Dividend returns are attractive Investors often place a high emphasis on generating income from their stock portfolio. The advantages of doing so in Australia are enhanced by the franking credit regime which eliminates the double taxation of dividends in shareholders hands. The resulting gross dividends can translate into strong returns for investors seeking to earn better returns than cash or term deposit rates. The model portfolio has a higher net dividend yield than the S&P/ASX200 Index and is then boosted by franking credits Australian shareholders have been spoiled over many years with regard to the income return generated by their stock portfolios. Not only has the equity market continuously paid a higher average yield of around 5.0% on industrial stocks than the MSCI World index return of 2.9%, but the franking credit regime has super-charged returns. In this note, we have extracted a selection of stocks from the Fat Prophets Portfolio that we believe would constitute the basis for a basic yield portfolio. We have also suggested one or two alternatives/additions that are not currently recommended or held in the portfolio. Our selection principles are not simply based on the current dividend yield but incorporate the following factors: Dividend yield

Franking credit balance and ability to fully frank dividends Board dividend policy Payout ratio Sustainability of dividends Growth capacity of dividends On that basis, we suggest the following portfolio as a basic income portfolio:

The model portfolio has a higher net dividend yield than the S&P/ASX200 Index and is then boosted by franking credits available to generate a gross yield of 9.6% in the current financial year. Members will notice the predominance of financial and industrial companies in the portfolio and a distinct lack of resource and energy stocks. The former groups are generally very good dividend stocks while the latter are generally very conservative with regard to payout policies. That is not to say that resource companies do not place a high degree of importance on shareholder returns. Our criteria for the income portfolio focuses on dividend payments but these are not the sole source of shareholder returns. Capital management more broadly can include share buybacks and capital returns with which resource companies are becoming increasingly active. The S&P/ASX 200 Index has a wide spread of yields according to sector, ranging from 2.6% in the energy sector to 8.4% in the telecommunications sector. According to the IBES consensus forecasts, the S&P/ASX 200 Index has an average dividend yield of 5.1% which is marginally above the 5.0% average interest rate for a 12-month bank term deposit. The range of sector yields is shown in the following chart:

Financials The bank sector is the best known for paying very good dividends and hence the yields are highly attractive. Our preference in this sector is for ANZ, Commonwealth Bank and Westpac, but from an income perspective, the National Australia Bank is a valid alternative. We have not included any of the smaller regional banks as we believe their earnings and dividends are under intense pressure. The yields within the major banks are quite similar as shown in the next table:

Although the bank sector is experiencing low earnings growth this year due to higher funding costs and low credit growth, the sustainability of dividends in this sector is quite dependable. We have included AMP and IOOF within this sector for their similarly attractive yields but also for our positive view on the underlying stocks. Industrials There is a broad array of companies in this list but the common theme is one of solid business fundamentals. Myer recently trimmed its interim dividend but we believe the company has set the business up very well for when retail sales turn the corner. In a similar vein, Telstra has reset its business after several years of uncertainty surrounding the introduction of the National Broadband Network. It now has a durable

earnings growth path and is even contemplating capital management initiatives beyond its impressive dividend payment. Wesfarmers and Woolworths have their respective food and liquor businesses as the firm basis for their dividend payments. Both companies have a mixture of staple and discretionary consumer businesses but both have excellent cash flow. Wesfarmers does have exposure to a range of other industries but we do not see this as a limiting factor with regard to its dividend payments. More generally, all of the industrial companies included in the portfolio have the same feature of good cash flow. This is an essential factor for companies to sustain and grow their dividend payments to shareholders. If cash flow gets squeezed as capital expenditure grows or operating earnings are crunched, then there will be pressure on the dividend. Property Property Trusts have always been a favoured sector for income stocks as they also pay attractive distributions. That is because as long as the Trusts fully distribute their net income, the distributions are tax free in the hands of investors. In effect, this is equivalent to a fully franked dividend. The BWP Trust was formerly the Bunnings Warehouse Property Trust which owns most of the property of the Bunnings Warehouse business. As the BWP Trust, it is now expanding beyond the Bunnings properties but sticking with the same successful bulky goods retail property category. All of its 70 properties are within Australia. The Westfield Retail Trust requires little introduction to most people who are familiar with the 54 shopping centres owned by the Trust across Australia and New Zealand. Risks The risks include the performance of the stock which can result in dividend cuts as seen in the recent results period. Even the banking sector has not been immune from this in the past, as shown in the next chart:

The dip in dividend payments was of course wholly attributable to the global financial crisis which forced a sudden adjustment to all banks capital positions and hence their dividend payments.

The Australian retail banks have recovered very quickly due to their excellent capital positions prior and subsequent to the GFC and their limited exposure to the factors that caused other major international banks to falter. There is also the potential for Boards to alter dividend policies although this is rare. Summary A stock portfolio that generates an attractive level of income without taking undue capital risk is achievable in the Australian market. Our suggested portfolio in this note is an aggregation of stocks that we consider fulfils our requirements for such a portfolio. The yield available from this portfolio substantially exceeds that from the S&P/ASX200 Index and also that of the 12-month term deposit rates available from the major retail banks. DISCLAIMER Fat Prophets has made every effort to ensure the reliability of the views and recommendations expressed in the reports published on its websites. Fat Prophets research is based upon information known to us or which was obtained from sources which we believed to be reliable and accurate at time of publication. However, like the markets, we are not perfect. This report is prepared for general information only, and as such, the specific needs, investment objectives or financial situation of any particular user have not been taken into consideration. Individuals should therefore discuss, with their financial planner or advisor, the merits of each recommendation for their own specific circumstances and realise that not all investments will be appropriate for all subscribers. To the extent permitted by law, Fat Prophets and its employees, agents and authorised representatives exclude all liability for any loss or damage (including indirect, special or consequential loss or damage) arising from the use of, or reliance on, any information within the report whether or not caused by any negligent act or omission. If the law prohibits the exclusion of such liability, Fat Prophets hereby limits its liability, to the extent permitted by law, to the resupply of the said information or the cost of the said resupply. As at the date at the top of this page, Directors and/or associates of the Fat Prophets Group of Companies currently hold positions in Avexa (AVX), Evolution (EVN), Cerro Resources (CJO), Energy Action (EAX), Mt Isa Metals (MET), Telstra (TLS), Woodside Petroleum (WPL), ANZ (ANZ), Austar (AUN), Carsales.com (CRZ), Gold Road (GOR), IOOF Holdings (IFL), Magellan Financial group (MFG), Paladin Energy (PDN), QBE Insurance (QBE), Platinum Australia (PLA), Datasquirt (DSQ), Hodges Resources (HDG), Newcrest Mining (NCM), Oil Search (OSH), Zambezi Resources (ZRL), Auroa Minerals (ARM), Billabong (BBG), Pioneer Resources (PIO), Runge (RUL), Westpac (WBC). These may change without notice and should not be taken as recommendations.

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