Four mid and small cap ideas for yield seekers

What a difference a week of gains in Australian shares makes. Commentators who bemoaned our stubbornly range-bound market now see it breezing through 6,000 points. Some say the market is going even higher now that it’s broken through a key resistance point.

The bullishness is a little overdone and premature. Still, our market was itching to rally. Local economic news is improving, China looks a touch stronger and the US sharemarket is reaching fresh highs. Our market earned its bounce in the first half of October, but looks fully valued after recent gains. Finding value is harder work.

If the rally persists into the New Year, albeit in fits and starts, expect more capital to rotate to the big cyclical growth stocks, such as miners. That could create value in defensive yield stocks, a part of the market that has lost its shine as former stars, such as Telstra, struggle.

I highlighted several defensive yield stocks for The Switzer Super Report in the past five years, notably Sydney Airport and Transurban Group. I’ve also identified Listed Investment Companies and Exchange Traded Funds for income-seekers who want diversification through listed funds.

Conservative income investors should stick to the ASX 200 for yield. The big-four banks look more interesting after price falls last year. Sydney Airport and Transurban, both fully valued, still appeal for long-term income seekers. Telstra has plenty of challenges, but remains an income-portfolio staple, even after its dividend cut this year. In property, Westfield and Scentre Group stand out. Medibank Private appeals in the insurance sector as a yield play.

Investors with higher risk appetite should consider mid- and small-cap stocks that offer reliable, attractive dividend yield – a market segment income investors often overlook. There is good reason for caution: smaller-cap stocks have higher risk than large caps and usually reinvest more profit for future growth, making their dividend less attractive.

My focus when choosing smaller stocks for dividends is to identify those offering a mix of capital growth and yield; that is, a reasonable total return. Small caps are fundamentally about capital growth, but do not discount their ability to pay and maintain juicy dividends.

Here are four mid- and small-cap ideas for those seeking a mix of growth and yield. These mostly contrarian ideas suit yield seekers with higher risk tolerance. These stocks are capable of delivering 6-8% yield, mostly fully franked, in FY18.

1. Harvey Norman Holdings

Buying a retail stock for yield looks like madness. Retail stocks have been hammered as investors fret about the struggling consumer and Amazon’s arrival in Australia. Harvey Norman has been the target of aggressive short-selling campaigns and some have written off its founder, Gerry Harvey – unfairly in my view.

I recall the bears writing off Harvey Norman after the 2008-09 Global Financial Crisis, only for the retailer to deliver a string of record profits. I reckon there’s a lot more life in Harvey Norman than the market recognises at the current price. The short sellers are wrong on this one at the current price.

Harvey Norman still has a bank of excess franking credits up its sleeve and is in a prime position when the economic cycle turns higher and consumers spend more.

A recovery in Harvey Norman, and other higher-quality retailers, will take time and has many short-term headwinds. Patience is needed. An expected yield of just over 6% fully franked, should suffice in the interim.

Chart 1: Harvey Norman

 Source: nabtrade

2. Genworth Mortgage Insurance Australia

The mortgage insurer looks like the last stock to own if mortgage stress skyrockets and tens of thousands of home owners default on their loans. Faster-than-expected interest-rate rises from the Reserve Bank or from out-of-cycle rises by banks, would trigger a wave of bad debts, blowing a hole in Genworth’s earnings and dividends.

Newspapers are full of stories about rising mortgage stress rates: broadly defined as home owners having to spend more than 30% of their pre-tax income on servicing a loan. If reports are to be believed, mortgage stress levels are near breaking point.

Mortgage stress is clearly a problem in some suburbs in capital cities. But I’m not convinced it’s as big as news reports suggest. Mortgage stress rates are based on surveys and the data is somewhat simplistic. Technically, I might be in mortgage stress because loan repayments are above 30% of pre-tax income, even though I own several assets that can be sold if needed or have a high income that easily covers living expenses.

I wrote favourably about Genworth in February 2017 for this Report at $2.91. The stock has mostly traded sideways (now $2.89) despite never-ending doom and gloom about mortgage stress this year. Genworth still looks attractive for risk-tolerant income investors.

Genworth’s strong balance sheet means it’s well provisioned should loan delinquencies rise faster than expected, particularly in the mining states. Also, Genworth should be able to maintain an attractive dividend by paying out profits as ordinary or special dividends.

At $2.89, Genworth is expected to yield about 8% fully franked, and trades on a forecast Price Earnings (PE) multiple of just under 10. The company’s recent contract extension with the National Australia Bank is good news, but plenty of challenges remain.

Chart 2: Genworth

Source: nabtrade

3. Shopping Centres Australasia (SCA) Property Group

Who would want to own retail properties when key tenants, such as Woolworths, face growing pressure from foreign entrants and as more discretionary retailers struggle to survive? Surely, retail property owners will face higher vacancy and be forced to reduce rents?

That’s the bear case. The performance of SCA Property Group, de-merged from Woolworths in 2012, belies that theory. SCA’s occupancy rate is almost 99% across its portfolio of 74 neighbourhood and sub-regional shopping centres. Key anchor tenant Woolworths is starting to deliver better sales growth and SCA’s discretionary retail tenants are performing solidly.

I rate neighbourhood shopping centres as property investments. Australia’s population growth is a big tailwind; add another 390,000 or so people each year, roughly the size of a new Canberra being built annually, more consumers will shop at suburban centres.

At $2.33, SCA is expected to yield almost 6% in FY18, based on consensus analyst forecasts. I don’t expect a lot of capital growth in the next 12-18 months, but enough for SCA to deliver a reasonable double-digit total return for investors.

SCA’s gearing is at the low end of its targeted range and it should benefit as more anchor tenants start to pay turnover rent in the next few years. The trust looks like a lower-risk way to benefit from an eventual pick-up in retail sales in the next few years.

Chart 3: SCA Property

Source: nabtrade

4. Regional Express Holdings

I never thought I would include a micro-cap airline in a story on dividend yield. I did say this week’s column had a contrarian bent!

Airline stocks have been terrible investments over the years, but the stellar performance of Qantas Airways and Air New Zealand this year reinforces potential.

REX, of course, is a different proposition to the big airlines. The $181-million airline services regional routes and provides charter flights and training. I became bullish earlier this year on REX and the smaller Aviation Alliance Services, which targets the resource sector.

Both will benefit from a pick-up in mining-sector conditions and higher travel demand for fly-in, fly-out (FIFO) workers. Regional airports in mining states, full of resource-sector workers in fluorescent vests at the peak of the boom, should have more life over the next few years.

REX’s latest result showed it is flying more passengers and benefiting from lower oil prices. The airline has invested heavily in spare parts and new hangars in the past two years, meaning it should be able to reduce capital expenditure and increase free cash flow. That is the key to lifting dividends and sparking a continued re-rating of the share price.

REX has more than doubled from its 52-week low of 76 cents. The stock is not cheap on a trailing PE multiple of 14 times. Market interest in REX is building. I expect gains to slow from here; a yield of about 6% fully franked, is an attraction.

Larger regional towns could be a surprise packet in the next few years. As capital-city property prices remain out of reach for many prospective home buyers, higher population growth in regional areas is likely. That, and a sustained pick-up in the mining sector, could shake some country towns out of several years of doldrums, stimulating regional air-travel demand.

That’s good news for REX and its dividend.

Chart 4: Regional Express Holdings

Source: nabtrade