Buying income stocks below fair value is getting harder by the day. The big-four banks, Telstra Corporation, Woolworths and Wesfarmers look fully valued, as do most utilities and large property trusts. The solution: look further down the market for yield.

Small and mid-cap stocks are usually favoured for capital growth rather than yield. They typically have lower yield than their larger peers because more earnings are being reinvested to grow the business. And their higher operating risk can be a turn-off for conservative investors.

But there are plenty of yield opportunities in small- and mid-cap stocks if you know where and what to look for. The key is finding higher-quality small companies with reliable, recurring income, and thus more capacity to pay rising dividends in coming years.

I favour the smaller Australian Real Estate Investment Trusts (AREITs) for yield, and nominated Shopping Centres Australasia Property Group (SCA), BWP Trust, and Charter Hall Retail REIT as “three standout yield ideas” for The Bull in April 2013.  

The main attraction was their high exposure to Woolworths and the Wesfarmers-owned Coles as anchor tenants. In a difficult market for retailers, I wanted small AREITs that were leveraged to the biggest and the best – not smaller retailers that subsequently had one profit downgrade after another this year.

SCA has a total shareholder return (capital growth and distributions) of 32 per cent over one year to September 4, 2014. BWP Trust has returned 26 per cent over that period, and Charter Hall Retail REIT has lagged with a 16 per cent return.

Although they look fully valued, those AREITs have capacity to pay higher distributions in coming years, and their high exposure to consumer staples retailing provides some comfort compared with small AREITS that rely more on struggling discretionary retailers as tenants.

I’m now extending this theme to ALE Property Group and Hotel Property Investments, two small AREITs with strong exposure to liquor outlets owned by Coles and Woolworths.

ALE owns a portfolio of 86 pub properties in capital cities that are leased to Australian Leisure and Hospitality Group, which is 75 per cent owned by Woolworths. Long leases, secure income and scope for higher rents make it among the more reliable small caps for yield.

Some good judges I know believe ALE’s book value is below the real value of its properties, given the potential rental uplift when key leases expire.  The well-managed ALE has outperformed many of its peers in the past 12 months.

Source: ASX

ALE reported 3.8 per cent growth in distributable income for FY14 and a distribution of 16.35 cents per share, slightly ahead of company guidance. Its FY15 distribution guidance is for the same again plus the rate of inflation.

 At $3.24, ALE is expected to yield 5.2 per cent in FY15, based on consensus analyst estimates. It has good long-term prospects for higher capital growth and income, but looks fully valued for now, and best bought on any significant price weakness below $3.

Hotel Property Investments looks more attractive. It listed on ASX in December 2013, issuing $2.10 securities. It owns 41 pubs and seven detached bottle shops, mostly in Queensland, and Coles, though its liquor outlets, rents about 95 per cent of its space.

Chart 2: Hotel Property Investments

Source: ASX

Like ALE, Hotel Property Investments (HPI) has long leases and secure income that can be used to pay higher distributions in coming years. Several key leases do not expire until 2021. The portfolio has significant strategic value given Queensland’s population growth, and benefits from the regulatory regime for large pub operators. There are worse assets to own than iconic pubs in the Sunshine State.

At $2.28, HPI is expected to yield 7 per cent in FY15, rising to 7.2 per cent in FY16, according to consensus broking estimates – an attractive yield in this market. Gearing at 47.5 per cent is higher than many small AREITs, but reasonable given HPI’s stable income stream.

Morningstar has a fair value of $2.60 a security for HPI and an accumulate recommendation.  We’ll back HPI to do a bit better than that and provide another double-digit total shareholder return over the next 12 months, making it among the more interesting small-cap income ideas.

Key risks include higher taxes on gaming machines, a key source of profitability, to prop up the Queensland budget, and other unfavourable changes to alcohol and gambling laws, which could hurt overall pub profitability as rents and leases roll over.

Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply stock recommendations. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at Sep 4, 2014.

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