Don’t overlook Legal & General’s capital growth potential while it trades at a bargain price

The diversified financial services company’s low share price is difficult to justify given its potential long-term prospects

The FTSE 100’s dire performance over recent years means that income investors can obtain sky-high yields from dirt-cheap stocks. The index currently yields 3.9pc but a substantial number of its members are offering income returns well in excess of 5pc.

This in itself may be sufficient to tempt some income investors to purchase a range of large-cap shares. However, in Questor’s view, cheap FTSE 100 incumbents offer far more than just a generous yield. Their bargain basement prices mean that they have significant capital growth potential over the long run.

While obtaining a larger portfolio in monetary terms may not be the primary objective of most incomeseeking investors, since they are naturally more likely to focus on dividends, a bigger portfolio makes the task of generating an attractive income much easier. Legal & General, for example, is among the FTSE 100’s highest-yielding stocks. New investors in the diversified financial services company can obtain an income return of 7.8pc at present, which is twice the yield of the index.

Furthermore, the firm has an excellent track record of dividend growth. Shareholder payouts have risen by 18pc over the past four years and been highly reliable, with no cuts or cancellations taking place during even the darkest days of the pandemic. In the 2022 financial year, meanwhile, dividends were covered nearly twice by the company’s earnings. This shows they were relatively affordable, with dividend growth expected to amount to 5pc in the firm’s most recent financial year.

Crucially, though, Legal & General’s share price could move significantly higher over the coming years. It has an extremely low valuation, with its shares currently trading on an earnings multiple of 6.5 having risen at an annualised rate of just 1pc in the past decade. This dirt-cheap valuation is set to become increasingly difficult to justify given the firm’s upbeat long-term outlook.

Its investment management division is set to benefit from interest rate cuts and an improving economic performance. They are likely to positively catalyse company earnings, investor sentiment and asset prices, which means higher management fees for Legal & General.

Similarly, the company’s exposure to the economy through operations such as its property arm means it is well placed to capitalise on a return to stronger economic growth amid an era of more dovish monetary policy.

Legal & General is also making encouraging progress in its pension risk transfer (PRT) business. This is essentially an insurance policy provided to defined benefit pension schemes that guarantees retirement benefits will be paid. The company, in a recent update to investors, said it is expecting 2023 to have been a record year for PRT premiums after securing its largest ever single transaction.

Although impending interest rate changes could impact future PRT demand, since they will almost inevitably affect the funding position of pension schemes, there is nevertheless a large addressable market in the UK and elsewhere that provides significant growth opportunities.

Of course, the company’s change in chief executive this year represents a substantial risk to investors. As this column has previously highlighted, the preceding chief executive had an excellent track record of delivering strong financial performance and high shareholder returns.

However, the stock’s ultra-low valuation means that it offers a wide margin of safety. Since being added to our income portfolio just over seven years ago, Legal & General’s share price is practically unchanged. While this is disappointing, our notional holding has generated an income return of around 49pc. Therefore, it has achieved its primary goal of providing a generous and reliable income over a multi-year time period.

For some income-seeking investors, a repeat of this performance in future years will be viewed as sufficient. After all, their main aim is to obtain a high and growing income that allows them to at least maintain their present spending habits over the long run.

However, due to its unjustifiably low valuation, Legal & General also offers significant capital growth potential. Alongside a variety of other dirt-cheap FTSE 100 stocks, it could propel dividend-focused portfolios to vastly greater monetary values that make the task of generating a worthwhile income far easier.

‘For some income seeking investors, a repeat of an income return in the region of 49pc will be viewed as sufficient’