There have been warnings recently that investors are taking on too much risk in their quest for yield. This comes as investors seeking income in a low-interest-rate environment push the values of major stocks such as Commonwealth Bank to record highs.
There is no doubt that investors need to focus on fundamental factors when buying yield stocks. But despite recent gains in income stocks, there are still pockets of solid-yielding companies selling at reasonable prices.
Yield and value
At Clime we manage portfolios of income stocks for Individually Managed Accounts (IMA), which we refer to as ‘Discrete Income Portfolios’.
We seek to both maintain investors’ capital and also generate income. When we add an income stock to the Discrete Income Portfolio, we ensure that not only is the yield sustainable, but that the stock itself also represents solid intrinsic value. We test that valuation by calculating the sustainable return on equity and ensuring the required returns are appropriate.
CBA and Telstra
The concerns about valuations of income-generating stocks are valid in some circumstances.
Two stocks, the Commonwealth Bank of Australia (ASX:CBA) and Telstra (ASX:TLS), particularly have had stellar runs. We believe that CBA has run too hard and too fast. Telstra has also been bid up by yield-hungry investors, but Clime views Telstra’s yield as sustainable.
Part of our concern is the macro environment. CBA is a lot more sensitive than Telstra to rising unemployment and the threat of house prices falling. So we would be wary of pay $91.04 for such an exposed stock.
Figure 1. Price vs value of Commonwealth Bank of Australia
Source: Clime, StocksInValue
Other pockets of yield
But investors don’t have to confine themselves to Telstra and the major banks. There are other areas where value and yield are on offer, such as REITs, small-cap stocks and regional banks.
We believe smaller banks are worth looking at, including Suncorp Group, which now makes the bulk of its profits from insurance. The stock, which at $13.95 is trading slightly above value of $13.22, is currently offering a forecast dividend yield of 7.3 per cent fully franked.
After a difficult GFC, Suncorp’s management has de-risked, simplified and streamlined the business. This has allowed it to report solid profits and increase dividend payments.
On the small-cap front, stocks such as The Reject Shop (ASX:TRS) offer investors a turnaround play and reasonable dividend yield. The company’s profits fell amid a difficult retail environment and rapid expansion of stores, but performance is showing signs of stabilising. The company has a forecast yield of 4.6 per cent this financial year, rising to 6 per cent in 2016.
There are also a number of REITS (real estate investment trusts) that are offering solid yields at reasonable value, such as Industria REIT (ASX:IDR), offering 8.2 per cent current yield, and Australian Industrial REIT (ASX:ANI), which provides 7.8 per cent current yield. A leisure-focused staple security, Ardent Leisure, has a 6.4 per cent forecast yield.
Another company worthy of consideration, Seven Group (ASX:SVW), has produced a better than expected result, announced another buyback and reaffirmed its intention to hold dividends at 20c fully franked (bi-annually). Thus at the current market price of $6.60, SVW is on a fully franked yield of 6.1 per cent.