5 Undervalued Income Stocks to Beat 4% Inflation

We reveal 5 undervalued income stocks that will help investors protect themselves against the higher inflation forecast

Karen Kwok 3 November, 2016 | 12:02PM
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Inflation will grow to 4% in 2017, four times higher than the current level, the National Institute for Economic and Social Research said on Wednesday.

Inflation will “accelerate rapidly” thanks to the “most striking feature” of the Brexit vote: the depreciation of sterling, the institute said. Sterling is now 20% lower than its value at the end of 2015.

The report predicted that inflation would not rise to the Government target of 2% until 2020. The NIESR said this expectation would keep the Bank of England from making any changes to its policy stance until the second half of 2019, when it would start tightening.

In September 2016 the consumer price index measure of inflation rose by 1%, compared with a 0.6% rise in the year to August, according to the Office of National Statistics.

“While we expect this to be only a temporary phenomenon, it will nonetheless weigh on the purchasing power of consumers over the next couple of years,” said Simon Kirby, Head of Macroeconomic Modelling and Forecasting at NIESR.

Slow UK GDP Growth in 2017

In the third quarter – the three months to the end of September, UK GDP growth was 0.5%, according the Office of National Statistics. The NIESR said growth “was more robust” than they expected, and have revised up their GDP forecasts to 2% in 2016.

“The positive outcome for GDP growth in the near term are very welcome, but this gives little to no guidance as to what will be the long run impact from leaving the EU will be,” Kirby said.

The robust consumer spending that is currently supporting overall economic performance is expected to slow over the course of 2017, and the NIESR expects UK ecomomic growth to slow to 1.4% in 2017.

Despite inflation forecasts being revised upwards, interest rates remain at a record low level of 0.25%. This is bad news for savers as prices are set to raise, said Danny Cox, chartered financial planner at Hargreaves Lansdown.

5 Undervalued UK Income Stocks

Investors can protect themselves against higher inflation with income paying stocks, said Adrian Lowcock, investment director at Architas.

Using Morningstar Select, we screened for UK stocks that offer a yield of more than the inflation forecast of 4%. They are all rated four-star by Morningstar analysts, meaning analysts believe the shares are trading below their current fair value estimate. Because of the undervalued nature of these stocks, investors should question the sustainability of these dividends.

Pearson (PSON) currently yields 6.9%. Morningstar analysts continue to believe that the company’s continued focus on education and emerging markets should provide long-term growth drivers.

Pearson has been active in returning capital to shareholders, with an average dividend payout ratio of 60% over the past decade, said Morningstar equity analyst Michael Field. Management has committed to continuing the level of dividend payout despite the ongoing restructuring program as an indication of its expectations for the business. 

Given the recent cash inflow from divestments and the reasonably healthy state of Pearson’s balance sheet, analysts believe the company is perfectly manageable to maintain the level of dividend pay-out.

Analysts expect that the company in its new form will continue to be active in returning capital to shareholders. The stock rises 2.7% year to date.

Centrica (CNA) yields at 5.6%. The stock is down 3% year to date. Despite Centrica’s decision on a 30% dividend reduction in 2015 after a sharp decline in earnings, Morningstar equity analysts believe that Centrica could begin to increase its dividend again starting next year.

“In May 2016, Centrica issued approximately £700 million of equity, with roughly 50% to be used to reduce debt. The other 50% will be used for two acquisitions. These two actions should repair Centrica's balance sheet over time,” said Morningstar analyst Charles Fishman.

However the company continues to face challenges due to the competition in the retail energy business. Low electricity prices continue to pressure earnings from Centrica’s UK power plants as well, said Fishman.

GlaxoSmithKline (GSK) yields at 4.9%. The stock is up 16.8% year to date.

The company’s dividend is under pressure with the majority of earnings going to fund the dividend, opening up the risk of a dividend cut, Morningstar analyst said.

Like all pharmaceutical companies, Glaxo faces risks of drug delays or non-approvals from regulatory agencies, an increasingly aggressive generic industry, and competition in the pharmaceutical industry, Damien Conover, director of healthcare equity research and equity strategy for Morningstar said.

However, Conover believes as Glaxo is strategically branching out from the developed markets into emerging markets, the fast-growing emerging markets will help support long-term growth and diversify cash flows beyond developed markets.

Aviva (AV.) yields at 4.3%. The stock is down 14.9% year to date.

The company reduced dividends to shareholders to retain more cash. It seems to have had a positive impact on the company’s financials, with capital surplus more than doubling and cash remittances continuing to improve, said Stephen Ellis, director of financial services equity research at Morningstar. As a result the improving cash flows might help increase the sustainability of dividend pay-out to shareholders.

“Aviva has trimmed a lot of weight and, as a result, has a sharper focus on balancing near-term growth and long-term profitability,” said Ellis.

Sky (SKY) yields at 4%. Sky has been spending much of its free cash flow on building up its broadband and telephony business, said Allan C. Nichols, senior equity analyst at Morningstar. Nichols expects that these divisions will require less capital going forward, potentially freeing up more cash flow for debt reduction. The stock losses 26% year to date.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
Aviva PLC481.30 GBX0.33Rating
Centrica PLC122.75 GBX2.12Rating
GSK PLC1,480.00 GBX-1.66Rating
Pearson PLC1,027.50 GBX0.64

About Author

Karen Kwok

Karen Kwok  is a Reporter for Morningstar.co.uk

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