Mid-caps are coming back in fashion

Mid-cap stocks have been overlooked in the yield hunt … but some are worth a look.

PORTFOLIO POINT: The mid-caps sector has underperformed the broader market, but the dividend yield focus could shift away from blue-chips to companies outside of the top 100 by market capitalisation.

The treasure is becoming increasingly difficult to find.

Like bargain hunters in an ‘op shop’, investors have been scouring the blue-chip bins for most of this year in the quest for high-quality and safe returns. And until now they have been amply rewarded.

Companies with fat yields have attracted investors. Those in on the ground floor have caught the dividend stream and the capital gains as others have clamoured for space on the bandwagon.

But, as I pointed out last week, the yield obsession has driven many companies to paying out higher proportions of earnings in dividends simply to attract investors and maintain share price momentum. Dividend growth is not being supported by earnings growth. It is instead being funded by higher payout ratios, now approaching 75% of earnings, which is way above the long-term average of 60%.

That strong appreciation in bank, infrastructure and other blue-chip defensive stock prices has forced investors to cast a wider net in the quest for yield. And many now are looking to mid-cap stocks and even small-caps.

The ASX has a fairly strict definition of mid-caps. They are the bottom 50 companies in the ASX100. But most investors, and certainly most analysts, have a broader and looser definition of mid-caps as anything below the majors and above and beyond the minnows. So the investment net encroaches well beyond the top 100.

The extent to which blue-chips have led the cavalry charge this year is extraordinary. Annual returns for the All Ordinaries Index shows growth of 10.25% this year. But a breakdown of those market wide average stats highlights the remarkable contrast between large and small.

Mid-caps, and that is on the ASX’s narrow definition, have risen by just 4.33%, while the Small Ordinaries Index has actually gone backwards by 1.75%.

The three-year stats tell a similar tale. The overall market is still in deficit by about 0.91%. During that period, however, mid-caps have retreated 4.58% and small-caps by 4.77%.

Those raw performance numbers indicate that mid-caps and small listed companies have been largely overlooked in the hunt for yield, until now. With the Reserve Bank tipped to cut rates again either tomorrow or early next year, a greater sense of urgency has crept into the quest for yield replacement.

A large number of analysts have now twigged to the limits to blue-chip share price growth based on potentially unsustainable dividends. That is not to say the banks and Telstra are not worth buying on any share price dips. But the sustainability of dividends is a key factor that needs to be taken into account. Even if sustainable, it is pointless investing for a yield only to see your capital erode.

The mid-cap world is inhabited by an eclectic collection of household names – companies once regarded as blue-chip – and rising up-and-comers. And it encompasses every market facet available on the blue-chip boards. Banks, financials, miners, industrials, retail, gaming, telcos and consumer staples are all there.

Among media stocks, Seven West Media will pay an estimated 8.4% net yield in 2013 while its regional affiliate Prime TV will pay 9%, forecast to rise to 9.4% in 2014.

Despite the travails in the retail sector, with Gerry Harvey declaring it the worst he’s seen in his 50 years in the business, Harvey Norman is delivering a net yield of 4.5% rising on this year’s forecast earnings rising to an estimated 5.6% next year. Myer is set to deliver 8.8% this financial year. That is far better than forecast in its over-hyped float three years ago, primarily because the share price, now around $2.75, represents far better value than the $4.10 issue price.

Of the stocks mentioned above, only Harvey Norman is trading on a price earnings multiple greater than 10, and it just scrapes across the line into double-digit PE territory.

The Aussie dollar has weighed heavily on industrials in the past three years, and in more recent times those servicing the mining sector have been battered by headwinds associated with the shelving of major contracts.

Despite this, engineering group Mondelphous remains a darling amongst analysts and brokers. An LNG specialist, it recently secured a maintenance contract at one of the Gladstone LNG processing plants and at its recent annual meeting announced revenues would climb 25% this year, much higher than the anticipated 15%.

It is delivering a 7.2% net yield, with RBS Morgans tipping that will rise to 8.2% in 2014 on a current PE multiple of 11.4. Elsewhere among engineering contractors, Transfield is yielding 9% on 2013 forecast earnings, which is tipped to rise to 9.4% the following year. Transfield is trading on a PE ratio of just 6.4. Bradken is another seriously cheap catch in this field, with a 9% yield and priced at less than 7 times this year’s earnings.

Where else could you buy a bank with an 8.1% yield, trading on a PE multiple of just 8.4? Only among mid-caps. For that is the position in which Bank of Queensland finds itself after a horror year in which its earnings plunged into the red, belted by rising bad debts, a slowing Queensland economy and slipping property prices. Not surprisingly, analysts are tipping strong earnings growth this financial year.

Little wonder then that with these kinds of opportunities over such a wide range of industries, fund managers are taking a serious look outside the top 50.

And a fortnight ago, fund manager Contango announced plans to launch a Listed Investment Company that would be focussed firmly on mid-cap territory, complementing its existing small-cap listed vehicle.

Contango’s new fund will build a portfolio of 30 to 40 high-yielding mid-cap stocks with a targeted minimum return of 7.2% of net tangible assets as at July 1 each year, payable quarterly in August, November, February and May.

Closing on December 6, shareholders in the float will be entitled to the February 28 dividend and will receive 1.1 options for every share taken.

LICs often trade at a discount to their net tangible assets, particularly during periods of a downturn or stagnation such as we have experienced in the past three years. It is a feature that detracts from their appeal and which has caused many investors to shun them.

An interesting feature of the Contango offering is that it has employed specific features to minimise the chances of this occurring. The company has a five-year sunset clause, which adds an element of urgency to the valuation of the portfolio. In addition, there are clear rules on buybacks and shareholder dilution.

Even among miners, opportunities abound for careful investors in the mid-cap range. Traditionally, yields from miners are far less than other sectors given the enormous capital requirements involved in exploration and development. That is particularly the case among juniors.

But sand mining group Iluka Resources, the world’s biggest zircon producer, is delivering an 8% net yield and trading on PE multiple of less than 6 despite forecast strong earnings growth for the next four years.

In agriculture, Graincorp remains the last of a once-proud collection of domestic operations to remain in local hands. Its share price shot higher on a takeover bid from an American group, ADM, but is still yielding 5.5%. Despite Graincorp’s rejection, ADM remains the biggest shareholder and a looming takeover war seems inevitable.

A multitude of opportunities exist in the mid-tier world, and with further interest rate cuts now almost inevitable on the domestic market it is likely more cash will flow towards this part of the market as the yield differential between cash and equities widens.