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5 criteria for choosing high-yield stocks

Christine St Anne  |  09 Nov 2012Text size  Decrease  Increase  |  

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Christine St Anne is Morningstar's online editor.

 

The Morningstar Income Equities Model Portfolio has achieved stellar returns, generating 9 per cent per annum in excess of the market over the last three years.

The portfolio is index unaware, which means its sector weightings are not influenced by their weightings in the index. Rather, the portfolio includes quality businesses. Morningstar looks to choose these stocks at healthy discounts to fair value.

The processes behind choosing companies that fit into the portfolio focus on robust cash-generating businesses that deliver sustainable quality dividends to investors, according to Morningstar senior resources analyst Mathew Hodge.

"In a nutshell, we are looking at quality companies that can generate good yields that are sustainable," Hodge says.

Hodge says there are a number of boxes that these stocks need to tick in order to be included in the income portfolio:

1. Moat rating

Morningstar applies a moat rating to stocks that have a competitive advantage in their sector. A moat can take many forms.

For example, in resources, a company may be a large, low-cost producer with high margins. This gives a company a high margin of safety if prices for its products fall. Another company with a moat is Woolworths (WOW).

Higher margins allow these companies to generate healthy cash flows, which flow back into relatively high and sustainable dividends.

It is worth noting that a number of large resource companies also have a moat rating. However, Hodge says that given the nature of the resources industry, these companies tend to reinvest excess cash into capital expenditure projects rather than increase dividends to shareholders.

"These companies will most likely fall into the growth category rather than into an income portfolio unless their position changes," he says.

Premium subscribers can access an in-depth report on Morningstar's moat ratings here.

2. Capital preservation

Hodge says capital preservation is a key attribute when building a quality income portfolio. The portfolio generally shies away from stocks with high price-to-earnings (PE) ratios.

A PE ratio measures the relative value of a company. A high PE valuation means a stock is more expensive than a stock with a lower PE ratio.

"If a company has a high PE, the market expects future growth to be better and there is uncertainty around that. This will impact the ability of investors to preserve their capital if market expectations or the growth outlook changes," Hodge says.