Income is cool again, and there is a sweet spot developing

From 1 July 2021 until now, the ASX200 has pretty much gone sideways. That’s two years of nothing.

But it’s been a pretty wild ride over those two years.

To be precise, the ASX200 is down about 2.5% over that time. That’s not really how markets are supposed to work, is it? I mean, you’re meant to get rewarded for the risk you take on.

Except there’s not much in the way of rewards for investors during an aggressive rate hiking cycle. You just have to suck it up and try and stay out of trouble.

On the plus side, when you take dividends into account, your head is just above water. Over the same time frame, the ASX200 Total Gross Return Index is up around 6%. That’s slightly misleading though. This index takes into account the benefit of franking credits. So unless you’re in a zero-tax environment, you won’t have experienced this return.

Anyway, the point I’m trying to make is that income has been the difference over the past few years, while capital growth has disappointed.

Now, I might be going out on a limb here, but my guess is that two years ago, how to secure a reliable income stream wasn’t really the main thing investors were thinking about.

Mid-2021 was bull market central. It was all about cryptos, SPACS and windfarms…

Income was for losers.

But now, income is cool. Term deposits are back, baby! 4.5%? I’ll take some of that, please.

So I’m thinking…how will hindsight judge this mindset in two years’ time?

It’s a tough question to answer. On the surface, it makes sense to be looking for income opportunities right now. With the RBA hiking rates and expected to keep them higher for longer, ‘risk-free’ options like cash and term deposits look pretty good.

The lagged impact of the rate rises will continue to slow the economy in the second half of the year. Oh, and there is $60 billion of the RBA’s term funding facility (AKA low-cost fixed-rate mortgages) due to be repaid in the September quarter.

That higher cost of financing will hit households immediately, and then spread through the economy in the months following.

So yes, earnings are under threat, and that means capital is at risk. Hence the desire for income.

This strategy certainly makes sense. But that doesn’t mean you opt for income at any cost.

Firstly, there is the contrarian angle to consider. As I said, two years ago, no one was interested in income. That’s because rates were pinned to the ground, and you had to be in the market to get anything.

But now, cash rates are at their highest in a decade. That’s NOW though. What about in two years’ time? They could well be much lower again. And if that’s the case, growth assets are the place to look.

But that doesn’t mean you need to abandon the search for income. There is an income/growth sweet spot developing in the market right now that gives you the opportunity for a juicy dividend yield AND growth.

While the ASX200 might be flat over the past two years, there are plenty of stocks that are down significantly from their highs.

In many cases, these stocks offer prospective dividend yields well above the cash rate AND trade significantly below a reasonable estimate of intrinsic value.

The way I see it, you can get a decent yield while you wait for the tightening cycle to play out. Then you’re in a good position to benefit from the eventual tailwind of a post-recession/slowdown easing cycle.

Now, I may be getting ahead of myself. But I’m looking out two years here. As the past two years have shown you, a lot can happen in this relatively short timeframe.

Of course, given the headwinds the economy faces, earnings and dividends are at risk. Which is why you really need to focus on the value aspect. If you can buy stocks at a deep discount to fair value, they’re already priced for a relatively poor outcome.

That way, if you get things wrong (which we all do) then the damage is manageable.

What stocks fit into this category?

With respect to my paying subscribers, I’m not going to reveal any specific names that I’m looking at right now. But I will say that the property trust sector looks very interesting on this front. The rate-rising cycle has hammered the sector and the fear over office valuations has made front-page news. From a contrarian perspective, this is positive.

Energy stocks also look good. While the oil price has halved since the peak, energy stocks have held up pretty well. If you value them based on higher-than-average prices through the cycle, they look cheap right now…and pay out a solid income stream to boot.

I think ‘higher-than-average’ energy prices are a fair bet, given just how bad our political class is managing this energy transition.

And there are plenty of other stocks that look good across a range of sectors.

Let me give you one example. About a year ago I recommended Insurance Australia Group (ASX: IAG). From memory, the prospective yield was around 4.5%, which was pretty good considering it reflected a dividend payout ratio of 50%.

At the time, IAG had declined 50% from its share price peak. It was under the pump from a series of weather-related claims and uncertainty over COVID-related claims.

A year later, readers are up over 25% on IAG (including divvys). Thanks to its depressed share price, it offered dividends AND growth.

These are the opportunities I’m looking for now. And they’re certainly available. You just have to be prepared to be uncomfortable when you buy. That’s how buying stocks that are out of favour works.

It’s like what I said to readers earlier this year when I recommended James Hardie (ASX: JHX) around $31. It had fallen 50% from its highs, had just delivered its third profit warning in a year, and was well and truly out of favour. I wrote:

‘That’s the nature of contrarian value investing. These are the ugly conditions where value lives. You’re simply not going to get the opportunity to buy quality assets at a good price when everything looks good.’

Now let me give you a different example. Commonwealth Bank (ASX: CBA) is an income investor favourite. It resides in most dividend ETFs, with a portfolio weighting as high as 12%.

I get that CBA is a quality stock. It’s outperformed all the other banks by a long shot through a number of cycles.

But you’re now paying a very high price for this quality. The company trades on a FY24 forecast dividend yield of around 4.4% and a PE multiple of 16.4 times. Relative to the rest of the market, that’s on the expensive side. But many would argue it’s the price of quality.

Fair enough…

But I like to look at banks from the perspective of their price-to-book (P/B) values relative to their return on equity (ROE). And this is where CBA looks very stretched.

Its forecast return on equity (ROE) for FY24 is 13.1%. Yet it trades on a P/B multiple of 2.2 times.

Compare that to another very high-quality bank relative to its competitors…JP Morgan (NYSE: JPM). It’s got a forecast ROE for FY24 of 13.4%, and trades on a P/B multiple of around 1.4 times.

On this metric, CBA trades at a near 60% premium to JPM.

CBA is either very expensive or JPM is very cheap. It’s probably a combination of both. And although the market they operate in is different, both are dealing with a rising rate environment and slowing economic growth. JPM is probably six months ahead of CBA in terms of the economic environment.

All this is to say that if you just focus on the yield, and not the price you’re paying for that yield, you’ll get into trouble. Especially in a market where more profit headwinds are likely, as the lagged impact of previous monetary tightening works its way through the economy.    

Based on historical ranges… there are a LOT of stocks out there right now that are trading at a significant discount to their intrinsic value.

And many of these stocks are currently paying great dividends.

In other words…

The dividend yields are stellar income right now. Often at least a couple of per cent more than the best term deposit.

But there’s significant VALUE to be found as well…if you know what you’re looking for…

It’s a ‘sweet spot’ with regard to dividend stocks that most investors are ignoring right now.

I’ve selected six specific stocks with this sweet spot in mind.

Click here to learn about my Royal Dividend Portfolio.