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Tony is a former managing editor of BRW, Shares, Personal Investor, Asset and CFO magazines. He writes a weekly column for BRW and The Australian Financial Review, specialising in small listed companies,IPOs, entrepreneurship and innovation.

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Dodge the bubble: When chasing yield, think small

Published 07 March 2013 10:25, Updated 07 March 2013 15:38

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Dodge the bubble: When chasing yield, think small

Retail stocks like Oroton look interesting from a yield perspective as consumer confidence slowly improves and cash registers ring louder later this year. Photo: Nic Walker

Warnings abound that a “yield bubble” is developing on the sharemarket amid rising valuation risks for Telstra and the big four banks after stunning gains in the past year.

But don’t accept the yield bubble argument just yet. The race for yield has a long way to run as investors who pay the top marginal tax rate and have funds in cash face negative real returns after inflation. Telstra’s forecast 8.7 per cent grossed-up dividend yield looks a lot better than 4 per cent in a bank term deposit.

Extraordinary growth in self-managed superannuation funds, and an ageing population, will lift demand for companies that pay high, reliable, fully franked dividends. It’s too early to call a structural change in demand for income stocks – my guess is investors would move back to term deposits in a heartbeat if rates went back above 6 per cent – but there is likely to be persistent interest in them.

Yield-focused investors who put new money to work have a tough task. Do they chase Telstra, bank shares and Australian real estate investment trusts ever higher and run the risk of muted capital growth or capital losses in the short term if income stocks lose favour? Or should they use listed funds, such as exchange-traded products, that specialise in yield and offer greater diversification?

Another option is small and mid-cap companies with rising dividends. Of course, conservative investors, and those seeking maximum dividends, should stick to blue chips. Smaller companies usually pay lower dividends because they need to retain more earnings to fund growth.

They are also more volatile than blue-chip stocks, which is not ideal for investors seeking income surety.

Some excellent small and mid-cap companies offer a mix of solid capital growth prospects, at current prices, and yields above 5 per cent; more after grossing-up the dividend for franking credits. Also, rapid earnings growth creates an opportunity to lift dividends in coming years. JB Hi-Fi is a good example: its interim dividend has leapt from 10¢ a share in 2008 to 50¢.

Even a 5 per cent dividend from a small or mid-cap stock, provided it is reliable, looks attractive compared with bank term deposit rates and an official cash rate at 3 per cent. Another quarter of a percentage point rate cut this year, which is no certainty, or banks trimming term deposit rates outside of RBA moves, will make holding cash even less attractive.

Higher inflation, should it occur, would hasten the exodus from cash, and encourage greater investment in income stocks,

I usually prefer fast-growing small-cap companies to retain more profits and reinvest to drive faster growth and compound earnings and shareholder returns. Surely it makes sense for a business earning a 20 per cent return on equity to reinvest capital, rather than give it back to shareholders who would struggle to find a similar return on each dollar of their equity.

But I accept that small and mid-cap companies must respond to shareholder preferences for higher dividends and paying them can attract more investors and support the share price.

Let’s hope we don’t see star companies limit their growth options by responding to market demand for higher dividends when earnings should be reinvested to capitalise on global growth opportunities.

Another attraction of using small-cap stocks for yield is valuation. Buying a stock only for yield is foolish: what good is a 7 per cent dividend yield if the stock drops by 10 per cent?

Those buying Telstra and bank shares now face a lower total shareholder return (growth plus income), given elevated share prices.

Small and mid-cap stocks, as measured by the Small Ordinaries Index, have underperformed large-cap stocks over one year. The Small Ordinaries Accumulation Index’s total return (including dividends) is minus 2.31 per cent, compared with 23 per cent from the S&P/ASX 100 Accumulation Index. The poor performance of small resources stocks, almost one-quarter of the Small Ords, has crunched returns.

If investor risk appetite strengthens, expect the performance gap between the Small Ordinaries Index and the top 100 stocks to narrow this year or next as investors increasingly chase smaller stocks. They might not offer the same yields as the top 100 stocks but could have more potential for capital growth, given the sector’s underperformance in the past year.

The accompanying table shows 10 small and mid-cap stocks that fit my criteria for yield. Retail stocks look interesting from a yield perspective as consumer confidence slowly improves and cash registers ring louder later this year. JB Hi-Fi, Myer Holdings, OrotonGroup and Breville Group were chosen.

Bulky goods property provider BWP Trust is another solid dividend payer.

Austbrokers Holdings, IRESS, IOOF Holdings, Monadelphous Group and listed investment company WAM Capital (an investor in small-cap stocks) round out the list. They may not look like typical dividend stocks, but an average yield of 5.6 per cent, plus potential for capital growth, suggests a double-digit total shareholder return over 12 months, with acceptable level of risk for most investors.

Small caps with good dividends

Company Forecast dividend yield % *
OrotonGroup 7
Myer Holdings 6.9
WAM Capital** 6.4
BWP Trust 6.2
Monadelphous 5.8
JB Hi-Fi 5.4
IOOF Holdings 5.3
Austbrokers Holdings** 4.9
Breville Group 4.7
IRESS 4
Average:  5.66

* based on consensus analyst estimates for 2012-13

** based on last reported full-year profit
Source: AFR.com

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