Income buy tips to generate 4.8 per cent yield

Earnings growth is scarce and, in Europe, the outlook remains uncertain, especially as the UK tries to negotiate Brexit, Italy holds its own referendum (on electoral reform) in December, and a number of countries run elections that could change the course of history.

European earnings are still 30 per cent below their 2007 pre-financial crisis peak, despite a decade of stimulus, and trail everybody else on the global stage. When profits are tallied at the end of this year, they are likely to be at the bottom of the pile, according to UBS.

If things don't pick up, Europe's recovery could age beyond the 15 years it took Japan to get over the bursting of its super bubble in 1989 - despite the region taking longer to react and falling from a higher peak.

This leaves Europe a deadline of five years to drive earnings 43 per cent higher, says UBS. Easy? No. Impossible? Perhaps not.

The investment bank's number crunchers divided the sectors into 'troubled', 'high-flyers' and 'in-between', based on how much profits had recovered from the financial crisis.

UBS's recovery roadmap does not rely on the 10 most-troubled sectors - including the miners, financials, energy, and banks - to claw themselves all the way back to their 2007 peak, although they are expected to contribute most to growth.

Representing two-thirds of the 50 per cent total market profit growth pencilled in by UBS over the next five years, analysts assume profits in the 'troubled' sector surges 36 per cent.

As the 'in-between' sector - including capital goods, transport retail, and media - already sits near 2007 profit levels today, analysts reckon they can grow a further 8 per cent, while the outperforming sky-high sectors - like pharmaceuticals, tobacco and healthcare - may only increase at half trend.

VALUE

With the recovery in US earnings way ahead of Europe, it's no surprise investors flocked to US equities, quickly wiping out any pockets of value.

But Europe hasn't been completely deserted: investors flew to the sectors that could grow during a crisis like moths to a flame. But scepticism over the strength of the region's overall recovery does leave opportunities.

The dispersion of European value - valuation discrepancies - still sits at a 16-year high, so it makes sense for investors to buy cheap stocks within sectors, argues UBS. Value stocks typically outperform by 20 per cent after reaching such elevated dispersion levels.

Investors should keep an eye on the pharmaceuticals sector, which has the widest price-to-book dispersion gap versus March 2009. Food retailers, retailers and banks follow.

But as America's value dispersion gap sits near a 16-year low, investors are unlikely to find cheap stocks within sectors, says UBS. Intra-sector gaps have shrunk, leaving growth cheaper relative to value.

However, if Europe does recover more quickly, its discount to the US will close. Using bottom-up analysis, UBS points to London-listed picks including bookie Ladbrokes Coral, drinks maker Britvic, builders merchant Travis Perkins, and housebuilder Taylor Wimpey.

Security services group G4S, drug giant AstraZeneca, oil major Royal Dutch Shell and mobile giant Vodafone also make the cut.

TOTAL RETURN GAP

Over the last decade, the total return gap between Bunds (German bonds are typically seen as the safest of the safe havens) and Eurozone equities has reached 92 per cent, the largest in the developed world.

Put in perspective, this return level is four times larger than the developed world, 20 times the gap in the US, and almost double the gap seen in Japan.

A recovery in profits alone will not close this gap, but UBS notes a clear link between the two, with profits allowing the market to rerate. As Europe relies heavily on the commodities industry, an improving backdrop will help - oil prices have stabilised and copper, coal and iron ore have jumped recently.

Europe is more exposed to commodity prices than the US: mining earnings matter 10 times more to Europe than the US, says UBS, construction nine times more and energy six times.

So, if the downwards correction really is behind us, as UBS believes, companies in the energy, utilities, mining and construction sectors will benefit. The entire rally will be underpinned by inflation.

HIGHER RATES MEAN HIGHER DIVIDENDS

During periods of low interest rates, investors move to high-yielding bond-like investments for income, including staples and defensives. But yields in these European sectors are typically smaller, with better opportunities found elsewhere.

In Europe, banks make up 14 per cent of total dividends, pharmaceuticals 11 per cent, and insurance and energy both 8 per cent.

Include the income from the banking, insurance, diversified financials and real estate sectors together and financials generate 27 per cent of European dividends.

And when rates inevitably do go up, financials will benefit. Low rates are great for those who have taken out loans, but it means banks make very little.

Their pay-out ratio has already fallen below its 20-year average. However, 'if rates rise sensibly, financial dividends are supported', says UBS.

Prioritising yield, growth and safety, UBS has picked its 35 favourite dividend plays, which 'optimises yield, growth and safety'. The portfolio yields 4.8 per cent and offers an estimated compound annual growth rate of 7 per cent until 2019.

According to its numbers, Taylor Wimpey has upside of 20 per cent to its target price and trades with a 2017 yield of 9.5 per cent, while broadcaster Sky has two-thirds of potential upside, plus 3.2 per cent prospective yield.

Of the consumer staples, Imperial Brands has potential to grow 28 per cent, while yielding 5 per cent. Spirits giant Diageo is tipped to surge by 21 per cent, with a 3.1 per cent yield.

Look at the chart below for a full breakdown of the UBS income portfolio.

This article was written for our sister website Interactive Investor.

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