What to do when yield becomes expensive? - Part 2

In a world of falling bond rates, the prices of reliable, high yield stocks have risen. That has a number of consequences for investors searching for income.

First, we're quietly being invited to climb up the risk curve. Woolworths, for example, currently offers a historical yield of 5.3% and Origin Energy 6.1%. Those figures may seem attractive but these stocks carry far more dividend risk than traditional income stocks like Scentre Group and Transurban.

That brings us to the second point. Over the past two years Scentre and Transurban have risen in price by a third and two-thirds respectively, a consequence of investor appetite rather than business performance. Similar stocks have benefitted from similar price rises. If you want income stability now, you really have to pay for it.

That leaves income investors with a challenging dilemma: should we take on greater share price risk in exchange for reliable dividends? Part 1 on Monday explained why the answer to that question was a clear ‘no'. What follows is an alternative strategy, one based on our Equity Income Portfolio, driven by value rather than yield at any price.

Before explaining the nuances, a few points are worth noting. First, if you already own traditional income stocks like ALE Property and Sydney Airport, purchased at a time when they were on our Buy List at far cheaper prices, you have less to worry about. There is no immediate need to sell just because their prices are now much higher. These stocks remain Holds.

Second, if you don't want to do the work of individual stock picking, our Equity Income Portfolio, currently yielding 4%, most of which is fully franked, offers a low-effort alternative. It may not sound like much but with bond yields down around the world, 4% is the new 6%. If you want more than that, then additional yield comes booby-trap-wrapped.

A glance down the far right hand column of the income portfolio makes the point. BHP Billiton currently yields 5.6%. Woolworths 5.3% and Origin Energy 6.1%. These figures are deceptively attractive, but all three are in the process of reducing their annual payouts. Woolies' assertion that it will continue to target a payout ratio of 70%, for example, is likely to result in a dividend yield of just 4.1%. BHP's and Origin Energy's dividends will suffer similar fates.

Although this highlights the perils of relying on historical yields, BHP and Woolies remain good value. Even after their expected dividend reductions, they might still possess a reasonable yield, but uncertainty over their earnings means uncertainty over their dividend. We've excluded them from our list for this reason.

Broadening the lens

To get an adequate return we need to broaden our lens, to our Growth Portfolio. There are 24 stocks in our Income Portfolio. Incredibly, the Growth Portfolio features 18 of them. The extent of the crossover shows how dependable yield has become expensive relative to growth.

In the middle sit a host of companies that deliver acceptable yield and attractive growth prospects. That's the basis for the ‘Okay yield and growth' mini-portfolio shown in Table 1, offering an overall yield of 5% plus the potential for some capital growth.

Whilst this mini-portfolio does not include stocks that require a high price for dividend certainty and those that face the likelihood of a cut, it does find a place for six companies currently on our Buy List (although Virtus has recently risen past our Buy price). That's evidence of our emphasis on value, with acceptable yield. Whilst the remainder are only Holds, many are close to our Buy price. If you are attracted to the yields on offer you don't have to stretch too far to reach them.

Assessing dividend safety

Of course we can't say for sure that the companies on this list won't have to cut their dividends. That's why we've included ten of them and this diversity provides protection against possible cuts from individual stocks. We've included free cash flow yield in the table alongside more traditional measures to help you assess the safety of the different dividends. If the free cash flow yield is far higher than the dividend yield, there's protection against a dividend cut. Where it is lower there's a significant risk of a cut.

Of the 10 stocks in total, two are banks and three more are in the broader financial category: IOOF, Perpetual and ASX. This too is an expression of value, a reflection of a sector that over the past year or so has fallen a little out of favour. The compensation for the risk is in the price and yield. All the usual caveats apply though: no more than 20% of your portfolio should be allocated to the banks, half that for conservative investors.

The two on our list where the dividend yield exceeds the free cash flow yield are IOOF and Perpetual. IOOF's dividend is not only above its free cash flow, but also its targeted payout range of 60–90% of underlying net profit. So far the company's strong balance sheet has enabled it to maintain the dividend in spite of this, but any large acquisitions might provide an excuse for a cut. We would most likely welcome such a move, though, as management has a great track record with acquisitions and, ultimately, what's needed to support dividends is a return to earnings growth after the expected flat result this year.

Perpetual, on a yield of 5.9%, is in a similar position. The current dividend represents about 90% of the (slightly reduced) earnings per share expected for this year, and there is some flexibility in the targeted range of 80–100%. However, earnings are dependent on the level of the sharemarket and ultimately, therefore, so is the dividend.

Surprises

­­The list offers a few surprises, with billing software supplier Gentrack the stand-out. Its yield of 4.1% is well supported by recurring revenue while new customers should lift profits over time. Most of the company's customers are utilities with few ever having left. An economic downturn is a risk, as is a reduction in IT spending but it's hard to see an imminent threat to Gentrack's yield. Liquidity is also an issue, so we recommend patience in building a position.

Commercial printer PMP is in a rather different situation. The generous dividend of around 5.6% (unfranked) initially looks somewhat vulnerable. But free cash flow far exceeds profit because accounting depreciation is greater than economic depreciation. In fact, profits are just 40% of cash flow. The greater worry is the competitive nature of the sector. The loss of a few large contracts could stop the dividend dead, which is why this recommendation carries a ‘speculative' label.

As for the remaining stocks – Monash IVF, ASX, Trade Me and Virtus Health – these are examples of reasonable yields topped up by genuine growth potential. All find a place in our Growth Portfolio for this reason.

The eagle-eyed will notice that the maximum recommended portfolio weighting for all the stocks put together is only 62%, which is why this is a ‘mini-portfolio'. It's not intended to be used as a full portfolio on its own. If you want the fully fledged variety, you will need to look at our Equity Income Portfolio, which offers more diversity (and a little more growth potential) in return for a somewhat lower yield.

Also, please remember that everyone's needs are different. There may be only a handful of stocks on this list that meet your particular criteria, or perhaps all do. Whatever the number, please read all the recent research on each company to understand the business and financial risks before you act, and then carefully reflect on the flexibility you may have to swap a little extra yield in exchange for a larger potential capital gain.

Note: The Intelligent Investor Inc,ome and Growth portfolios own many of the stocks mentioned. You can find out about investing directly in Intelligent Investor and InvestSMART portfolios by clicking here.

Disclosure: The author owns shares in PMP.