZR shares with it.

Plodders often form the centre of an industry rationalisation, as is happening with our ports. Because the shares are only moderately priced to start with, and internal cash flow tends to be strong, the debt for such a takeover can usually be successfully serviced from cash produced by the target company.

In a market where everything is starting to look expansive, there is a lot of demand for moderately priced plodders. The takeover bids for Capital Properties, Calan, Lyttelton Port and Ports of Auckland all created substantial share price jumps.

There is demand from ordinary investors as well, who know how vulnerable high P/E shares are in a market downturn. The downside to this is that plodder prices have been driven up and the their usually low P/E ratios are rising.

However, the dividend yield for the plodders remains among the highest on the market, at around 5 per cent, and with cash in your pocket every year, you can afford to sit out one or two bad market years.

* Neville Glaser is head of research for the Investment Research Group in Auckland. He is a former senior editor of South Africa's Financial Mail, and a former business editor of the National Business Review.