02 Oct 2020

A new model for income investing

Mark Walsh

Associate Investment Director

Declining dividends push us towards a total returns approach

Here at Investec Wealth & Investment, and indeed the wider wealth management industry, clients tend to be categorised into one of three broad groupings when it comes to their investment objective – to achieve capital growth, income, or a balance of the two.

 

Of these, income investors have arguably been impacted to the greatest degree recently (in the context of one’s investments. Needless to say, there have been those who have suffered far more deeply with the human impact of the pandemic).

The dividends dilemma facing income investors

Historically income stocks have always held a certain shimmer when it comes to building a diversified investment portfolio. Even for those who do not require the income, there is a benefit to collecting the dividend, reinvesting it, and hopefully enjoying some capital growth in the good times too. In the bad times, investors would still, at least, expect to receive the income; one is being “paid to wait” as the common industry phrase goes.

 

Furthermore, the premier UK stock market, the FTSE 100, has historically served up these sort of stocks in abundance – oil and gas, tobacco, and banks are all sectors that have fitted the bill nicely. This all sounds perfectly logical, until that healthy dividend is cut in half or suspended indefinitely, as we have seen in recent months.

This ‘Covid crisis’ has left many investors with no particularly safe place to hide, certainly when it comes to income.
Speculation around sustainability

Yet, arguably, the bigger question is: are these the sort of sectors that are going to thrive in the future, and is being overexposed to them going to be detrimental to the long term performance of your portfolio? Traditional income stocks have vastly under-performed over the last few years, and so income investors have in the most part seen their portfolios lag the performance of the wider stock market indices. Perhaps rather aptly, this ‘Covid crisis’ has left many investors with no particularly safe place to hide, certainly when it comes to income.

Income investing must evolve

So, where do investors go for yield? Interest rates are at record lows and consequently so too are bond yields. Gold has performed strongly but pays no income, and equity dividends are being slashed indiscriminately. Our answer is certainly not to reinvent the wheel but perhaps to amend our perspective slightly on how we view ‘income’.

 

In the very literal sense an investor’s natural income is derived largely from equity dividends and bond interest but the income they take from their portfolio does not necessarily have to come exclusively from these sources. A large number of our clients take their income via a fixed monthly or quarterly standing order. Ultimately that standing order must come from somewhere, and if it’s not funded entirely by natural income then it has to be coming from capital.

 

Historically this has not appealed to investors. Taking the natural income is one thing but once you start eroding the portfolio’s capital you restrict its ability to grow. This remains true, to an extent, but given the discrepancy in performance between traditional income and growth stocks in recent years it is important to look at the wider investment picture.

 

The focus should always be the portfolio’s total return, that is, capital plus income, with a view to maximising this over the long term. This strategy expands the investment universe of suitable investments to include growth sectors and those exposed to favourable global themes. A regular distribution to the client as part of this total return strategy, rather than simply focusing on those stocks that pay the highest dividend, should be the preferred option.

The focus should always be the portfolio’s total return, that is, capital plus income, with a view to maximising this over the long term.
The total returns approach in practice

Let’s take Royal Dutch Shell as an, admittedly rather crude (excuse the pun), example. This stalwart of the FTSE 100 income payers has, until recently, paid a very attractive dividend.

 

Shell has provided a return of -44.70% since the beginning of 2019 to 9 July 2020 including all dividend payments over that period. Amazon has returned +98% over the same period, whilst on paper paying nothing in income. I say “on paper” as clearly a large income could have been taken from that capital growth whilst maintaining portfolio returns far in excess of the equivalent income payer. It would be unjust not to mention that Shell has been significantly impacted by the fluctuations in the oil price over that period, but one could quite easily substitute it for British American Tobacco or Lloyds Bank and receive a similar result. This comparison is of course using the extremes for simplicity, but you see the point – total return should take precedence.

 

To conclude, we are certainly not saying there is no longer a place for high yielding stocks in a portfolio but generally speaking the sustainability of the dividend and more importantly sustainability of the business should outweigh any short term income gain. A wider focus on the overall total return of the portfolio is crucial to its performance. The intricacies of how much income the client requires on a regular basis can then be configured within this main focus and should result in a higher quality, more diversified and well-rounded portfolio.

About the author

To contact or read more about Mark Walsh, visit his biography here.

Find out more

Whether you are looking to invest for the first time, or have an investment portfolio already, if you don’t know where to begin, or know exactly what you are looking for, we can help. Contact your local Investec experts in Cheltenham today, to discover how we can help you to fulfil your financial goals, and live life the way you want to.