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2 mid-cap dividend stocks with 25%+ upside

Dividend shares which offer over 25% upside potential may sound unlikely. After all, many investors view stocks with high yields as purely defensive, low-growth opportunities. However, this could not be further from the truth. Certainly, some higher-yielding shares offer stability rather than high earnings growth potential. But here are two mid-cap stocks which appear to have a potent mix of income and growth appeal.

A challenging period

The share price performance of retailer Dunelm (LSE: DNLM) has been hugely disappointing in the last year. It has fallen by 35% and shown little sign of any recovery potential. The company’s sales are expected to be negatively affected by Brexit, with higher import prices contributing to an increasing inflation rate. This could mean that non-essential purchases are postponed or avoided altogether. Since many of Dunelm’s products fall into that category, its near-term outlook is somewhat uncertain.

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In fact, in the current financial year Dunelm is forecast to record a fall in its bottom line of 10%. However, it is due to reverse this with growth of 14% next year. This means that its dividend should still be covered 1.6 times by profit in the next financial year, which makes its yield of 5% seem all the more enticing.

Added to this is a valuation which indicates there is at least 25% upside potential. Dunelm trades on a price-to-earnings (P/E) ratio of 14, which is lower than its historic average P/E ratio of 18.6. If it is able to meet its guidance over the next two years and its P/E ratio reverts to its long-term average, the company’s share price could move as much as 50% higher. Assuming a margin of safety given the uncertain outlook for the UK economy, a gain of half that appears to be relatively likely.

Changing industry

Regulatory change has caused IG Group‘s (LSE: IGG) share price to fall by 44% in the last six months. Restrictions on marketing and advertising could cause the CFD/spread betting industry to experience a more difficult period in future. However, IG Group has a size and scale advantage over many of its peers and it should therefore be able to better cope with external challenges faced by industry operators.

In terms of its dividend, IG Group currently yields 6.5%. This is among the highest yields in the FTSE 250 and since its shareholder payouts are expected to be covered 1.3 times by profit in the 2019 financial year, they appear to be sustainable.

Alongside this, IG Group is expected to record a rise in earnings of 6% in 2019. With its shares trading on a P/E ratio of 11.9 versus a historic average of 15.6, there is scope for a 25%-plus share price rise. For this to take place, the company’s shares would need to revert to their long-term average P/E and IG Group would need to meet its guidance over the next two years. Given how quickly the outlook can change within the financial services sector, there seems to be a good chance of this occurring.

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Peter Stephens owns shares of IG Group Holdings. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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