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Lincoln’s best 10 mid-cap stocks for income

This article appeared in the May 2014 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.

Learn how to identify reliable high-yielding stocks, beyond the banks and other large-cap stocks - and understand the risks.

Photo of Tim Lincoln By Tim Lincoln, Lincoln

It's a common lament we hear: "I'm an income-seeking investor and I own the big four banks and Telstra, but what other dividend-paying stocks are out there?"

The official cash rate is at an historic low and the Reserve Bank looks likely to hold interest rates steady for the foreseeable future. For some time now, income-focused investors have been allocating more capital to shares, particularly the four big banks and Telstra, to fulfil their needs.

Outside the obvious picks in the ASX 50 index (the top 50 shares by market capitalisation); there are plenty of household names that provide sound investment fundamentals with an attractive gross dividend yield. Investors should look for mature profitable companies with sustainable earnings and cash flow, and a sound history of financial health.

A survey of the mid-cap stocks in the ASX 200 index creates ideas for high yield that are well above the market average. We found regional banks, real estate investment trusts (REITs), retail businesses, infrastructure companies and, to a lesser extent, financials (excluding banks). Investors with a healthier appetite for risk can look for yield even in the rarest of places - mining.

Identifying companies with the right income exposure

Use these three signposts to help spot companies with reliable, rising dividend yield:

1. Mature and financially healthy

Dividends are less common outside the world of mature healthy companies, which is why investors naturally gravitate towards the large caps (stocks with high market capitalisations). They will generally be making profit and generating cash and with limited growth opportunities to invest in, they are able to return excess cash to investors through dividends.

This is rare at the other end of the market. Small caps and start-up companies will be struggling just to make a profit and what they do make is typically ploughed back into the company to fuel further growth.

Any prospective income-focused stock should at least be profitable. At a minimum, investors should be looking to achieve capital preservation via the investment, so the business needs to be a going concern for the foreseeable future.

Lincoln uses its Financial Health methodology to measure key accounting ratios relating to each company's profitability, cash flow, liabilities and assets in order to assess insolvency risk. This process is a key component in helping us pick stocks.

No amount of dividends can make up for a significant loss of capital, so investors should stick to businesses with either a consistently Strong or Satisfactory level of Financial Health.

Lastly, investors should check the usual indicators such as earnings per share (EPS) for the state of a company's profitability. It should be growing EPS over time and building a profitable business. Perhaps counter-intuitively, a profitable business paying Australian company tax is ideal, as investors will subsequently benefit from the additional tax benefits of franking credits on their dividends.

2. Ability to generate cash flow

How the business makes and collects money is important. Even if a company is profitable, there is no guarantee that it has the cash to pay out dividends. Dividends are paid from the cash produced by the company, and a profitable company, like many retirees, can be "asset rich but cash poor".

Liquidity and a company's cash balance are important measures to assess the likelihood of strong dividends in the future. You could also calculate free cash flow, which is the company's operating cash after capital expenditure requirements. Read this to mean, money that is available to be paid out as dividends.

Annuity style cash inflows (meaning a steady stream of cash inflows) are a good signal to look for. Australian Real Estate Investment Trusts (A-REITS) and infrastructure businesses often have a healthy pipeline of cash being generated to help fund distributions. Lincoln has identified businesses such as BWP Trust (BWP), Cromwell Property Group (CMW) and Spark Infrastructure Group (SKI) that fit the bill. But investors should be aware that the distributions paid by these sorts of stocks typically don't include franking credits.

3. Corporate structure

The corporate structure of the business might also provide a tip-off. Stocks with the legal form of a trust (for example, the REITs discussed above) are required to distribute all the cash earned from their assets. This in turn allows REITs to maximise their yields.

In some cases, advantageous tax treatment of income-shielding items means the cash available for distribution by REITs may be higher than the net income for tax purposes. This idea is not limited to REITs. Some discretionary consumer businesses have adopted trust structures. They include Ardent Leisure Group (AAD), which also pays an above-market yield. 

Don't just stick to the banks

If you are not keen to venture too far outside your comfort zone, regional banks offer attractive yields and are not too far removed from the ordinary activities of the big banks but on a smaller scale. However, astute investors already holding the big four banks will not be diversifying their exposure.

Although the yield from holding only the banks might look attractive, investors should not forget the lesson of a GFC-style event, which caused significant anguish for those overweight in banks.

Do not throw out basic investing principles when looking for yield. You should hold a diversified portfolio of yield-producing stocks. Those such as BC Iron (BCI), Mineral Resources (MIN) and Woodside Petroleum (WPL) represent yield exposure in the otherwise unloved mining sector.

It might seem counter-intuitive at first to look to the mining sector for yield, but it makes sense because mining stocks represent a significant portion of the market. Some mining companies also tick the boxes in terms of profitability and cash management.

Given our need to diversify and mitigate risk, investors should not ignore any sector entirely without judging each business on its merits.

Beware of dividend traps

Dividend traps are stocks that appear to possess attractive yields because of recent share price falls. A business might appear to offer a high yield when considering historical dividends, but it is important to remember that it is the future dividends that investors are buying. Remember, if the dividend yield looks too good to be true, it probably is.

Look beyond the big banks

Beyond the obvious, the big four banks and Telstra, there are plenty of opportunities for yield in mid-cap companies. Look for businesses with predictable cash generation and sustainable earnings, but do not ignore fundamentals such as financially healthy and profitable businesses.

Below is Lincoln's preferred portfolio of dividend-paying stocks: (Editor's note: Do not read the following ideas as stock recommendations. Do further research of your own or talk to a licensed financial adviser before acting on themes in this article).

Lincoln's mid-cap income portfolio

Code Name Industry Financial health Lincoln rating Forecast dividend yield
Franking Forecast gross dividend yield
Forecast earnings per share growth
FXL FlexiGroup Limited Diversified financials Strong Borderline Star Stock 4.22% 100% 6.03% 14.41%
WPL  Woodside Petroleum Limited Oil & Gas Strong Preferred income stock 5.83% 100% 8.32% 29.85%
BCI BC Iron Limited Metals and mining Strong Star Stock and Lincoln preferred income stock 11.42% 100% 16.32% 105.39%
MIN Mineral Resources Limited Mining services Strong Preferred income stock 5.90% 100% 8.43% 7.60%
BWP BWP Trust Real estate investment trusts (REITs) Strong Preferred income stock 6.17% 0% 6.17% -0.64%
CMW  Cromwell Property Group Real estate investment trusts (REITs) Strong Preferred income stock 8.08% 0% 8.08% 12.78%
SKI Spark Infrastructure Group Infrastructure Strong Preferred income stock 6.88% 0% 6.88% 46.73%
AAD  Ardent Leisure Group Leisure Strong Preferred income stock 5.10% 7.6% 5.26% 16.53%
RCG RCG Corporation Limited Retail Strong Borderline Start Stock and Lincoln preferred income stock 5.33% 100% 7.62% 9.94%
BOQ Bank of Queensland Limited Banks Strong Preferred income stock 4.96% 100% 7.09% 11.84%

Source: Lincoln, as at 24 April 2014

About the author

Tim Lincoln is managing director of Lincoln, one of Australia's premier fundamental analysis research houses and fund managers, offering intelligent sharemarket solutions for the conscientious investor.

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