The UK equity market is "undervalued", according to Neil Woodford. In a recent article, the fund manager said that the fact he's able to build a portfolio offering a 5% yield for his new Income Focus Fund "is evidence of this undervaluation".
Unlike many of his peers in the fund management sector, Mr Woodford publishes full details of all his funds' holdings at the end of each month. His team also provides a monthly round-up of portfolio changes that's published on his website.
The Income Focus Fund is still in its launch period, so this information isn't yet available for the new fund. But based on his existing holdings and previous comments, I think there are several stocks investors can be confident of seeing in the newcomer.
A key holding
Woodford Funds is already the third-largest shareholder of Legal & General Group (LSE: LGEN), with a 5% stake worth £729m. But I feel certain that this stock is also likely to be a major feature of the new Income Focus Fund.
Legal & General has long been one of Mr Woodford's top stocks. And it's easy to see why. The group is very profitable and generates a lot of surplus cash. Much of this is returned to shareholders through dividends. The stock currently offers a forecast yield of 6.2%.
The shares are cheaper than you might expect for such a profitable business. Legal & General generated a return on equity last year of 19%. And despite the group's profits rising by an average of 11.5% per year since 2011, the stock currently trades on an undemanding P/E of 11.
I believe Legal & General remains a compelling buy for income and long-term growth. I'd be very surprised if it isn't one of the top five holdings in the Woodford Income Focus Fund.
A profit maker for the fund?
Shares of outsourcing group Capita (LSE: CPI) have fallen by 47% over the last year. But this struggling firm is a top 10 holding in the Woodford Equity Income Fund. Woodford Funds is Capita's second-largest shareholder, with a 10% stake worth about £375m.
The fund averaged down its holding last year, buying more stock after the share price collapsed. In a blog post on the Woodford Funds website in January, Capita shares were described as trading "way below the intrinsic value of the business".
Capita's recent 2016 results suggest to me that Woodford's confidence will eventually be rewarded with healthy profits. Underlying earnings fell by 20% to 56.7p per share, but still provided a decent level of cover for the 31.7p per share dividend. Encouragingly, this payout was also covered comfortably by the group's adjusted free cash flow of £409m.
The main risk remaining for equity investors is Capita's net debt of £1.8bn. It hopes to address this problem by selling its Asset Services and Specialist Recruitment businesses during 2017.
It currently trades on a forecast P/E of 10, with a dividend yield of 5.7%. If Mr Woodford believes this dividend can be maintained, then I believe the stock is a no-brainer for the Income Focus portfolio. Aside from its income potential, it might also prove to be a very profitable turnaround buy.
These stocks could be 5% buys
Capita and Legal & General aren't the only big-cap stocks with the potential to provide a reliable 5% yield. I suspect Mr Woodford will buy at least two of the companies featured in our latest retirement investing report, 5 Shares To Retire On.
The stocks featured in this new report share many of the quality characteristics which Mr Woodford looks for in new buys.
The good news is that this report is completely FREE and carries no obligation. To download your copy today, simply click here now.
Roland Head owns shares of Legal & General Group. The Motley Fool UK has no position in any of the shares mentioned. 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.