Can equities meet the requirement for income?

In the search for income, his cautionary words come to mind: “The first rule of investment is not to lose money. The second rule is not to forget the first.”

With government bonds in overvalued territory and interest payments scarcely matching inflation, the ability to meet a client’s income requirement through bonds has been compromised and there is the prospect of capital loss.

By contrast, equities have become a key asset class in the consideration of income generation. Of course, they represent a very broad field – one that offers temptation to those easily distracted by chasing capital gains.

However, experience shows that following Buffett’s low-risk axiom can generate not just the income stream clients need, but the additional opportunity for good capital growth as well.

An income-bias strategy – one that seeks out sound businesses on reasonable valuations with superior earnings growth, capable of generating the strong internal cashflow generation to enable management to provide a progressive dividend growth policy – can offer surprising returns.

While seeking out portfolio gains, it is important to be equally vigilant in limiting the potential for loss. Avoid falling into ‘value traps’ – buying equities that yield 6 per cent or 7 per cent, as these are often unsustainable. Higher-than-average and static dividend yields may indicate a greater-than-average risk to future income loss and limited opportunities for capital appreciation.

Be mindful of liquidity issues too. Buying high-quality, recognisable equities might sound boring but there will nearly always be a market for these, providing the opportunity to make a reasonably quick exit if necessary.

Two firms – 3i and WPP – offer an illustration of how stocks bought for their strong, growing income appeal can generate capital return and how the combination of growth and income add up.

At the beginning of 2012 both were on attractive valuations and their dividend yields were in line with the FTSE All Share yield, between 3 per cent and 4 per cent. Both offered a story of changing fortunes that held out the prospect for superior returns.

The 3i Group is an international investment company. It had struggled post the financial crisis, but its new management team’s strategy was to rationalise the firm, pay down debt and release value through asset disposals, raising the potential for a growing stream of income and capital distribution.

WPP is the world’s largest advertising agency. It had also been through a tough time, but recovering corporate advertising spend, the growth of digital and WPP’s exposure to emerging markets promised to drive future earnings and dividend growth.

Both companies delivered on their strategies and generated enhanced income and excellent capital growth.

Share prices have recovered significantly and the likelihood of enjoying these kinds of returns again is lessened, but the approach arguably still offers a better chance than most of meeting income objectives, delivering the prospect of capital growth and reducing the risk of losing money in real terms.

John Langrish is chief investment officer at James Hambro & Partners