Written by David Walker, Senior Analyst, StocksInValue
Original article first published in StocksInValue
Inadequate yield on fixed interest products, produced by ultra-low bond yields globally, continue to drive income investors into the equity market. There is an ocean of demand for yield which will only grow as the proportion of citizens in pension mode rises with the ageing of the population.
But indiscriminate buying of equities for high dividend yields can be dangerous. Ultra-high dividend yields often predict the dividend will be cut or omitted, or the company will downgrade its earnings guidance or fail.
To earn more income from equities and preserve capital, investors should buy stocks only at a discount to a robust estimate of what a company is intrinsically worth away from the sharemarket. This ensures the investor does not overpay for a stock which happens to be popular in the market but is at risk of falling due to overvaluation.
Investing against a sensible intrinsic valuation also protects the investor against the volatility currently afflicting the equity market. When the latest global macro disappointment strikes, investors holding overvalued stocks are vulnerable while those with stocks trading at or below value are better protected. Ranking stocks by dividend yield alone is not safe investing.
To help preserve capital in the volatile equity market, income investors should prefer stocks which pay attractive yields and are undervalued. There are such opportunities in the market if you know where to look. We used StocksInValue’s filter search functions to find five stocks with above-average dividend yields and discounts to value investors could/should consider. The stocks are ranked below in descending order of dividend yield.
National Australia Bank, NAB.AX (See valuation)
Forecast dividend yield: 6.9% fully franked
Share price: $28.56 (5/11/15)
Forward valuation: $32.89
NAB is the best-placed major bank in the increasingly challenging Australian banking environment. After the demerger and IPO of Clydesdale, the sale of 80% of the Australian life insurance operations, the Great Western bank divestment, an increase in reinsurance of the life book and the sale of commercial real estate loan books in the UK, NAB will be a simpler business focused on the more profitable Australian and New Zealand traditional banking markets. The strategy should boost group return on equity by at least two percentage points – an invaluable support at a time of increasing regulatory capital requirements, slowing economic growth, peaking residential mortgage lending and competitive pressure on interest margins.
We also like NAB’s sector-leading exposure to business lending, which we forecast to accelerate.
On 30 September the common equity tier 1 ratio was 10.2%, above the bank’s target range of 8.75% – 9.25%.
While declining bad debts expense has supported earnings since the global financial crisis, we expect no more than a modest normalisation of loan impairment charges across the banking sector over the year ahead. Credit quality is supported by improved debt-servicing capacity from lower lending rates, low corporate gearing and support for asset prices from global liquidity.
In our view NAB is oversold. We recently topped up our position in our model portfolio.
Commonwealth Bank of Australia, CBA.AX (See valuation)
Forecast dividend yield: 5.7% fully franked
Share price: $75.85 (5/11/15)
Forward valuation: $81.25
CBA is our second-favourite large ASX bank for its long record of superior profitability and growth, which are the product of consistent focus on the profitable Australian banking market (not failed offshore jaunts), technological leadership and conservative management of costs, capital, loan book diversification and loan risk underwriting. Like NAB, CBA raised capital early and does not need another large equity raising. CBA does not have WBC’s excessive exposure to Sydney and Melbourne investor loans, nor ANZ’s exposure to impaired loans in the mining and agricultural sectors.
The stock is fluctuating with general sentiment on ASX equities. In the September quarter, revenue growth was steady, underlying interest margins were flat and credit quality improved. CBA should also benefit from an acceleration in business lending. We built a weighting in our model portfolio during the August-September correction and would further increase the weighting on another pullback to the low $70s.
Retail Food Group, RFG.AX (See valuation)
Forecast dividend yield: 5.7% fully franked
Share price: $4.52 (5/11/15)
Forward valuation: $5.78
RFG is Australia’s largest multi-food franchiser as the licensor of 12 well-known brand systems including café/bakery shops Donut King, bb’s cafe, Brumby’s and Michel’s Patisserie; Quick Service Restaurants including Pizza Capers and Crust Gourmet Pizza; coffee brands Gloria Jeans, Esquires Coffee, It’s a Grind Coffee House, and Di Bella Coffee; and mobile coffee brands The Coffee Guy and Café 2 U. The firm makes money from upfront franchise fees and a percentage of franchise revenue.
RFG is a global business, with 1,000+ outlets in 40 countries in addition to ~1,500 outlets in Australia. The firm is on track to open ~250 new stores in 2015 as part of a plan to have 3,500 outlets in three years’ time, up from ~2,500 currently. The company has a solid record of brand system management and sensible acquisitions in a sector where consumption (of coffee, snack foods and staples) is steadily growing. Return on equity averaged 23% over the last five years.
Credit Corp Group, CCP.AX (See valuation)
Forecast dividend yield: 4.9% fully franked
Share price: $9.35 (5/11/15)
Forward valuation: $13.89
CCP’s core business is purchasing and collecting on debt ledgers. CCP purchases this debt from banks, telcos and car dealerships at a fraction of the total value of the debt on the ledger based on its estimate of the proportion of debt likely to be recovered. Revenue is then earned from debt collection and fees for related services. CCP benefits from its economies of scale and analytical superiority and hence is able to achieve greater profitability than its peers.
As the core domestic business is now mature, CCP is pursuing growth in consumer lending in Australia and debt collection in the US. The consumer lending segment has just reached critical mass and as the loan book grows, gross margins will expand and drive profitability higher. CCP is able to leverage its extensive credit database to grow the consumer lending operations. This is a unique aspect of CCP’s business, which does not do payday lending.
Recent share price weakness reflected concern about increased competition from the entry of Encore Capital into the market, via its acquisition of a controlling stake in Baycorp, and the exit of Westpac from funding payday lenders. We viewed these concerns as overblown, continued to see CCP as a deep value investment and topped up in our model portfolio. After the earnings upgrade at the 5 November AGM we increased the model weighting because the stock was still undervalued by dollars, this time with confirmed earnings momentum.
JB Hi-Fi Limited, JBH.AX (See valuation)
Forecast dividend yield: 5.4% fully franked
Share price: $17.63 (5/11/15)
Forward valuation: $21.25
The retail environment is challenging, with consumers cautious about discretionary spending, but JBH’s business model of high turnover and a low cost base is compensating. The FY15 result beat the top end of company guidance. The major theme of the result was JBH’s transition away from structurally declining software sales to appliance categories like homewares, which are benefiting from the strength in the building cycle.
Consumers see JBH as a price leader and are attracted to its after-sales service and online support, which is available across its nationwide store network. Store locations are carefully chosen in areas with high foot traffic to maximise sales and convenience for shoppers.
The store-roll out and category expansion underpin a solid outlook. JBH ended FY15 with 187 stores, including 43 in the Home format. Six new stores are planned for FY16. JBH’s category expansion through JB Hi-Fi Home leverages trust in the JB Hi-Fi brand into appliances categories.
Let Clime help deliver the income stream you need