Record low wages growth and weak consumer confidence confirms two trends: interest rates will stay on hold for most of 2015 and the “yield” story will keep driving markets as low bank deposit rates force investors into higher-dividend stocks.
Income investing is becoming harder by the day. Plenty of stocks offer a 4-5 per cent yield, more after franking, but look overvalued after price gains this year. Never buy stocks for yield alone; what good is a high yield if capital losses erode the total return in the long run?
Bank stocks offer little excitement at these levels. Regulatory risk from the Financial System Inquiry is a significant headwind, particularly if the Government forces banks to hold more capital and investors share in the pain through slightly lower dividends.
Another favoured yield source, Australian Real Estate Investment Trusts (AREIT) is problematic. Weak consumer confidence and low wages will weigh on the retail sector, particularly in the lead-up to Christmas, and on REITs exposed to discretionary spending. Commercial REITS will suffer higher vacancy rates, despite office tenant demand strengthening.
Utilities look a better bet. Sydney Airport, APA Group and Transurban Group have attractions, although none are cheap. The same for Telstra Corporation. However, higher, reliable yield from utilities might suffice income investors, given near-term capital growth prospects are limited.
With blue-chip yield stocks mostly fully valued, investors have good reason to look further down the market to small and mid-caps. These stocks do not suit conservative long-term portfolio investors who need income to fund their retirement. They are better off with utilities and banks.
Self-managed superannuation funds (SMSFs) in the accumulation phase should look closer at mid-caps. Some offer competitive yield and have decent capital growth prospects, meaning trustees can achieve income and keep growing wealth, albeit with higher risk.
The same rules apply with mid-cap yield: focus on the dividend’s sustainability rather than the headline rate; choose high-quality companies with a good return on equity (preferably above 15 per cent) and a strong balance sheet (low or no debt).
Here are three mid-cap stocks for income investors:
The leading paint manufacturer seems an odd choice as a yield stock, given its fortunes are tied to the cyclical housing sector. It benefits from exposure to established housing and renovations markets, which have good prospects and are less volatile than new housing.
DuluxGroup has a forecast yield of 4.3 per cent in FY16, fully franked, according to consensus analyst forecasts. A price-earnings (PE) ratio of 16 times FY16 earnings is not cheap, although one can’t expect PEs to be at historical averages in this market, given record low rates.
Continued low interest rates is good news for housing. Slow wages growth and rising job insecurity will encourage more home owners to stay put, meaning rising demand in the renovations market in coming years. DuluxGroup’s latest full-year result suggests a modestly better outlook.
2. Genworth Mortgage Insurance Australia
I am slightly wary of including recent initial public offering as yield ideas. Too many floats disappoint in their first year or two, as the hoopla of their listing fades. It usually makes sense to wait until IPOs stgelop more trading history as a listed company before buying.
Genworth Mortgage Insurance Australia is an exception. The home mortgage insurer raised $583 million through an IPO in May 2014, at $2.65 a share. This column nominated Genworth as a top stock to play the housing trend, in June 2014, at $3.06 a share. Genworth last traded at $3.53, having peaked at $3.90.
Genworth is benefiting from lower loan arrears and claims on loan defaults. A strong property market, rising house prices, bigger loans, and thus greater demand for mortgage insurance is a strong tailwind, provided loan defaults remain manageable. Genworth would be the last stock to own if the property market turned to bust, but it’s hard to see housing momentum slowing amid record low rates.
An expected 7 per cent dividend yield in FY15, fully franked, according to consensus forecasts, is an attraction. Capital growth could slow after such strong gains since listing.
3. Pact Group Holdings
The packaging group had a difficult start to life as a listed company after raising $648 million last year in one of the market’s largest IPOs. Its $3.80 issued shares touched $3.10, then recovered to $4.08.
Pact’s maiden full-year result in August, better than expected, boosted market confidence. Pact has improving cash flow and falling debt, and margins are expanding slightly. It is hard to see Pact race higher, given challenging trading conditions in Australia and offshore. But a PE of 12.4 in FY16, according to consensus analyst forecasts, is undemanding. An expected 5 per cent yield, partially franked, should appeal to income investors.
I always like companies that continue to grow and beat market expectations in tough trading conditions. All too often the market praises managers in booming sectors and attacks those in weak ones. Well-run companies that grow in all market conditions are the ones for income investors to own.
Tony Featherstone is a former managing editor of BRW and Shares magazines. The column does not imply any 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 November 13, 2014.