Three mid-cap stocks with high yields and room to grow

Each week, a professional investor tells us where he’d put his money. This week: Mark Wright of Seneca Investment Managers picks his three favourites.

Two crucial observations shape our approach to UK equity investing. Firstly, mid-caps have outperformed both large and small-caps over the long run. Secondly, both high-yield and high-quality stocks outperform mid-caps. So we focus on high-quality and high-yielding mid-caps.

High dividend yields reflect negative sentiment towards a stock and a potential opportunity for contrarian investors. Contrarian investments typically perform well because investors suffer from loss aversion and therefore often ditch promising stocks in a panic. As Warren Buffett says, be “greedy when others are fearful”.

A star in a troubled sector

Babcock International (LSE: BAB) is a top-notch company with a high dividend yield. It has been tarred with the same brush as other support-service companies such as Capita and Interserve, which have all hit trouble in recent years. The company’s valuation has fallen by approximately 60% on metrics such as enterprise value to earnings before interest, tax, depreciation and amortisation.

We believe the company is fundamentally different to others in its sector. It has a very skilled workforce, and these workers are in short supply. The company operates in complex, highly-regulated and often secretive industries (such as nuclear submarines), so it would be hard for potential competitors to gain a foothold in Babcock’s markets.

Contracts are long-term in nature. And unlike many peers, Babcock does not depend on cost-plus contracts with the hope of additional work to earn a decent overall return.

A bank with room to grow

OneSavings Bank (LSE: OSB) is another high yielder, and we believe it is a first-rate lender. The company is well capitalised and thanks to its back-office functions in India it has one of the lowest cost-to-income ratios in the sector. OSB targets niche markets where it has a competitive advantage, such as lending to professional buy-to-let landlords. As a result, it earns an attractive net-interest margin. Combined with its low costs, this means that OSB generates a very high return on equity and is far more profitable than high street lenders such as Lloyds Banking Group.

Asset growth has been strong, despite negative press about the buy-to-let sector, whereas assets have been shrinking at bigger banks. This is exactly why we invest in mid-caps: they have much greater growth potential. OSB does not need the UK economy to expand in order for it to grow its business, but Lloyds does.

A European leader

Phoenix Group (LSE: PHNX) acquires and manages closed life assurance and pension funds; it is Europe’s biggest operator in its field. The stock yields over 8%, despite the company having grown the dividend by more than 3% a year over the last three years.

The acquisition of Standard Life Aberdeen’s insurance business will make the dividend more sustainable by bolstering assets under management. Regulatory costs are steadily increasing, as is the appetite of insurance firms to release capital from their closed life businesses. The acquisition environment is therefore positive, which is why we think more dividend increases are on the cards over the next few years.