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10 top income stocks for portfolios

This article appeared in the June 2013 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.

After share price rises in the past year, dividend yields on many popular income stocks are reducing. But attractive, reliable income from stocks is still available if you know how - and where - to look, and can avoid yield traps, reports ELIO D'AMATO.

Photo of Elio D'Amato By Elio D'Amato, Lincoln

Many previously unloved companies have enjoyed a strong bounce in the past 12 months, including Telstra Corporation (+39.0 per cent), Wesfarmers (+41.3 per cent) and National Australia Bank (+33.8 per cent0. This is the price return alone. They returned around 50 per cent to shareholders when dividends are included.

Although the earnings growth for these companies varies, current levels in no way justify the phenomenal share price returns. Which begs the question, what are the drivers behind these share prices?

Market trends

First, let's look at some prevailing market trends.

The official cash rate is now at its lowest since the inception of the Reserve Bank of Australia 1960. It has cut the interest rate by a total of 150 basis points since May 2012, down to 2.75 per cent. The investor community is priming for a further rate cut later this year after a batch of soft economic data released in May.

Borrowers have benefited from lower loan repayments despite, previous to the most recent move, banks passing on only part of the cuts.

However, much to the chagrin of the RBA and retailers, this additional discretionary income in customers' pockets has not resulted in increased retail spending, nor has it stimulated the muted housing market, as shown by the latest Australian Bureau of Statistics figures.

On the other hand, interest rates on deposits have fallen, leaving little incentive for investors to park their cash in the bank, or relatively low-yielding traditional fixed-interest investments.

Also, there is a noticeable shift in the demographic of investors as well as their changing investment preference. The baby-boomers cohort of about 5.5 million people born between 1946 and 1965 have started to reach retirement age and are transitioning into the pension phase, in which both capital gains and income on superannuation are tax free. Hence, these investors are best positioned to benefit from the great Australian gift of franking credits. The value of these credits is often not factored into the share price and can be worth up to 43 per cent of dividends.

Furthermore, after talking with many Lincoln Stock Doctor clients who are in this phase of their lives, most have said they much prefer a steady income, relative to capital gains. As more baby-boomers reach the pension phase, we expect to see further demand for income-generating assets, which further underpins the case for high-yielding stocks.

Meanwhile, property investing seems to have lost its sparkle. This had been a favourite pastime of many astute investors, with a particular outperformance in the property market over the past 20 years, and they have been rewarded handsomely.

Much has been said about the "housing bubble" in the Australian property market as prices relative to average incomes remain among the highest in the world. Although the housing market is holding up, buyers are reluctant, as shown by subdued housing activity in the past few years despite record low interest rates. This leaves prospective return-seeking investors with one less avenue to search.

Buying shares for yield

The above factors make a compelling case for investing in the sharemarket, particularly in companies that provide a steady and secure income. This is the common denominator between Telstra, Wesfarmers and NAB, and the answer to why their share prices have outperformed the market.

There have been many other examples of this trend over the past year, particularly with the volatility of commodity prices affecting the mining sector. This led investors to seek refuge in more defensive sectors and a continued preference for high yields and capital preservation.

Lincoln Stock Doctor holds the view that this current trend will continue and the fundamentals remain intact for high-yielding stocks despite the strong run many of them have had in recent months. During this time we have also seen the grossed-up market yield (inclusive of franking credits) decline from about 6.5 per cent to 5.5 per cent per annum. This still remains attractive compared to alternative investment options such as term deposits and bonds.

Therefore, despite talk surrounding "the yield bubble" in income stocks, we believe that attractive yields will continue to support share prices of quality companies in the foreseeable future. But it is important to pick companies based on sound quantitative and qualitative measures, rather than only based on their yield.

Four steps to finding healthy income stocks

  1. Financial health
    Stock Doctor first considers a company's "financial health" by analysing its financial statements and its key profitability, balance sheet and cash flows ratios. Although many large-cap companies tend to be leveraged, as long as they are profitable and supported by strong cash flows, debt obligations do not pose a major concern. Hence consistent profitability and strong operating cash generation are good predictors of sustained dividend payments.
  2. Outlook and earnings stability
    It is important to identify companies with a positive earnings trend and sustainable dividends. Dividends should be supported by company earnings. It is generally a red flag when companies pay out more dividends per share than earnings per share (EPS), as this is clearly not sustainable. One example is GUD Holdings (GUD) where the company reported full-year earnings per share of 63 cents and paid dividends of 65 cents per share for the 2012 financial year. Despite its high dividend yield of 8.2 per cent, inclusive of franking credits, its share price has underperformed as the earnings are expected to deteriorate further.
  3. Dividend policy and dividend payout ratio
    Look for companies with a clear dividend policy and target payout ratio; or in the absence of that, look at the historical payout ratio. For example, a Lincoln preferred income stock, Telstra, have given guidance of dividends of 28 cents for 2013 and 2014 since 2012 - the same dividend amount since 2002. Although it lacked growth, the dividend guidance provided investors with certainty and clarity.
  4. Franking
    The franking portion of the dividend can be as high as 43 per cent of the dividend when taxed at the company rate of 30 per cent (a fully franked $1.00 dividend has franking credits of $0.43: $1.00 / (1 - 30%) - $1.00 = $0.43). Not all investors can obtain the full refund of the franking credits, because of personal tax circumstances, and therefore it is not fully priced into share prices. So it is in the best interest of investors with lower marginal tax rates to take advantage of this mispricing and look for companies that pay fully franked dividends.

Lincoln's preferred income portfolio

These 10 companies meet Lincoln's criteria for financial health and offer attractive yield.

(Editor's note: Do you read the following ideas as stock recommendations. Do further research of your own or talk to your financial adviser before acting on themes in this article.)

Code Name Financial
Health
Earnings per share (EPS) Growth (%pa) Forecast EPS Growth (%pa) Forecast Dividend Yield (%pa) Franking Gross Dividend Yield (%pa)
AAD Ardent Leisure Group Strong 2.24% 3.21% 7.12% 6% 7.30%
ANZ Australia & New Zealand Banking Group Ltd Strong 4.03% 6.05% 5.62% 100% 8.02%
CFX CFS Retail Property Trust Group Strong 3.15%  3.82% 6.45% 1% 6.46%
CMW Cromwell Property Group Strong 6.48%  8.95% 7.07% 0% 7.07%
GEM G8 Education Limited Strong 14.14%  34.21% 4.32% 100% 6.17%
PMV Premier Investments Limited Strong 31.15%  9.87% 5.05% 100% 7.21%
SRV Servcorp Limited Strong 415.98%  8.74% 4.21% 100% 6.02%
TGA Thorn Group Limited Strong 5.05% 1.40% 4.78% 100% 6.83%
WBC Westpac Banking Corporation Strong 4.47%  6.16% 6.15% 100% 8.79%
WPL  Woodside Petroleum Limited Strong 18.35% -0.58%  6.66% 100% 9.52%

Source: Lincoln Stock Doctor Data at 23/05/2013

About the author

Elio D'Amato is chief executive of Lincoln, a leading wealth manager and research firm.

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