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It is hard to see demand for reliable dividend-paying stock abate anytime soon. As interest rates are cut again this year, more funds will move from cash to equities in search of higher yield. Higher-quality mid-cap industrial stocks could be next to benefit.

The dividend darlings have, understandably, been blue-chip defensive growth stocks: Telstra Corporation, the Big Four banks, Woolworths and Wesfarmers. But as their valuations appear increasingly stretched, investors will be forced to look further down the market for yield.

Expect more small and mid-cap stocks to respond with higher dividend payout ratios, the occasional special dividend, and other capital-management initiatives to lift their yield. They know an army of Self-Managed Superannuation Funds (SMSF) are re-rating stocks with reliable, fully franked yield.

The SMSF had $135 billion in cash and term deposits – 28 per cent of the sector’s total assets – at December 2012, Australian Tax Office data shows. A mountain of SMSF cash will increasingly feel the strain from low interest rates, and be forced into higher-yielding equities.

Small and mid-cap stocks have an added attraction: better aggregate valuations than blue-chip stocks. The S&P/ASX Small Ordinaries index is down 11 per cent (on a total return basis, including dividends), over one year. That compares with a 21 per cent gain in the S&P/ASX 200. Contrarians will note the extent and length of small stocks relative to larger ones, and see it as a potential long-term buying opportunity in small caps.

Out-of-favour small resource stocks have pounded the Small Ord’s returns – a situation made much worse by this month’s brutal sell-off in gold stocks. Small industrial stocks have also underperformed their larger peers as investors seek the safety of blue-chip stocks.

The severe underperformance of small stocks is uncharacteristic in the early stages of a bull market. Typically, high-quality small growth stocks lead bull markets as confidence improves. That has been the case overseas, with the widely watched Russell 2000 index outperforming the Dow Jones Industrial average this year.

But the “new normal” and historically low global interest rates mean this bull market could be very different from previous ones. Defensive income stocks could lead this bull market for much longer than expected, especially if the official cash rate is cut again this year, as seems increasingly likely after a recent run of softer-than-expected economic data.  

The prospect of persistent demand for yield; blue-chip income stocks with increasingly stretched valuations; and the severe underperformance of small-cap stocks is an intriguing situation. It suggests a much closer look at high-quality small and mid-cap stocks with reliable yield is warranted.

Higher market volatility this week and the heavy sell-off in global equities strengthens the case to stick with more defensive income stocks.

I still favour the Australian Real Estate Investment Trust sector for mid-cap securities with reliable yield. The A-REIT sector has performed strongly: the S&P/ASX 200 A-REIT index has a 36 per cent (including distributions) over 12 months, which is well ahead of the broader market.

Or course, A-REIT valuations are not nearly as attractive as a year ago, when several of the key ones traded below the value of their net tangible assets (NTA). Many A-REITs trade at near parity to or above NTA, but the sector still appeals from a yield perspective.

A-REITs exposed to more defensive retailing such as supermarkets are especially interesting. Three stand out: BWP Trust; Shopping Centres Australasia (SCA) Property Group, and Charter Hall Retail Group. It’s still too soon to chase smaller A-REITs more exposed to discretionary spending, given weak consumer confidence.

SCA Property Group was 2012’s largest float, raising $472 million. After listing in late November, its $1.40 issued units have risen to $1.63. The $895 million trust owns 69 high-quality shopping centres and retail assets across Australia and New Zealand, with Woolworths as the main tenant.

Occupancy rates have improved slightly to 96 per cent, and another six centres are due to be added to the portfolio by June 2013. It has achieved slightly higher rental yields than expected. Having grocery-related stores as key anchors is a terrific asset, given non-discretionary sales growth has significantly outperformed that of discretionary sales.

SCA’s 6.3 per cent forecast yield (on Morningstar numbers) is attractive. Its NTA, $1.58 at December 2012 compares to the current $1.63 unit price. SCA looks fully valued, but income-driven investors who have a long-term investment perspective will still find its yield attractive.

Like SCA, Charter Hall Retail REIT and BWP Trust have higher-quality retail tenants. Charter Hall counts Woolworths and Wesfarmers as key tenants in its Australian property portfolio and BWP Trust relies on Bunnings Warehouse as its core tenant. BWP is the only A-REIT focused solely on bulky goods retailing.

Both A-REITs offer yields above 6 per cent, and have more defensive characteristics compared with property groups that rent space to retailers that rely on discretionary consumer spending.

Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at Feb 14, 2013. The author implies no stock recommendations from the above commentary. Readers should do further research or talk to their financial adviser before acting on themes in this article.