Income investing: Avoid too much jam

Now, I am not about to argue that income investing is, in itself, a bad thing. But what I am going to advocate is that a focus on this rather than on a balance between income and growth is a bad thing both for companies individually and, perhaps more importantly, for economic growth in aggregate.

We live in an unusual era: wealth is highly concentrated in the baby boomer generation, who are either already retired, or are close to retirement. The skew in wealth towards this demographic has a series of implications and while the populist media like to focus on the social implications of growing inequality and the rich-poor divide, I will focus on something with a potentially greater impact on Western markets and economies: the impact of an ageing and retiring investor base.

The problem as I see it is that as individuals move towards retirement, two things change in their investment requirements: firstly, they require income from their investments to replace the previous income from work, and secondly, but probably equally importantly, their time horizon progressively shrinks: an increasing awareness of their own mortality and consideration of the average life expectancy means that what happens 20 years from now seems broadly irrelevant. In economic terminology, their discount rate increases – they put less value on the future value of their investments and more on the current (realisable) value.

On a personal level these changes simply alter the types of investment that the individual is likely to select – probably lower-risk assets in general, but within equities, a clear preference for higher dividend paying, quality businesses. The problem, however, comes when a large proportion of the investor base (by assets, not number of people) shift to these preferences at a similar time.

The result, as we have seen in the investment industry, is a proliferation of income-generating products – a quick look at the top selling funds in 2012 shows a strong preference by investors for income. But as more and more fund managers build equity products seeking income, and as more and more investors shift into these products, the proportion of the stock market owned by investors seeking income increases. The result is that company chief executives become progressively more incentivised to pay (and increase) dividends – both implicitly (because higher dividends are likely to encourage more fund managers to invest and so push up the share price of their company) but also explicitly (as fund managers demand increase dividends funded by profits).

But if the money is there, why does this matter? Simply, because there are a series of options for chief executives regarding how to “spend” free cashflow produced by the business. Dividends and share buy backs are options, but so too are investments in future growth (whether this be R&D, expansion into different markets, or even acquisitions).

And while there is good empirical and theoretical evidence that a dividend discipline often improves company management decisions on investments, an excessive demand by shareholders for dividends has the potential to push management to forgo investment which while profitable in the longer term may dissatisfy their shareholders by providing less “jam today”.

Is there evidence of this happening in the market? Given current depressed levels of confidence, it is difficult to say, but there is an unusually low level of capital expenditure and investment by corporations, and a preference for both stockpiling cash - cash levels of US corporations are at all time highs (indicating to investors the potential for future higher dividends) and increasing current dividends. Only once confidence returns to equity markets will we be able to judge whether low confidence is masking a shift in management’s attitude towards dividends.

Perhaps the bigger question, that I have only briefly touched on, is why does this matter? The problem is that as more and more potentially profitable investments are neglected by management in favour of increasing shareholder payouts, the potential for future growth is eroded. Over a one or three-year time horizon, or perhaps even on a five-year or more horizon, it could be broadly immaterial. But on a multi-decade view, the effect could become pronounced, with businesses in zero or even negative growth as they suffer from a structural lack of investment in new growth opportunities.

The risk of course, is that all of this potential for profitable investment is “mopped up” by China and emerging markets in general, accelerating the decline of the west. Retirement for a wealthy generation should and need not hasten or exacerbate economic decline, but it does have the risk of so doing.

Taking sensible dividends from companies is a sound investment strategy, but just as you should not kill the goose that lays the golden eggs, investors should be wary of excessive milking

The risk of course, is that all of this potential for profitable investment is mopped up by China and emerging markets in general, accelerating the decline of the west.

James Bateman is head of manager selection of Fidelity’s Investment Solutions Group