One of the biggest advantages small investors have is that they are not part of the herd, so it's possible to achieve better than average returns. As retail shareholders, we don't have to answer to an angry client, and our ability to market ourselves does not depend on performing reasonably well every six-month period.
Index funds buy and sell companies in accordance with their size, and therefore achieve slightly under average returns (to account for fees). Many large active funds, especially superannuation funds, tend to charge high fees and basically hug the index – so often do noticeably worse than average over the long term. In comparison, both value investing and momentum investing have been show to produce superior results, though these styles of investing are more difficult to achieve. For those who like to receive ongoing income, dividend-paying companies will be easier to hold for long periods of time, resulting in higher overall returns. If you're looking to buy undervalued dividend stocks, start with these three companies.
United Overseas Australia Limited (ASX: UOS) is a holding company that owns shares in a number of other companies. The main assets are shares of UOA Development Bhd (UOABD), a Malaysian property developer, and UOA Real Estate Investment Trust (UOAREIT), a Malaysian real estate trust, though the ownership structure is ridiculously complex and includes a number of other assets. Both UOADB and UOAREIT trade on the Malaysian stock exchange. Boutique fund manager Tony Hansen has published the preeminent analysis of the company, for those interested.
United Overseas Australia has a very rare characteristic: it trades at well below book value and pays a dividend – it may even be the only Australian company that Benjamin Graham would have considered investing in! According to the Australian market, United Overseas Australia is worth about $588 million. Yet according to the Malaysian stock market, it's worth a lot more than that. Behold these figures (based on the 2013 Annual report):
UOA Development Bhd | UOS Ownership: 68.23%
Earnings: $119 million | UOS Share: $81 million
NTA: $869 million | UOS Share: $592 million
Market Cap: $1,031,770,000 | UOS Share: $703 million
UOA REIT | UOS ownership 46.25%
Earnings: $15 million | UOS Share: $6.9 million
NTA: $216 Million | UOS Share: $99.9
Market Cap: $197,717,000 | UOS Share $91.4 million
The main risk with UOS is that the entire Malaysian property market is headed for a crisis or crash. If that does happen, the company will be in a position to capitalise on the opportunity because it has no significant debt. However, earnings would take a big hit, and the dividend might shrink or even stop temporarily. Given management's great track record I'm inclined to think that even in the worst case scenario, investors could make a good return if they simply continued to hold. Keep in mind that I've only covered two of the company's assets – it also owns (parts of) a number of other properties from which it derives steady income and cash flow.
If you can stomach exposure to the Malaysian property market, then the history of modest share price appreciation combined with a reasonable dividend will be attractive, especially given the apparent margin of safety. It's worth noting that United Overseas Australia sometimes develops former slums: some people may have reservations about that. I can live with that, as all development will upset someone. Clearing slums is nowhere near as bad as dumping dredge in the Great Barrier Reef Marine Park, in my opinion.
A perhaps more exciting option would be to invest in accounting software developer and retailer Reckon Limited (ASX: RKN). Although I don't own shares, Reckon is near the top of my watchlist because of its divided yield of 4.4% and an impressive history of sustained growth, prior to being somewhat disrupted by the switch to software-as-a-service.
Reckon has recently made the decision to develop its own software rather than continuing to pay licensing fees to Intuit. I think that is a dangerous path, but it could well pay off for shareholders. In particular, it seems likely to me that Reckon will be able to continue to provide specialist software to many accountants. At the moment, I'm afraid its retail offering might get caught between a rock and a hard place as XERO FPO NZ (ASX: XRO) and MYOB battle it out. That's what causes me to hesitate and that's probably why the share price has taken a hit.
If you're after sustainable cash flows and a predictable business, it's hard to go past M2 Group Ltd (ASX: MTU). The asset light telco's share price has taken a beating of late, and the stock yields over 4% at current prices. At its most basic level, M2 borrows money to buy customers (that is, it buys other telcos) then profits from improved economies of scale. However, its current high levels of debt mean that – in my opinion – it needs to consolidate a bit before making another acquisition.
M2's most important business is selling broadband connections, and internet customers are generally very sticky – when's the last time you changed your internet provider? As M2 pays down debt, its cash flow improves and it can afford to either make another acquisition or increase its dividend. If the company also manages some organic growth, it's very likely the share price is good value at current prices.
Foolish takeaway
Each of these stocks pays a dividend of over 4% – far better than a term deposit. Of these companies, UOS looks best value, followed by Reckon then M2. Reckon is on my watchlist because if customer numbers grow (despite the competition) then it is currently a clear bargain. I'll be ready when the company next reports (if it's not too late). United Overseas Australia is a stalwart in my portfolio, because I think even if the Malaysian property market crashes (which is possible) the company will survive and probably take advantage of the situation.
