The Income Investor: buy these unpopular shares for high yield and growth

A contrarian investing approach that focuses on high-quality dividend stocks provides an attractive income return, argues interactive investor’s new columnist Robert Stephens.

At first glance, the stock market’s income return appears to be relatively unimpressive. The FTSE 100, for example, yields 3.9% at a time when it is possible to achieve a similar income return from easy-access savings accounts. Two and 10-year gilts, meanwhile, currently yield in excess of 4% apiece, while fixed-rate bonds offer income returns above 5%.

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However, the FTSE 100’s relatively modest income return does not paint the full picture. A whole host of its members currently have dividend yields that are far higher than that of the index. It is therefore possible for income investors to build a diverse portfolio of stocks that offers a hugely attractive income return compared with other mainstream assets.

Unpopular stocks

While some of today’s high-yielding stocks may pay an unusually generous dividend, in reality low share prices are the reason why a number of FTSE 100 members offer exceptionally high income returns.

They may be unpopular among investors, and therefore cheap, for a variety of reasons. For example, they could be experiencing tough operating conditions within their industry. Or an uncertain near-term outlook for the UK, and global, economy may be weighing on prospects. Either way, their low share prices present income investors with an opportunity to obtain a high yield.

Temporary challenges

Clearly, there is little point in buying a high-yielding stock with poor long-term prospects. After all, it may ultimately be unable to afford its current level of dividend. However, companies that face a difficult short-term outlook, but are fundamentally sound businesses, are likely to be excellent income investments.

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Indeed, trading conditions in all industries ebb and flow, while the economy’s performance follows a perpetual cycle of boom and bust. Investors who are willing to buy income stocks while temporary challenges are present, are likely to benefit from their improving financial performance as industry and economic-related conditions ultimately strengthen.

Focusing on fundamentals

Key to the approach of buying cheap, high-yielding stocks is ensuring they are fundamentally sound businesses. While this is undoubtedly subjective, is centres on balance sheet strength, the size of a company’s competitive advantage and the affordability of their dividend.

For example, a firm that has modest debts as a proportion of its net assets, as well as its net interest payments being covered several times by operating profit, is unlikely to fail as a result of difficult trading conditions that negatively affect profitability in the short run.

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Similarly, companies that have a competitive advantage such as a unique product, strong loyalty among customers or lower costs than their rivals, are more likely to survive a tough economic period to recover over time.

Meanwhile, companies that can easily afford to pay their current level of dividends are likely to maintain, or even grow, their shareholder payouts during the current period of economic difficulty. Indeed, there is far less chance of a dividend cut among companies that can cope with stagnant, or even falling, profits on a temporary basis.

Source: Refinitiv as at AM 12 June 2023. Bond yields are weighted average coupon (WAC) of selected bond ETFs as at 9 June 2023 except global infrastructure bond which is 12-month trailing yield. LIBOR is interest rate banks lend money to one another (3 month LIBOR as at 9 June). Best accounts by moneyfactscompare.co.uk refer to Annual Equivalent Rate (AER).

A contrarian approach

Buying unpopular stocks may not feel instinctive to all investors. In fact, adopting a contrarian standpoint may go against their gut instinct at a time when the stock market’s performance is lacklustre, the economy is flirting with a recession and trading conditions are weak for many firms. Ultimately, though, investors who are able to focus on facts and figures, rather than following the emotions of the investment herd, can purchase shares in high-quality companies when they offer attractive yields.

Moreover, buying cheap stocks with high yields can lead to stunning capital returns. As history shows, the economy and stock market have always recovered from their variety of challenges to return to growth. This is likely to prompt higher profitability, particularly among fundamentally sound businesses, as operating conditions improve. In turn, this could boost investor sentiment that translates into higher market valuations.

Rising profits are also likely to equate to growth in shareholder payouts that increases the income return of a dividend-focused portfolio. This could further enhance its total return over the long run.

Taylor Wimpey

FTSE 100 house-builder Taylor Wimpey (LSE:TW.) is an obvious example of an unpopular stock that offers long-term income investing potential. It is a member of this year’s £10,000 annual income portfolio created by interactive investor’s Lee Wild, and, while its shares have risen by 10% year-to-date, they are down 38% in the past five years. As a result, they currently yield 8.2%, while the company’s policy to pay 7.5% of net assets as a dividend each year further enhances its income appeal.

Investors are understandably concerned about the firm’s prospects amid rising interest rates that could suffocate demand for new homes. However, with a net cash position of £864 million and dividend cover of 2.1, its income prospects are more robust than many investors may realise.

The company’s solid balance sheet provides it with scope to strengthen its competitive position through the purchase of land at discounted prices. And with demand for new homes likely to exceed their supply, as per a longstanding trend that has spanned several decades, the company’s operating environment is set to improve over the coming years.

Trading on a price-to-earnings (PE) ratio of just 5.8, Taylor Wimpey’s shares include a wide margin of safety that suggests they offer good value for money.

BHP

Commodity stock BHP Group Ltd (LSE:BHP) has fallen out of favour with investors over recent months. Its shares have declined by 18% since February as investors have become concerned about weak commodity prices that prompted a 27% decline in the firm’s half-year profit, as well as a 40% cut to its interim dividend.

However, even assuming a similar cut will be made to its full-year dividend, the company’s shares still yield around 6.6%. And with the world economy’s growth rate forecast to improve, demand for commodities is likely to do likewise and create better operating conditions for the firm.

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BHP is exposed to long-term growth trends as a result of its focus on future facing commodities, including copper and nickel. They are widely expected to experience rising demand as the world transitions to cleaner forms of energy, since they are used extensively in renewables infrastructure and electric vehicles.

With the company’s net interest payments on debt covered over 16 times by operating profit in the first half of the year, its solid financial position means it is set to successfully ride out present economic weakness.

WPP

Cyclical stocks such as advertising behemoth WPP (LSE:WPP) generally lag the market during periods of economic uncertainty. Indeed, the company’s shares are down by 23% since the start of last year so that they now have a dividend yield of 4.5%.

The company’s net interest payments were covered over six times by operating profit in its most recent full year. This shows it has the financial means to cope with a period of slower growth. And with dividends covered 2.5 times by profit last year, the stock’s income resilience is relatively high.

With a dominant market position, as well as the financial strength to make further acquisitions, the firm’s long-term performance is set to improve as the world economy’s growth rate accelerates. The company’s latest trading statement showed it is on track to meet full-year guidance, with it reporting continued spending among clients.

As with Taylor Wimpey and BHP, WPP’s share price could fall further in the near term should investor sentiment weaken. However, the potential for paper losses should not dissuade income investors from purchasing high-yield stocks that are fundamentally sound and which offer significant long-term dividend appeal.

Robert Stephens is a freelance contributor and not a direct employee of interactive investor.