Morningstar Australasia’s joint head of equity research, Andrew Doherty, recommends against retail investors taking on the extra risk of borrowing.
“Risk aversion and falling interest rates drive investors towards stocks that offer reliable dividend yields at levels that are attractive in comparison with interest-paying securities,” it says.
The joys of discovery
“More and more investors who previously saw stock returns as primarily a function of capital gains (share price increases) are discovering dividend investing.”
As well as a strong weighting towards the major banks and Telstra, Morningstar’s equity income portfolio (as at August 2012) included grocery retailer Metcash, QBE Insurance and diversified energy company SP AusNet – with the latter two holdings having only partially franked dividends. Other companies with reasonable yields include Wesfarmers and Woolworths.
Competitive advantage
Crucial to Morningstar’s investment picks, says Doherty, are companies that have a competitive advantage such as through patents and government licences, low business risk and good cash flow. It then works out a fair value for the company, with the aim of buying it at a discount to fair value. Diversification is also important.
Lincoln Indicators chief executive Elio D’Amato says it is important investors have a structured approach to building their portfolios, starting with choosing companies that are in good financial health.
Rock solid
“At the end of the day you need to make sure your investments have a rock solid balance sheet, bankable profits and consistent operating cash flow whereby they are positioned to absorb shocks to their operations,” he say.
D’Amato says that, short of sitting in on the odd board meeting, the best way to assess how management is steering a company is to look at the numbers based on past performance. Key metrics are return on assets, earnings per share growth, return on equity and revenue growth, he says.
Blue skies
“Finally you need to assess the company’s prospects. Is it blue skies, where are the potential road blocks and, most importantly, can it keep growing? At the end of the day, if a company grows consistently over time the share price will follow.”
Companies that could hold a place in a longer-term, conservative portfolio and with good dividend-paying potential are ANZ for its growth plans in Asia, Woolworths, Wesfarmers and gambling company Crown.
As well as a focus on income-generating stocks to account for the gearing, Hewison Private Wealth director and adviser Andrew Hewison favours a more diversified approach to portfolio construction.
“Listed investment companies provide fantastic exposure, mainly to blue chips and, although seen to be conservative in nature, they have provided double-digit returns over the last 20 years,” he says.
“You may look at the portfolio and say that it is income-focused rather than growth, but that’s the beauty of the current market – substantial growth opportunities now lie in income stocks,” says Hewison.