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This article appeared in the October 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

In times of volatility, total returns from a high-dividend company may outperform the market. The current environment represents such a time, as shares struggle to post meaningful gains despite a strong reporting season in 2011. But caution must be exercised to determine whether these yields are sustainable.

Photo of Tim Lincoln By Tim Lincoln, Lincoln

Financial markets have been in a continuous volatile flux since 2007. Investors, faced with this unpredictability in capital value, have turned to high-yielding shares for more reliable returns from their investments.

The drivers of uncertainty have been numerous and varied, including the recent US debt ceiling crisis, Standard & Poor's credit rating downgrades, and the ongoing euro zone debt problems affecting investor confidence and share prices.

Despite the recent large fluctuations, it has been rare for the All Ordinaries index to decline in value over a given 10-year period. Therefore, with an assumption of relative capital stability, there is an investment case that in choosing 10 quality shares with high dividend yield, with the added support of franking, investors are likely to outperform the cash rate.

Many shares at present offer a dividend yield exceeding 5 per cent. After adjusting for the effect of franking credits, this equates to a gross yield of approximately 7.15 per cent, well above bank deposit rates. A high fully franked dividend yield may be of particular value to those in the pension phase of investments because they generally pay little or no tax and hence are entitled to the full benefits of franking credits.

One unique attribute of the Australian tax landscape for local investors is that franking credits can be offset against taxable income. Knowing this, many Australian companies often pay a relatively high portion of earnings as dividends in order to transfer their franking credits to shareholders, further bolstering the dividend yield investment case.

However, not all investors are the same. A 70-year-old who needs income for retirement has different requirements to a 30-year-old who is 40 years away from retirement. Although there are some examples, it is rare for a company to be able to deliver both high income and high growth.

The majority of profit growth in recent times has come from the mining sector, which has benefited from a robust Chinese economy. These mining companies, however, often sacrifice dividend payouts to reinvest surplus cash into capital-intensive growth projects. Thus, the majority of high-yield shares are in the non-mining sector. These are generally more mature businesses, which in the current environment offer modest growth opportunities. But there are cases where a share's current value is not fully recognised by the market and therefore investors can access the best of both worlds.

Is the dividend sustainable?

The first question a dividend investor should address is whether the current dividend is sustainable. An attractive yield may be an illusion attributable to a large share price fall, as opposed to a strong cash flow and payout ratio. In these cases, future earnings may decline and future dividends are correspondingly uncertain.

These "value traps" may be experiencing underlying issues within the business. To determine whether a yield is sustainable or may increase in the future, the company's "financial health" and a strong understanding of its fundamentals are crucial to the strength of future earnings and hence its forecast dividend stream.

In seeking higher yields, investors should not necessarily sacrifice investing in fundamentally strong and financially healthy businesses. Investors should consider their personal circumstances and select investments that suit their financial needs. In assessing any particular company, the key is a balanced consideration of high yields and the need for reinvestment to grow earnings.

10 high-yield shares

Lincoln Indicators has selected 10 businesses that fit this mould and may provide investors with long-term attractive dividend yields and capital stability, or even growth in the future. With markets trading at depressed prices, it may be surprising to see some businesses that are usually associated with capital growth paying out fully franked dividends in excess of 5 per cent of the current share price.

(Editor's note: Do not read the ideas below as share recommendations. Do further research of your own or talk to your financial adviser before acting on themes in this article).

1. Hansen Technologies Limited (HSN)

Lincoln's Financial Health rating Dividend Yield Price to Earnings Ratio Current Share Price
Strong 6.94% 10.06 $0.865

HSN is a billing systems provider. It has a reliable stream of defensive earnings as customers rarely leave HSN's billing solutions because of their tailored nature and the administrative burden to do so. A strong balance sheet with a net cash position should allow HSN to continue to reward shareholders through solid dividends.

2. Fleetwood Corporation Limited (FWD)

Financial Health rating Dividend Yield Price to Earnings ratio Current Share Price
Strong 6.85% 12.02 $10.65

FWD has two key divisions: recreational vehicles and manufactured accommodation. The company had a good year operationally in FY2011 as a result of the earnings accretive acquisition of BRB Modular. Although we are expecting growth to be more modest this financial year, recent contract wins support our belief that the company will continue to offer a robust dividend.

3. Australia & New Zealand Banking Group Limited (ANZ)

Financial Health rating Dividend Yield Price to Earnings ratio Current Share Price
Strong 7.14% 9.10 $19.32

ANZ is Australia's third largest bank and has performed well operationally in recent times, having improved its net interest margin. ANZ is well capitalised and has a greater exposure to business lending than its peers, and is therefore likely to continue paying a healthy dividend, in Lincoln's view.

4. RCG Corporation Limited (RCG)

Financial Health rating Dividend Yield Price to Earnings ratio Current Share Price
Strong 6.38% 12.88 $0.47

RCG owns and operates a number of footwear businesses, including The Athlete's Foot. Although the company is exposed to the struggling retail sector, we expect it to report further profit growth in the 2012 financial year, which should allow RCG to at least sustain its current dividend.

5. Bradken Limited (BKN)

Financial Health rating Dividend Yield Price to Earnings ratio Current Share Price
Strong 5.34% 12.18 $7.40

BKN is a supplier of differentiated consumable products to the resources, energy and freight rail industries. With the company trading on a low price-earnings multiple of 11 times forecast FY2012 earnings per share, and a forecast dividend payout ratio exceeding 60 per cent, BKN is a company that offers investors the combination of a substantial dividend coupled with strong growth prospects.

6. JB Hi-Fi Limited (JBH)

Financial Health rating Dividend Yield Price to Earnings ratio Current Share Price
Strong 5.20% 11.95 $14.81

JBH is a specialty discount retailer of branded home entertainment products and has experienced very strong profit growth over recent years through its store rollout program. We expect growth to be moderate in the 2012 financial year because of a challenging environment, but expect JBH to pay a healthy dividend.

7. NIB Holdings Limited (NHF)

Financial Health rating Dividend Yield Price to Earnings ratio Current Share Price
Strong 5.34% 11.14 $1.415

NIB Holdings is a national provider of private health insurance and related healthcare activities. Over the past few years the company has achieved strong profit growth by growing its client base and improving margins. NHF expects this to continue into this financial year and the company's strong financial position should allow it to maintain a resilient dividend.

8. Mystate Limited (MYS)

Financial Health rating Dividend Yield Price to Earnings ratio Current Share Price
Strong 7.58% 10.90 $3.56

Mystate offers a range of financial products and services. In the 2011 financial year the company reported healthy profit growth on the back of cost-management initiatives and development of its loan book above the system growth rate. MYS recently announced a large acquisition of The Rock Building Society. This should lead to further earnings growth this financial year and potentially an increased dividend.

9. GWA Group Limited (GWA)

Financial Health rating Dividend Yield Price to Earnings ratio Current Share Price
Satisfactory 9.09% 9.49 $1.98

GWA is a supplier of building fixtures and fittings to households and commercial premises. Following the recent sell-off in the shares, GWA is trading at levels only briefly seen during the global financial crisis and not previously seen since 2001. We are of the view that the sell-off is overdone and are expecting a modest uplift in earnings per share in the 2012 financial year, which should allow the company to maintain its current impressive payout ratio.

10. Wellcom Group Limited (WLL)

Financial Health rating Dividend Yield Price to Earnings ratio Current Share Price
Strong 7.37% 9.60 $2.24

Wellcom provides web-offset printing, pre-media and data management services in Australia, the UK, New Zealand and Asia. The company has now experienced two years of solid profit growth. We are expecting an uplift in earnings in this financial year through further organic growth and geographical expansion. The company's low price-earnings ratio and relatively high payout ratio makes it suitable for income-seeking investors, in Lincoln's view.

About the author

Tim Lincoln is managing director of Lincoln, a fundamental analysis research house and fund manager, offering intelligent sharemarket solutions for the conscientious investor.

From ASX

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