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Building a share portfolio for income can generate the best returns in the investment industry. The key is stock selection, keeping in mind the major objective for investing is dividend yield rather than capital growth.

So with this in mind, analyst Carey Smith of Alto Capital has established an income portfolio that he believes should generate consistent and rewarding returns now and in the long term. “It’s currently possible to construct a diversified portfolio of between five and eight companies that will yield 8 per cent or more on a grossed-up basis, twice the return of high interest term deposits,” Smith says.

He says near record profits enable Commonwealth and Westpac banks to post attractive dividends. He forecasts both banks to yield almost 6 per cent in 2009/10 and more than 8 per cent after allowing for imputation credits. Smith says investors can rely on both banks to deliver attractive dividends as they have an enviable track record and have performed relatively well during the worst of the global financial crisis.

Fundamentally, both banks are well capitalised, offer sound businesses, benefit from large deposit bases and are expected to have lower bad-debt provisions than their competitors. He says there’s “no doubt” profitability of the Commonwealth and Westpac banks will be adversely affected by a reduction in available capital in the short term. “However, both banks will use this period to increase market share by taking customers from their struggling small-to-mid sized competitors.” Smith says.

He expects Commonwealth Bank to pay a full-year dividend of $2.25 a share in 2009/10. He says Westpac, Australia’s leading bank by market capitalisation, will extract cost-saving synergies from the St George Bank acquisition, and the bank’s sheer size enables it to apply immense pressure on competitors for more market share in the home lending space. Westpac will be able to do better deals, and Smith expects Westpac to post a full-year dividend of $1.15 a share in 2009/10.

In building an income portfolio, Smith looks for stocks with strong free cash flows, high returns on equity and invested capital and a history of at least 10 years without missing a dividend payment. Smith says Telstra generates very strong cash flows from its “almost monopoly” position as Australia’s premier telecom company. Expect the company to increase mobile and internet market share after investing heavily in new technology.

The regulatory risk for Telstra is changes in government regulations. “However, the Rudd Labor Government, like its predecessor, is aware Telstra is the most widely held company by Australian voters and I believe it would be reluctant to upset their constituents via a major negative regulatory decision,” Smith says. He expects Telstra to be pay a full-year dividend of 25c a share in 2009/2010, below consensus forecasts of 28c. Smith forecasts Telstra’s grossed up dividend yield to exceed 10 per cent in 2009/2010.

Smith describes office products supplier Corporate Express as a “cash generating machine”, with returns on equity and invested capital mostly above 35 per cent, ranking it near the top of most businesses. Corporate Express is 59 per cent owned by Staples, the world’s biggest office supply company.  This enables Corporate Express to leverage off Staples’ significant buying power. “Very little capital is required to maintain earnings so the majority of cash flows are directed to dividends and the acquisition of smaller companies,” Smith says. He forecasts Corporate Express to pay a full-year dividend of 26c a share in 2009/10, equating to a grossed up yield of 10 per cent.

Sharemarket investors benefit from imputation credits attached to dividends under Australian Taxation Office rules. The company pays 30 per cent tax on profits. This means an investor on a 30 per cent marginal tax rate (earning up to $80,000 a year) receives the dividend tax-free because the company has paid the tax. Term deposits and other savings accounts don’t offer the same concessional tax treatment. Interest on these accounts is taxed at the investor’s marginal rate.

QBE Insurance, a leading provider of general insurance and reinsurance services in Australia, the Pacific, Asia, the Americas and Europe, is one of the best-managed and most profitable insurance groups in the world, according to Smith. He says insurance premiums are generally invested in financial assets; the global insurance industry has incurred huge losses in response to falling asset prices.

“But QBE’s conservative investment approach has enabled it to endure the global financial crisis better than most other global insurance companies,” Smith says. “We believe QBE will use this current period to make sensible bolt-on acquisitions, or potentially acquire a distressed competitor.”  He expects QBE to pay a full-year dividend of $1.25 a share in 2009/10, yielding investors above 7 per cent on a grossed up basis.

Westfield Group is the biggest retail property company in the world by market capitalisation, with investments in 119 shopping centres. Although Westfield’s share price has suffered, Smith says the company has out-performed its competitors, and expects it to buy more shopping malls from distressed sellers. “Because Westfield is a property trust rather than a company, it pays distributions rather than dividends,” Smith says. “Distributions don’t carry franking credits; they carry a tax-deferred component on the purchase price. We forecast Westfield to pay a distribution of 93c a share for 2009/10, 50 per cent tax deferred, implying a yield above 8 per cent.”

Smith says an effective income portfolio should ideally consist of between five and eight stocks, spread across diverse industries for maximum exposure. Stocks should be included in the S&P ASX 200, as big companies are more likely to sustain dividends, while smaller firms are prone to reducing or eliminating them. “By concentrating on the income stream of a company, day-to-day share price movements are inconsequential, which can reduce investment stress in these times of extreme volatility,” Smith says. “The capital gains component of a portfolio is secondary in the short term (one-to-three years), although very important in the long term (three-to-10 years). A benefit of owning solid income companies is dividend yield will rise if the share price falls for whatever reason. And good companies tend to sustain yield in the 5-to-6 per cent range when company share prices are rising.”

Smith includes Tabcorp Holdings in his income portfolio on the basis that gaming and wagering are partly immune to harsh economic times. He says Tabcorp offers a stronger balance sheet after recently raising $300 million and receiving approval to re-stgelop Sydney’s Star City Casino for $475 million. He expects Tabcorp to pay a full-year dividend of 55c a share in 2009/10, equating to a grossed up yield of 11 per cent. “This is an excellent income stream going forward,” Smith says.

He says the monopoly position enjoyed by The West Australian daily newspaper is behind his decision to include West Australian Newspapers in his income portfolio. The company is able to sustain circulation despite a global shift to the internet for news and entertainment. “The monopoly position has enabled the group to sustain returns on invested capital above 30 per cent,” Smith says. “The group pays out 90 per cent plus of reported earnings as dividends.” Smith expects West Australian Newspapers to pay a full-year dividend of 35c a share in 2009/10, yielding above 11 per cent on a grossed up basis.

TABLE: Sharemarket analyst Carey Smith, of Alto Capital, establishes an income portfolio. He forecasts full-year dividends per share for 2009/10, dividend yield and grossed-up yield.

 

 STOCK

 SHARE PRICE (3/8/09)

FORECAST DPS  09/10               

 

FORECAST DIVIDEND YIELD % (09/10)               

GROSSED UP YIELD % (09/10) 

Westpac Bank       $22.10 $1.15 5.7 8.1 
Commonwealth Bank                $43.65             $2.25 5.8 8.2
Telstra Corporation  $3.52 $0.25 7.4 10.5
Corporate Express    $3.81 $0.26 7 10
QBE Insurance    $19.61 $1.25 6.3 7.1
Westfield Group    $11.70 $0.93 8.2 8.2
Tabcorp Holdings    $24.95 $0.55  7.7  11
West Aust. Newspapers    $6.00 $0.35 8    11.4

 

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