Income investors are always looking for ways to enhance the yield in their portfolios, but Quilter Investors’ CJ Cowan explains how the choice of income stream can tilt your portfolio in ways you might not expect.
When investing to deliver a natural income, it is crucial to consider more than just the headline yield figures of your underlying holdings. In particular, you should note both the sustainability of your income streams and the potential for dividend growth.
Investing with an income focus will tend to introduce a style bias to your equity allocation, structurally tilting the portfolio towards value and quality stocks and away from growth stocks.
Value investments are favoured because stocks that are trading at low multiples will likely have particularly high dividend yields. Indeed, the three variables considered for inclusion in the MSCI World Value Index are: price to book value; price to (12 months forward) earnings; and dividend yield itself. The first two you want to be towards the low end of the scale and dividend yield of course should be at the high end.
Quality, as an investment factor, features prominently in income portfolios because a high return on equity, stable earnings growth and low leverage are all eminently desirable traits in a company hoping to deliver a sustainable dividend.
In contrast, growth stocks typically pay out very small dividends or none at all as their earnings are all reinvested into the company. The primary source of value attributed to the stock is in the growth in earnings that will hopefully be delivered in the future.
The traditional way to value a financial asset is to discount its future cashflows into present day money using the current interest rate. For equities you might use earnings or dividends as well as a terminal value for the stock.
A higher discount rate (derived from prevailing interest rates) means every future pound is worth less in today’s money. For this reason, assuming earnings themselves stay constant, rising interest rates will automatically devalue a company’s future earnings expressed in today’s terms. In particular, this affects the price of growth stocks, since such a high proportion of their value is derived from growing future earnings.
Assessing income potential
Over the past decade growth has consistently outperformed value, helped in part by the regime of low global interest rates that helped fuel the broad-based equity rally by sustainably reducing the discount factor.
Many question how much longer this can continue. Relative valuation of value versus growth stocks is as stretched as it has ever been and in developed markets, with the exception of the US, interest rates seemingly cannot go much lower.
At the beginning of September 2019, we saw a sharp reversal of this long-term trend, as value suddenly outperformed growth. Some attributed this to a bout of profit taking from investors who had ridden the growth wave, but it occurred at the same time as a rapid back-up in US Treasury yields, which was likely a contributory factor.