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Most of the time, investors buy a cheap stock because they’re hoping for the share price to rally. This is perfectly fine. Yet undervalued stocks can also be used when it comes to trying to target a second income. Here’s how.
Falling prices, rising yields
A dividend yield‘s the most common way to compare stocks that pay out income. The calculation looks at the dividend per share relative to the current share price. So let’s say that a share’s cheap due to a fall in the price. One impact of this (assuming the dividend per share hasn’t changed) is that the dividend yield will have risen. Therefore, targeting cheap stocks can provide a potentially enhanced yield for income investors.
However, it’s not as simple as that in practice. Investors need to dig deep to understand if the fall in the stock’s due to internal problems that could cause management to cut the dividend. For example, if the share price has fallen and the company’s struggling to pay debts and has poor cash flow, this wouldn’t be a smart purchase.
Yet if the drop’s due to a short-term factor such as slightly weaker results than expected or as part of a wider sector or market drop, the future dividends might not be impacted.
A property example
Urban Logistics REIT‘s (LSE:SHED) a stock to consider. The share price has fallen by 10% over the past year, helping to push up the dividend yield to 7.21%.
I’d call the stock ‘potentially cheap’ due to the fact that the share price trades at a 34% discount to the net asset value (NAV) of the business. What this means is that the managers have a portfolio of logistics warehouses and other commercial property. At any point in time, this portfolio has a NAV. In theory, the share price should be similar to this NAV. However, differences can happen due to investor sentiment or other factors. But in the long run, the current discount should decrease.
Investors will like the fact that it has high-quality tenants, usually large companies in the logistics space. DHL is the biggest tenant. This should prevent large default risks as these are well-established firms. However, one risk is that it’s quite concentrated on this sector. This is unlike some other REITs that are exposed to a wide variety of commercial tenants.
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Income potential
If an investor took advantage of cheap shares with an average yield of 7%, income could build over time. If £350 was invested each month, after a decade the pot could be worth £61.3k. In the following year, without adding any cash, this could pay out £357 in an average month.
This isn’t guaranteed and peering this far into the future is definitely not an exact science! But the strategy of buying undervalued income stocks can be a winner.
