Strategies that bear results

Barbara Drury asks four fund managers where to look for stocks that offer good dividend income and growth.

Barbara Drury asks four fund managers where to look for stocks that offer good dividend income and growth.

Buy in gloom and sell in boom is sharemarket advice that has been proved right over and again. There is no doubt that investors are gloomy the question is, are we gloomy enough yet?

"The problem is that no one will ring a bell and tell you it's time to get back into the market," the chief executive of Lincoln Indicators, Elio D'Amato, says.

"You only make money in stocks by buying low and selling high. If you want your investments to perform over the long run you need exposure to growth in up-and-coming companies."

That's a difficult message to sell when Australian shares fell 11.1 per cent in the year to June 30. Size and quality were no defence, with only five of the top 20 stocks posting gains. After a year such as that, it is a brave investor who shifts money from the safety of a bank deposit into the uncertainty of shares.

But the tradeoff between risk and reward is slowly shifting as the yields on term deposits fall along with official interest rates.

Where investors were able to get a guaranteed return of 6 per cent on a one-year term deposit 12 months ago, the going rate has dipped to less than 5 per cent and is expected to fall further.

Yields on 10-year government bonds are skirting 3 per cent, down from more than 5 per cent two years ago.

By comparison, the dividend yield on the local sharemarket is close to 5 per cent and it is possible to construct a quality portfolio including the banks and Telstra with a dividend yield of about 7 per cent more including franking credits. This widening gap between the risk-free return from cash and bonds and the priced-for-risk return from shares is getting more tempting, but investors should not expect miracles.

The Australian market looks cheap at the moment at 10.8 times earnings compared with a historic price-earnings ratio of 14.5. But experts warn that growth will remain elusive while the world is deleveraging, Europe remains in crisis, US growth is anaemic and China is slowing.

"At the moment markets are so sceptical they don't believe anything people tell them and they don't believe growth till they see it. That's where the opportunities are," the head of Australian equities at Fidelity, Paul Taylor, says.

A dividend strategy focused on the big end of the market is a rational response to the current investment climate, but if you want a bit of growth with your income you need to cast your net wider.

ROB TUCKER, S.G. Hiscock

The SGH20 portfolio manager, Rob Tucker, says it is difficult to beat the overall market return if you only invest in the top 20 stocks. In the SGH20 fund (seeking the best 20 investment ideas from the top 300 stocks) CSL is one of only three top-20 stocks. "We think we can add value where stocks are under-researched and undervalued," he says.

He says dividend growth might stall in the next 12 months, posing a trap for investors in so-called defensive sectors such as utilities. These utilities face regulatory resets - where their regulated return is lowered to match the change in the risk-free rate (10-year bond).

This means dividend payments are likely to be lower for these stocks over the next two years to three years.

"It's important not to buy shares just for yield," Tucker says. "You can't have all your money in telcos, banks and utilities you need to diversify.

"Equities are still growth assets, so we focus heavily on free cash-flow growth, which should support dividend growth on a three- to five-year view."

Tucker looks for stocks with a strong economic moat such as the pricing power that comes from a strong brand or patent and high barriers to entry into their market. The fund currently has a bias towards healthcare stocks that are well positioned to benefit from the higher spending of an ageing population.

Tucker says Ramsay Health Care is in a good position to help the government solve the shortage of hospital beds and looks set to deliver 13 per cent compound dividend growth during the next three years. It currently sits on a dividend yield of 2.4 per cent.

Blood plasma group CSL is a solid performer with a global franchise and a pipeline of new products that should help the group grow organically. It has low debt and generates good free cash flow to fund acquisitions or share buybacks. Engineering consultancy WorleyParsons offers exposure to the mining services sector, which has been heavily sold recently. Tucker says Worley is one of the top global players in its field and is well positioned in the oil and gas sector. He expects the pipeline of capital spending in the LNG and shale oil industries will be robust during the next five years, providing longer-term growth. In the meantime, investors get a 3.8 per cent dividend yield.

Cardno is a professional infrastructure and environmental services company. Because it invests in professional employees it is not capital-intensive and generates good free cash flow, not to mention a dividend yield of 5.1 per cent, with an estimated 15 per cent dividend growth rate over the next two years.

Treasury Wine Estates is a turnaround story with minimal capital investment over the next three years. Tucker says the value of the company's wine inventories is not reflected in the balance sheet and is currently undervalued by the market.

He says the brand-conscious Asian market should provide a good five-year growth story for its premium Penfolds labels.


UBS Wealth Management

The head of investment strategy at UBS Wealth Management, George Boubouras, recommends a combination of quality cyclical stocks leveraged to growth in sectors such as mining, energy and consumer discretionary, with defensive stocks such as utilities, telcos and healthcare with cash flows that can deliver sustainable dividends. "Investors need to be able to sleep at night," he says. "If you are not sleeping, you are in the wrong portfolio."

Boubouras acknowledges that popular dividend stocks are expensive but says investors are prepared to pay for the certainty of dividends.

"Volatility is not going away and the market still faces challenges," he says. "Earnings growth and good-quality dividends is all I'm aiming for in the current environment."

He recommends accumulating Telstra shares on any price dips for its quality dividends from strong cash flow business models.

Westfield offers investors exposure to its quality global options and dividend-focused domestic business with a dividend yield of more than 5 per cent.

"One can search for higher yields but, as always when chasing a dividend, search for certainty of delivery," he says.

For a more defensive stance, AGL Energy has the largest retail customer base in the country, which Boubouras says offers the most defensive exposure to the utilities sector, plus a dividend yield of more than 4 per cent. Transurban is a quality infrastructure asset with predictable cash flows from toll roads in Sydney and Melbourne providing a dividend yield of more than 5 per cent.

Boubouras says Coca-Cola Amatil is currently expensive. However, he says the business generally trades at a premium to the overall market because of the certainty of its earnings and its reliable 4 per cent dividend yield.


Fidelity Worldwide Investment

Despite the slow growth outlook, Taylor says some sectors and stocks will grow faster than others. He is investing in high-quality companies with strong balance sheets and good growth prospects and/or a high and sustainable dividend yield.

"If you can find a dividend yield of 7 per cent and earnings growth of 3 per cent, that's quite a strong position in a low-growth world," he says.

Taylor says companies that deliver sustainable dividends will be bid up in this market but company strategy is vital. He says Sydney Airport is a good long-term investment because of its strong and sustainable dividend yield (currently 7.2 per cent) and structural growth. "It is one of the few China consumption plays as Chinese become more important to our tourism market", he says.

Insurer Suncorp Group is more of a turnaround story. Not only was it hammered by natural disasters including the Queensland floods but it was caught out in the financial crisis with bad loans to property developers.

"We think its problems are cyclical, not structural," Taylor says. "We think it should be a 15 per cent ROE [return on equity] business, not a 0.75 per cent ROE business, so there is a lot of upside. It was one of the only insurers to pay out on flood insurance, which was good for the brand."

Taylor also likes Goodman Group. While retail and office property are weak, industrial property has been a beneficiary of the internet because it creates more need for distribution hubs rather than retail space.

It currently offers a dividend yield of more than 5 per cent.

One of the themes of Taylor's portfolio in the current market is to focus on the essentials of life such as supermarkets, banks and energy while consumers shun discretionary spending.

He says Origin Energy has been marked down because of uncertainty surrounding its coal seam gas to LNG project in Queensland, cost blowouts and speculation that the company may need to raise equity.

"All that is already priced into the stock and as we get more clarity it will provide price upside", he says. In the meantime you've got a good stable business with a dividend yield of 4 per cent.

ELIO D'AMATO, Lincoln Indicators

D'Amato is confident that shares will hold up in the second half-year, with companies supported by low interest rates, no inflation, falling oil prices and low wage growth. He urges investors to use this period of market weakness to weed out poor-performing companies and consider unloved stocks that are fundamentally good businesses.

Heavy share-price falls during the past few months have exposed some attractive valuations, especially in the unloved mining, energy and mining services sectors. He singles out copper and gold producer PanAust, Maverick Drilling and Exploration and global drilling and services company Boart Longyear, which all have strong forecast earnings per share growth but are trading at a discount of more than 30 per cent below Lincoln's valuation. Boart also has a forecast dividend yield of 4.89 per cent.

Similarly, iron ore heavyweight Fortescue is trading at a 27 per cent discount to Lincoln's valuation of $6.60 a share. D'Amato says the latest low inflation figure out of China adds weight to his belief that it is near the bottom of a cyclical downturn and iron ore will be leveraged to the recovery when it occurs.

"It's important to get on these trains before they leave the station," he says. "Don't put all your money in at once but in three or four parcels over time."

D'Amato says Corporate Travel Management, a global corporate travel operator, has the ability to continue to beat expectations with forecast earnings growth of 19.8 per cent a share. "The market is always a risk/reward tradeoff. At the moment you can get a good yield investing in the banks rather than putting your money into one," he says.

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