income stocks by elio damato

Top income stocks for FY18

The information in this article is market commentary only and reflects Lincoln's views and beliefs at the time of preparation, which are subject to change without notice. To obtain up-to-date information, please contact us.

The outlook for income stocks and yields over the next 12 months.

Investing in income stocks has become popular with numerous investors as high dividend yields, anaemic interest rates and valuable franking credits have led many to consider the attractive returns on offer. Our Stock Doctor Star Income Stocks, for example, have experienced a strong period of total return outperformance over the market for the past four years.

It is important to note that investing in stocks for dividends is still an investment in the sharemarket, and a thorough assessment of the business and its financial health, coupled with volatility, needs to be considered in determining the level of portfolio risk an investor is willing to take.

Hence, when investing for income, it is crucial that stocks are not only healthy but also have a good history of paying dividends from a stable earnings base.

In recent times, income stocks have been considered growth investments because of strong total returns (dividends plus share price appreciation) across the board.

Is income investing as attractive today as it was when the market turned away from high-quality growth businesses towards high-dividend yielders? Or will we see the sun set on what has been a wonderful time to be an income-seeking investor?

Bond rate comparison

Let us start with an assessment of the current yield of the market versus the one-year bond rate. The theory is that the closer bond rates are to dividend yields, the more likely investors will make a risk-adjusted decision to choose bonds (or a cash investment) ahead of equities.

If the primary objective for investing is a regular income stream, an investor may be willing to sacrifice the potential for capital gains for the certainty of an income stream, with little to no downside risk.

As shown in the chart above, in the past few years the gap between bond rates and dividend yields has been quite large. This has created a more attractive environment for high-income-paying companies, as investors have been desperate to find stronger income than the interest rates on offer via traditional cash investments.

With a run-up in interest rates unlikely any time soon, it is fair to assume there is still an investment case for shares over the next 12 months to supplement income. On that basis, let’s turn to more specific factors that will move the pendulum to either the bull or bear case for income stocks.

The case for income investing for the next 12 months

  • Interest rates are still low. Notwithstanding the closing gap, this still make dividends attractive and is also good for businesses as access to funding remains cheap.
  • Dividends continue to be strong. Investors can construct a portfolio from a wide range of strong-dividend-paying stocks, even outside the traditional banks and Telstra. This will help mitigate portfolio concentration risk and help insulate investors from some volatility. Currently at Stock Doctor we have 23 Star Income Stock recommendations for income-seekers to consider.
  • Holding assets protects against inflation. Irrespective of your views on volatility, you can’t hold cash if you want protection from inflation over the long-term. While there is unlikely to be any strong upswing in inflation soon, investing in assets such as shares protects against inflation if, and when, it re-emerges.
  • Income stocks can also be used for growth investing. While it is true that many stocks are large-cap businesses with little to no chance of achieving dynamic earnings growth in the near term, there are a number that have successfully combined solid business growth with a strong dividend payment. This has netted strong total returns for investors and we expect more cases like this throughout the year.

The case against income investing for the next 12 months

  • Interest rates are expected to rise over the long-term. Although the chart highlights the one-year bond rate, which is expected to remain stable, many believe we are at or close to the bottom of the interest rate cycle. Although it may not be immediate, interest rates are likely to rise at some point, creating a negative impact on the so-called bond proxies.
  • Income stocks are trading at premiums to their valuations. This is normally reserved for high-growth companies where investors will pay a premium price today for the quality businesses of tomorrow. Many income stocks have seen their share prices spike above historic price-earnings ratios in the case of industrials. Real estate investment trusts have spiked above their net asset values (per share). This has been fuelled by expectations of increasing profits and asset revaluations. This will normalise.
  • Pressure on some bellwether income-payers is emerging. An obvious example of this is Telstra Corporation. Prized for its high dividend, the looming revenue hole and increased competitive landscape has left many investors (including ourselves) doubting whether the dividend will be sustainable. Remember, dividends are paid from after-tax earnings. If earnings are expected to decline over time, there is only one way dividends can go.

Some thoughts in summary

Given the nature of our market and tax treatment of dividends, there will always be a place for income investing in financially healthy stocks paying sustainable dividends that result in an above-market yield into the future. We see no immediate risk to that over the next 12 months.

We also believe that astute investors willing to do a bit of work and take active control of their portfolio will still be able to generate above-market returns from applying an income-focused investment strategy.

While it is true that a lazy set-and-forget income strategy may not yield the same returns next year as they have over the past three (as the cycle looks to be turning), we believe there are still good times ahead.

However, investors need to keep an eye on portfolio management, as some past income favourites may disappoint. Selecting the great businesses and avoiding the bad ones as a core part of stock selection will ensure that no matter what price volatility may occur, you can rest easy through the cycle knowing dividend cheques will keep rolling in.

Below is a list of four Stock Doctor Star Income Stocks that have delivered for investors and offer the potential for a good total return in the year ahead.

(Editor’s note: Lincoln’s blogs are point-in-time statements. Please note the date of issue. Do not read the following ideas as stock recommendations. Do further research of your own or talk to a financial adviser before acting on themes in this article).

Lincoln’s Star Income Stocks are characterised by their consistent financial health, above-market dividend yield, earnings stability and the company’s ability to maintain dividend payments into the future. Star Income Stocks are suitable for investors looking for income as a priority from their share investments and want to invest in quality businesses. Source: Lincoln Stock Doctor as at 6/9/2017

Published Tuesday 13 June 2017 | ASX Investment and finance newsletter

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