Three mid-caps for income in 2020

Media stories about high-dividend stocks can be dangerously simplistic. They focus on headline yield, overlooking future dividend growth, company valuation and risk.

Or the stories neglect that the stock’s yield is inflated by its falling share price, which in turn reflects market fears that the dividend will be cut or the company is poor quality.

As I have written before, conservative, income-seeking investors should get yield from investments with a professional manager such as listed investment companies or quoted managed funds.  Why buy a stock purely for a 5% yield and take on single-company risk when you get a similar return (after fees) from a diversified portfolio of stocks and benefit from professional management?

Investors who prefer to source yield through direct share ownership should follow four rules.

Rule one: always focus on the potential total return (capital return plus income), not just the yield component of it. Never treat a stock like a surrogate for fixed-interest income.

Also, overpaying for a stock with an attractive yield is never a good idea. I know some self-managed superannuation trustees who care only about the yield because they intend to hold the stock for years or decades. Yet the return ultimately depends on the price paid for an asset.

Rule two: if you are risk averse and need share income to live on, stick to blue-chip companies with dominant market positions and strong balance sheets. Never buy miners or other cyclical businesses only for yield and take extra care with micro-cap stocks with high yield.

Rule three: ideally, favour companies that offer a mix of capital and income growth. Look for higher-quality companies that can deliver rising revenue, profits and dividends. Buy them during market pullbacks when they trade below intrinsic or fair value.

Finally, focus on future, not historic yield. I’ve been criticised in years past for recommending stocks with 3-4% yield by income investors who believe that is too low. They did not realise that yield will grow in coming years as the dividend-per-share lifts.

Here are three mid-cap companies to consider.

1. Link Administration Holdings (LNK)

The superannuation funds administration and share registry group has underperformed: the three-year total return (including dividends) is almost zero, in a rising market.

After plunging in May 2019 following a profit downgrade that rocked the market’s confidence, Link began to recover to $6.50, although it is well down on peak prices near $9.

Link has had its problems, but funds administration and share registry have attractive business models. Funds administration, about a third of group revenue, benefits from three- to five-year contracts and customer switching costs are high.

A retention rate of above 90% and a large number of clients that have been with Link for well over a decade highlight how funds administration and share registry have attractive, recurring revenue.

Link in January announced the acquisition of Pepper European Servicing (PES) for around $266 million upfront – a deal that is expected to be double-digit accretive for Link’s earnings per share. PES provides end-to-end loan servicing, advisory and asset-management services.

At $6.50, Link has a trailing dividend yield of 3.1% – not enough to excite income investors. But the dividend-per-share is expected to grow from 20.5 cents in FY19 to 28 cents in FY21, on Morningstar numbers. After franking, the estimated FY21 yield is almost 6 per cent.

Morningstar’s $8.10 valuation for Link suggests it is undervalued at the current $6.50. Link can grow its share in fund administration and the global bull equities market should be a tailwind for its share-registry and stakeholder-management and communication business.

Chart 1: Link

Source: ASX

2. Platinum Asset Management (PTM)

The prominent fund manager has had a tough few years because of disappointing fund performance. Platinum’s three-year annualised total return is 2%.

The global bull market in equities should be a tailwind for Platinum and other global equities managers as their funds under management grow.

However, Platinum has been left behind and like other listed investment managers could tumble further in the next few weeks if market fears of a Coronavirus pandemic intensify. Wealth managers are obvious underperformers in a market sell-off.

At $4.65, Platinum has a forecast dividend yield of 5.7%, based on the consensus of eight broking firms. After full franking, the grossed-up yield is a touch over 8%. Most brokers have flat dividend-per-share growth for Platinum over three years.

Much will depend on Platinum’s fund performance and how it, like other active managers, responds to the threat of low-cost index funds. Although Platinum’s fund performance has lagged in the past few years, it has a good long-term record and valuable brand recognition. Its contrarian investing style should eventually pay off in an overvalued global equities market.

Still, it will take time for Platinum to convince the market of its fund performance turnaround and there could be short-term volatility in the share price if pandemic fears spread. Prospective investors will need patience.

In the meantime, shareholders could be content with an 8% grossed-up yield in Platinum, reasonable scope to maintain the dividend, and a share price that broking firms, on average, believe is worth a little above $5.

Chart 2: Platinum Asset Management

Source: ASX

3. Servcorp (SRV)

Servcorp has had a tough few years after profit downgrades and lower-than-expected growth in its US operations. Its rallied in 2019 off a low base but over three years the annualised return is negative 6%, shows Morningstar data.

I rate Servcorp’s prospects in executive suites, virtual offices, co-working facilities and secretarial services and its footprint across 24 countries. More of a small-cap rather than a mid-cap, it is among only a handful of Australian companies that have such a genuinely global business in a long-term growth market.

The overhyped, overvalued WeWork gave co-working a bad name and for a time weighed on Servcorp’s share price. Greater competition from Regus was another headwind for Servcorp. But the underlying trend of more companies and business owners seeking flexible workspace at low cost and outsourcing services is undeniable.

Founder and CEO Alf Moufarrige said at the Annual General Meeting in November 2019 that Servcorp will “probably have a record free cash year of $65 million” and intimated it would pay a 20 cent dividend, down from 23 cents in FY19.

Servcorp has no debt and strong free cash flow, but needs to improve its return on equity (ROI) – 10.6% at the end of FY19 is too low to drive a sustained share-price re-rating. Servcorp is at least heading in the right direction.

At $4.26, Servcorp has a forecast yield of 4.7% (assuming the 20 cent dividend), partially franked. The few brokers that cover Servcorp (too small a sample to rely on) have a forecast yield of 5.34% (before franking) in FY20. The consensus share-price target is $5.12.

As a smaller cap stock, Servcorp suits experienced investors who seek a mix of capital growth and income. After a challenging period, Servcorp can get its dividend rising again in FY21 and beyond as it delivers higher free cash flow and benefits from the boom in flexible office space.

Chart 3: Servcorp

Source: ASX