What matters most when it comes to deciding if a share is right for your portfolio?

Valuation may play a role. The quality of the business may be a consideration. But before you get to those things, it’s important to ask whether the share fits with the financial goal you are trying to achieve.

If your goal is to build a stream of passive income, it’s unlikely that a share with no dividend will fit the bill. Likewise, if you are targeting long-term capital growth, you might lean towards companies that can invest more of their profits back into the business.

This article is for those of you in the income camp.

My source material was Morningstar’s recently updated Australia and New Zealand Best Ideas List. There were quite a few new entrants to the list this time, including two shares forecast to yield over 7%.

APA Group ★★★★

Moat rating: Narrow
Price to Morningstar Fair Value: 0.85 (undervalued)
Forward yield forecast: 7.07%

Morningstar’s Adrian Atkins sees APA Group (ASX: APA) as Australia's premier gas infrastructure company. Gas transmission and distribution is the core business, generating more than 80% of group earnings. Power generation—wind farms, solar farms and gas power stations—contribute about 11%, while electricity transmission, asset management and investments contribute the balance.

APA has a large portfolio of unregulated gas pipelines that serve energy retailers, LNG exporters, and major industrial/mining companies. APA generally earns returns 100 to 200 basis points above regulatory returns to compensate for higher demand risk. By contrast, APA’s electricity transmission and gas distribution networks are regulated, with returns set by the Australian Energy Regulator to provide fair profits after covering reasonable costs.

APA Group's narrow economic moat stems from its unparalleled gas pipeline network, which benefits from efficient scale. Domestic gas markets are served by a handful of pipeline firms, of which APA is by far the largest. New entrants are deterred by high capital costs, while incremental demand growth can be met most cost-effectively by upgrading existing pipelines.

APA Group generally pays out 60%-70% of free cash flow. This relatively conservative distribution policy is appropriate because the current level of free cash flow is not maintainable over the long term without massive investment in new projects. Morningstar forecasts a forward dividend yield of just over 7%. That could be attractive to investors seeking yield, although it should be noted that 2023’s payout was unfranked. You can read more about the impact of franking credits here.

Atkins thinks APA Group shares are worth $9.10 each, compared to current levels of around $8. The shares currently command a four-star Morningstar rating.

Dexus ★★★★★

Moat rating: Narrow
Price to Morningstar Fair Value: 0.66
Forward yield forecast: 7.10%

Dexus (ASX: DXS) is a diversified Australian real estate investment trust (REIT). It generates income from charging rents, managing property for clients, investment services and property development. Rent from office and industrial properties accounts for the vast majority of income, and this is dominated by high-quality office buildings in Sydney.

Dexus having interests in many trophy assets including Sydney’s 1 Farrer Place, and 1 Bligh Street. It also owns or manages a seasoned industrial portfolio, including the massive Dexus Industrial Estate in Truganina, one of Victoria and Australia’s fastest growing industrial precints. It also has a small healthcare portfolio and some retail sites attached to offices it owns. Dexus has sold stakes in several assets into funds management vehicles that it manages.

Morningstar has awarded Dexus a Narrow Moat based on the stickiness of funds in its investment management wing, the company’s smallest but fastest growing segment. Clients face switching costs here as withdrawals come with the prospect of notice periods, exit penalties and potential tax ramifications. Dexus’s trophy Sydney and Melbourne CBD offices also benefit from barriers to entry. While adding new supply isn’t impossible, new developments can take 5-10 years or longer to come to fruition due to hurdles including site acquisition, planning approvals and return requirements.

The group’s office portfolio is currently earning higher-than-market rents, which implies earnings downside as leases expire and tenants negotiate lower rents. However, the average office lease length of 4.5 years gives Dexus time for the market to recover. Morningstar’s Jon Mills thinks that’s likely as people return to the office and several major transport projects including the Sydney Metro are completed. The rise of hybrid working, though, is a wild card.

In the industrial segment, Dexus’ tenants are paying below-market rates and Dexus may be able to implement large price increases when leases expire. Mills also expects the group’s funds management earnings to grow, and notes that Dexus trades well below its net tangible assets of AUD 10.04 per security.

He estimates it trades on a fiscal 2024 distribution yield of 7.1%, which he thinks offers a cushion and good compensation for investors while they wait for a recovery.

A warning on dividend yields

It would feel wrong to bring up dividend yields without mentioning the risks of being seduced by a high backwards looking yield that won't continue into the future. I wrote on how to avoid dividend disaster to help you avoid situations like this.

And as I’m writing about dividends, it would be rude not to mention the work our very own Mr Income, Mark LaMonica. Go here to read why Mark is an income investor. Or go here to see him show you how to build an income portfolio.

Morningstar Investor subscribers can see August 2024's newly updated Australia and New Zealand Best Ideas List here. 

For other undervalued share ideas from Morningstar analysts, take a look at these articles:

But don't forget that individual shares or funds should only be purchased as part of an overarching investment strategy. Here is a step by step guide to building yours.

Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.