Two solid income generating stocks

Rarely have there been so many good-quality, cash-generative UK equities offering attractive yields, says professional investor Colin Morton. Here, he tips two such stocks to buy now.

Each week, a professional investor tells MoneyWeek where he'd put his money now. This week: Colin Morton, portfolio manager, Franklin Templeton UK Equity Income Fund.

Since the British government slashed interest rates to a historic low of 0.5%, many income investors have found life difficult. Banks have lowered their rates on deposit accounts, so when you factor in tax and inflation, savers face a significant negative real return. The picture for government bonds is no better ten-year gilts yield just over 2% again offering a negative real return. So what are the options for yield-hungry investors?

In my view, UK equities represent the most compelling asset class for income investors. The average yield on the FTSE All-Share index is 3.4% and in all my time as a fund manager I have rarely seen a situation where there are as many good-quality, cash-generative companies offering attractive yields. This is a unique set of circumstances and a great opportunity for UK equity income investors.

I look in particular for well-managed British companies offering consistent dividend growth. But I am also looking for businesses with the capacity for capital growth. Unfortunately, Britain's economy is still anaemic and the government's austerity measures mean growth prospects will remain limited. However, the good news is the FTSE 100 has evolved to a stage where we are no longer forced to focus solely on Britain.

FTSE 100 companies are increasingly global and able to access the world's growth hot spots. In fact, approximately 60% of revenue made by FTSE 100 firms now comes from overseas business. So Britain's main market offers a healthy proportion of companies that are well-managed, cash-generative and competing on the global stage.

It is these types of companies, offering consistent dividend growth, that I look to buy. I am happy to invest across a diverse range of sectors in the FTSE with a greater emphasis on solid, reliable profit generators rather than cyclical stocks. My biggest overweight sector holdings are in pharmaceuticals, utilities, media, and tobacco.

Currently my biggest holding in the portfolio is Reed Elsevier (LSE: REL). This company brought in a new CEO, Erik Engstrom, in November 2011. Over the last six to 12 months the business has made great strides in aligning itself with shareholder interests.

There are very few high-quality firms operating within this business and I believe the value of many of these assets has not yet been optimised. Trading at a price/earnings (p/e) discount of between 20% and 25% to the rest of the market, this is an attractively valued stock.

The second biggest holding in the portfolio is pharmaceutical company AstraZeneca (LSE: AZN). The fear with all major pharmaceuticals is that their key drugs will eventually come off patent and they will then face severe competition from generics. This is a challenge for AstraZeneca over the medium term, but I think this has been well factored into the price.

On the flipside positives include the financial strength of the company it's a net cash business with no debt. It is also paying a dividend yield of 6% and is returning further cash to shareholders by buying back its shares. Trading on a p/e of seven and at a discount of about 40%-50% to the rest of the market, AstraZeneca is another stock offering compelling value for investors.

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