In terms of the style of investing referred to as ‘growth investing’ the so called ‘father’ of this is probably Thomas R Price Jnr (1898 to 1983). Mr Price believed that when you invest for growth you are typically seeking capital appreciation over the long term and you will therefore choose investments that you believe will exhibit a faster than average increase in share price over the coming years. With growth stocks profits, rather than being paid out to shareholders, are generally reinvested in the company to achieve further growth.
Alternatively the ‘father’ of ‘value’ investing is generally considered to be Benjamin Graham (1894 to 1976). Mr Graham developed the idea of buying stocks below their intrinsic value to limit downside risk and promoted the idea that stocks often trade at prices that do not reflect their intrinsic value. Income investors and value investors both want to own the stocks of established, profitable companies; however, income investors acquire stocks that have a history of paying dividends to shareholders. The general expectation therefore is that income paying stocks are more ‘mature’ than growth stocks, which might be considered the up and coming youngsters, and therefore perhaps more risky as a consequence? Income investors, hopefully, receive money just by holding stocks. Income and value investors are both concerned with a stock’s fundamentals.
When thinking about a potential choice between capital growth and income it must be noted that some investors, such as Warren Buffett, have stated that there is no theoretical difference between the concepts of value and growth in consideration of the concept of an asset’s intrinsic value (see the 1992 Berkshire Hathaway Annual Report for Buffett’s discussion of this). In addition, if just investing in one style of stocks, diversification could be negatively impacted.
So should investors consider growth and income separately?
In my opinion successful investors are like successful generals: they have realistic objectives and a clear strategy. First however investors have to consider what their objectives are?
In terms of objectives these can be many and varied but investors might perhaps use as a useful starting point some age-based generalisations/stereotypes?
The reason for this is that an investor’s age often determines the period over which they are aiming to invest. Thus, younger people are usually at the stage where they are trying to accumulate wealth and can work to a timescale of several decades. As a result they can normally afford to invest for capital growth rather than income and to take some risks with their money. Older people on the other hand, often working to a shorter timescale, will usually be more cautious and they may need to rely on the income from their investments to meet various living expenses or special “treats”. (As I say these are simply starting points and generalisations/ stereotypes.)
The fact is however that in my experience few people fit a stereotype exactly. Individuals are just that and people’s lives are all different and unpredictable. Generally individuals planning for the future will not know if they might get divorced, change jobs or be made redundant. I do not believe that anyone can necessarily accurately predict what their circumstances will be in 10 years time? You can plan but in no way can you be certain. So although it is sensible to have a broad financial plan it is also sensible to have one that is flexible enough to accommodate the unexpected and this generally means having diversified assets.
A stark choice between capital growth and income ignores some very important points. First, inflation can substantially erode the purchasing power of capital, meaning that it is important that income seekers preserve the real (inflation-adjusted) value of their capital (unless of course they are happy to erode capital). Second, an investment can produce very different results, depending on how you use it, how long you hold it for and when you buy and sell it. You could, for example, purchase a growth-focused investment but potentially generate income from it in the future by encashing a proportion of the investment each year to generate income, and that income can potentially be tax efficient if it is within annual CGT exemptions.
Having said that I do accept that for many it is perceived wisdom that dividend paying stocks potentially reduce risk in a portfolio because, for example, with the use of accounting ‘tools’ such as amortisation and depreciation the ‘true’ state of a company may not be as clear as one might at first assume. But if a company is paying a dividend then that is cash that has to be generated. There is also the argument that high dividend companies tend, again as a generalisation, to be in more ‘mature’ industries and are therefore more defensive if markets were to suffer a setback.
I do accept that when considering an investment strategy certain investments are skewed to accentuate one or the other aspect of capital growth or income. It is important to remember however that the yardstick professional investors use when considering performance is generally total return, which includes both capital growth and income. Focusing solely on growth or income can produce, at best, a partial and at worst a misleading picture.
For me the most important initial consideration in portfolio construction is asset allocation or the process of determining optimal allocations for the broad categories of assets (such as equities, fixed interest, cash and property) that suit an individual’s investment time horizon and risk tolerance. We are all aware that studies have shown that this allocation may account for more than 80 per cent of the return of a portfolio. This is because each asset class will generally have different levels of return and risk. This leads to the concept of an ‘efficient portfolio’. An efficient portfolio is one which has the smallest attainable portfolio risk for a given level of expected return (or the largest expected return for a given level of risk). Optimal asset allocation is unlikely to be attained from one fund or from investing simply in growth or income producing assets.
The fact is that even if a client is looking for capital growth it may be appropriate to include in their portfolio income producing assets and to reinvest or accumulate the dividends or interest produced by these assets. Alternatively for someone looking for income do not necessarily ignore growth-focused investments as part of the overall strategy.
In today’s ever changing and evolving world please remember that ultimately investment is an “art” and not a “science”. As US General George Patton once said: “Never tell people how to do things. Tell them what to do, and they will surprise you with their ingenuity.”
Andy Gadd is head of research of Lighthouse Group
Key points:
* The choice between income and growth might not be as simple as one might first think
* Some investors, such as Warren Buffett, have stated that there is no theoretical difference between the concepts of value and growth in consideration of the concept of an asset’s intrinsic value
* When considering an investment strategy certain investments are skewed to accentuate one or the other aspect of capital growth or income
