Finding reliable yield in this market – at an attractive price – is a bit like playing a game of whac-a-mole. When a pocket of yield emerges, investors pour in, flattening the opportunity.
I have scoured the market for yield this year, covering income funds, Exchange Traded Funds (ETFs), Listed Investment Companies (LICs) and Trusts and stocks for The Switzer Report. With term deposits paying 1.5%, rarely a week goes by when I am not asked about yield.
As I have written previously, conservative income seekers should stick with funds rather than buy stocks directly. Why buy a single stock for a 5% yield when you get a similar result in a professionally managed fund (after fees) with far greater diversification?
I’ve seen too many investors buy stocks for yield over the years – treating them as a bond surrogate – only to suffer capital losses that wipe out the total return. Telstra Corporation is an example; those who bought it for yield have a slightly negative total return over five years.
That said, experienced investors who can tolerate higher risk, and prefer buying stocks directly for yield, could consider small- and medium-size companies. Some are yielding above 6%, more after franking, and trading on single-digit Price Earnings (PE) ratios.
Caution is needed: investors should primarily buy small caps for growth rather than yield. In theory, small caps should reinvest more of their profit to keep growing the business rather than give as much back to shareholders through dividends, although that is not true of all small caps.
Small-cap industrials, as a group, seem unusually undervalued. Growth in ETFs and the decline in active funds management have led to more small caps than usual being overlooked. Some trade on valuation multiples that have barely moved in the past decade.
I follow a few rules when choosing small caps for yield. The first is valuation: overpaying for a stock to access its yield invariably ends badly. Always focus on the total return.
Second, look forward with dividends rather than back. What matters is the future yield and whether the small cap can grow earnings and dividends. The usual rules apply: a growing return on equity, and steadily rising future earnings and dividends over time.
Third, a healthy balance sheet. Small caps are risky enough without buying those with stretched balance sheets and risk of breaching loan covenants. Avoid small caps that could slash future dividends because they have to get their balance sheet back in order.
Fourth, beware small caps that are highly cyclical. Some small retailers, for example, have attractive yields on paper but could be dividend traps if retail conditions contract further and they are forced to cut earnings guidance and lower or suspend dividends.
Here are 3 small caps worth considering for yield.
1. Alliance Aviation Services (AQZ)
I have written favourably about Alliance (AQZ) in the past few years and it remains a preferred micro-cap. The airline has a total return of 57% annualised over three years, Morningstar data shows.
Alliance provides contract, chartered and allied aviation services in Australasia. Almost three quarters of the company’s revenue is from the resource sector as it brings fly-in, fly-out workers to mine sites around Australia and to Papua New Guinea.
My initial interest in Alliance was based on its leverage to a recovery in mining activity and rising aviation demand in the resource sector. The stock was smashed during the mining downturn in 2014, slumping to 41 cents, and looked a bargain. It is now $2.48.
Alliance declared a record final dividend of 8.8 cents in FY19, up 40% on a year earlier. The total dividend of 15.6 cent equates to trailing yield of 6.2%, or 8.8% after full franking.
A few brokers that cover the stock have the dividend rising to 17 cents a share in FY20, giving a forecast grossed-up yield of 9.7% at the current price.
Alliance has reduced its gearing to 26.2% and has its lowest debt in years, despite investing in new aircraft. The company said in its latest profit result that it retained a “positive outlook” for 2020, meaning the dividend should at least be maintained if resource-sector conditions hold up.
The addition of five aircraft to the fleet, likely in the first half of 2020, is probably the main danger to the dividend if the board retains extra capital to help fund the purchase.
Alliance is down from a peak of $3 before its profit release in August 2019 and Qantas has taken a 19.9% stake (subject to an Australian Competition and Consumer Commission review).
Alliance is due for consolidation after strong price gains. But its prospective grossed-up yield should satisfy income investors.
Chart 1: Alliance Aviation Services
Source: ASX
2. Southern Cross Media Group (SXL)
The radio group was hammered in October after a negative trading update. Southern Cross shares fell 25% as the market feared weakening advertising markets.
Southern Cross has 78 commercial radio licences and owns the Hit and Triple M networks. It also owns 86 mostly smaller television channels. Like other media companies, Southern Cross struggles when the economy weakens and advertisers cut back.
I outlined a positive view on Southern Cross in August 2018 at $1.28, in a column about radio stocks. The stock hit $1.43 in July 2019, but has slumped to 87 cents after its downgrade.
On Morningstar’s numbers, Southern Cross has a prospective yield of 7.6% in FY20, or 10.8% after grossing up for full franking at the current price. Morningstar values Southern Cross at $1.30 a share and recently added it to its best Australian stock ideas list.
High yields look attractive but can be a trap if dividends are cut. Although revenue was down this quarter, Southern Cross is maintaining its share of radio advertising, taking costs out of the business, and is well within its debt convents on the balance sheet. I expect the company to hold its dividend, assuming the economy improves a little next year.
The December quarter is usually the busiest for radio and Commercial Radio Australia’s expectation for stabilisation in advertising volumes before returning to growth next year seems reasonable.
Longer term, radio accounts for about 60% of Southern Cross’s revenue and has proved to be resilient compared to other traditional media channels. Many have written off radio, but population growth, longer commute times and the podcasting boom are helping the medium.
The key issue, for now, is valuation. At 87 cents, the market is factoring much bad news – and possibly another earnings downgrade – into Southern Cross. The stock is on a forward PE of 10 times and looks a touch undervalued.
Chart 2: Southern Cross Media Group
Source: ASX
3. Shine Corporate (SHJ)
I included the listed law firm in a column on “five neglected small- and mid-cap stocks” for this report in September 2019 at 77 cents. Shine has rallied to 87 cents since that story.
As an aside, some other stocks in that feature, notably Ardent Leisure Group, have rallied in the past month.
I wrote about Shine at the time: “For all the short-term challenges, Shine has a good position in a long-term growth market and room to expand through acquisition of smaller firms. Gross operating cash flow continues to rise and Shine has implemented some good innovations in online claims for motor-vehicle injury and is expanding its family law practice.”
At 87 cents, Shine is yielding 4.3% unfranked. That won’t scream out to income investors, but I include Shine in anticipation of rising dividends over the next few years. And a rising share price, with Shine on a trailing PE of eight times, despite solid long-term growth prospects.
Chart 3: Shine Corporate
Source: ASX
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article consider its appropriateness and accuracy regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at 5 November 2019.
