I wish I had a US dollar for every time an Australian equities fund manager has said to me in the last two years, “With earnings growth hard to come by, investors are focusing on yield.”
Should income investors focus exclusively on dividend yield? Or is this missing the forest for the trees? How should value investing fit into the income investor’s process?
Pre-retirement, an investor may want income strategies to form a defensive part of their portfolio, with the income generated complementing other growth or higher risk strategies in their portfolio.
Post-retirement, there is an array of needs. The income investor may seek to preserve the longer term purchasing power of their income. Growth in that income, and if possible the underlying capital, would still be a priority. Somebody who is deeper into retirement might be less concerned with income or capital growth, wanting just income to live on.
On top of this is the legacy factor. Some retirees set a high priority to ‘leave their portfolio behind’ for a dependent spouse or other family members, or they may have a charitable goal. In these cases, growth is still a priority.
The characteristics of an ideal income stock
In an ideal world, an income stock would provide all of the following characteristics:
- a high dividend yield
- a dividend yield that increases over time
- preservation of capital
- low risk of large drawdowns (decline in value), to avoid sequencing risk
- favourable tax characteristics, full franking if possible
- a high level of liquidity.
The reality is often far different from the ideal. The best future income-producing businesses may have stock which is overvalued, and hence trading on a fairly low dividend yield. In volatile market environments, stable, safe and high quality businesses may also trade at a premium.
Various academics have suggested that dividend yield is a sustainable market anomaly, in addition to more traditionally recognised factors such as value, size and momentum. Whilst this claim is a matter for continuing debate, perhaps we should think of dividend yield as a hybrid market factor, capturing the value risk premium, but adding another dynamic – the ability of the business to produce free cash flow and hence pay out ready income.
A higher payout ratio may in fact reduce the intrinsic value of a business, particularly if that business has the opportunity to reinvest those funds at high rates of return (as explained in James E Walter’s, ‘Dividend Policies and Common Stock Prices’, Journal of Finance, 1956).
Despite this fact, Elroy Dimson, Paul Marsh and Mike Staunton, from the London Business School published a study spanning the years 1900 to 2010 on the returns shown by the lowest to highest yielding markets over time. The results showed a near linear relationship between yield and return, with positive correlation. That is, the higher yielding markets did the best. In their book ‘Triumph of the Optimists’, they stated that the real reason for the superior performance of stocks over other asset classes was the reinvestment of dividends.
But this doesn't help many income investors. Don’t they want to spend the dividends?
Focus on stocks with high rates of reinvestment
I suggest that rather than focusing on high initial yields, there is a far more important driver for income investors and early stage retirees with maybe 20 years or more left in retirement: stocks with high rates of reinvestment. Whilst the income investor is not reinvesting the dividend, the underlying business, if producing high rates of return on assets, is continually growing its capital base by reinvesting retained profits, enabling dividend growth over time.
Presumably, the wish list item of capital growth would be satisfied as long as the market recognises the growth in book value by increasing share prices over time. History has shown that the market usually does reward book value growth.
So what are some of the key things to look for in a stock that has high rates of reinvestment?
Firstly, look at the most recent and 5-year average Return on Assets (ROA). A ROA higher than 15% is good. I prefer to filter on ROA rather than Return on Equity (ROE), as it captures leverage on the balance sheet and thus penalises highly geared businesses. Then, obviously, you need to make a call on whether that ROA can be achieved going forward.
To assess the reinvestment rate, you can apply the following simple formula:
% of profits reinvested = 100% - (dividend yield% x PE ratio)
Whilst these stocks with high reinvestment rates will most likely have a low current dividend yield, their ability to compound book value and grow dividends over time might mean a higher average yield over 10 or 20 years than current high dividend yield stocks.
A great example of this was nine years ago, comparing the yield on CSL with Telstra. CSL was trading at around $5.95 per share after adjusting for subsequent stock splits, and its yield was quite low, 2% or less. However if you still owned that stock today, the last two half-year dividends delivered a yield of around 19.4% on that $5.95 initial purchase price. The dividends have grown so much that it is now an extremely high income producer on that initial price. The simple average of these two yields is 10.7% over the period. CSL’s share price has also gone from $5.95 to $67.55 as I write. The capital investment has multiplied itself 11 times.
In contrast, Telstra at the time was trading around $5.00 on a high yield, and while it is still on a good but lower yield, it has experienced little capital growth, currently trading at $5.19.
Telstra has had minimal reinvestment, due to a high payout ratio, whilst CSL has reinvested substantially in its long term growth. Perhaps CSL was a much better ‘income stock’ (if there is such a thing) than the traditional yield play of Telstra, particularly for the retiree with a long retirement ahead of them. Capital gains could have been harvested along the way also, supplementing that lower initial yield.
Valuation is always important
The other obvious fundamental piece of analysis is to determine whether the stock is initially trading at a valuation discount. If so, this discount should further augment the positive effects of reinvestment and the initial yield. If the stock is currently trading at a premium (which I believe is the case for many such quality stocks at present), then your total rate of return over a 10 year period will be slightly lower if valuations normalise. For investors with a very long holding period, and long retirement ahead of them, this might not be as crucial as it would be to the investor with a much shorter time horizon. A high valuation would however create increased drawdown risk.
So to summarise, the key sources of equity income are:
- the initial yield
- the future growth in dividends, caused by a business retaining profits and reinvesting
- capital gains that may be harvested as quasi income
- franking credits, particularly for the low tax rate investor
- your initial purchase price relative to intrinsic value, as a discount will likely augment total return while a premium will likely reduce it.
Equity income can also be generated by fund managers that employ option writing strategies, but these are complex and require almost a lifetime of experience in options markets to implement successfully. For retail investors who like to participate in the benefits of compounding reinvestment in a quality business, a buy and hold approach is an appropriate investment style.
One final point to note is that the income investor should seek other diversified sources of income which have low correlations to equity market beta. Examples of this might be equity market-neutral funds, or market-neutral absolute return fixed income products.
Matt Olsen is Head of Research at Select Investment Partners.