Generally in investing, to find the best growth and income stocks, you have to look past the large-caps, to smaller players.
Small-caps usually have more room to grow earnings, and as a result, dividends. When companies reach a certain size, growth starts to slow because there just isn’t more room to get bigger.
For example, for a company like Unilever to be able to grow at 20% or more a year, it would have to find an extra €10.6bn of sales per annum, that’s just under the same value of sales Marks & Spencer produced in the whole of 2016.
However, while most large-caps are unable to achieve double-digit growth rates, there are some exceptions. Specifically, I believe that Lloyds (LSE: LLOY) and Vodafone (LSE: VOD) could both achieve double-digit returns for investors over the next few years, making them perfect picks for your portfolio.
Vodafone has been undergoing a huge overhaul of its business in recent years. These changes have held back growth, but they now seem to be paying off.
Last week, Vodafone’s shares surged after management announced that the firm’s earnings before interest, tax, depreciation and amortisation would expand 10% next year and free cash flow would exceed €5bn, easily covering investment spending and an expected dividend outflow of €3.9bn.
With earnings and cash flow growing again, sentiment towards Vodafone is already improving. The shares are up around 10% since the beginning of the year and should continue to move higher as income seekers return.
Vodafone trades at a forward P/E of 29, which looks expensive, although I believe it is more appropriate to value the stock on its dividend yield. With a yield of 5.9% the shares look both undervalued, and attractive. If the payout returned to the market average of around 3.8%, the shares could be worth around 350p, 59% above current levels. Finding such a tremendous opportunity with a defensive income play like Vodafone is rare.
Returning to growth
Like Vodafone, Lloyds has transformed itself during the past few years. The bank’s recovery from the financial crisis is now largely complete and management is concentrating on growth, as well as returning capital to investors.
City analysts expect shares in Lloyds to yield 6.1% for 2017 and 6.7% for 2018. At the same time, the shares look to be severely undervalued as they trade at a forward P/E of only 8.2.
Using the same valuation method as Vodafone, if Lloyds’ yield returned to the market average, the shares could be worth as much as 105p, 59% above current levels. And even if the market does not bid the shares up to this level, investors will be well rewarded with the 6.1% payout.
As one of the UK’s four main high street banks, there is some concern that Lloyds might suffer if the UK’s decision to leave the EU leads to an economic crisis. While this is a very real risk, the bank’s Tier 1 capital ratio of 13.5%, as reported at the end of the first half, gives it a large financial cushion to weather any economic storm.
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Rupert Hargreaves owns no stock mentioned. The Motley Fool UK has recommended Lloyds Banking Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.