1 PLIGHT OF SAVERS
The search for income has intensified in recent years as it has hit home that low growth and low interest rates are here to stay in the developed world. In the UK, the Bank of England base rate has been at an historic low of just 0.5% since March 2009 – and there’s no indication that this will change any time soon.
Darius McDermott, managing director of Chelsea Financial Services, the investment fund broker, says: “Anyone still in cash should really consider taking on a little more risk to get better returns: £10,000 left in cash when interest rates first went to 0.5% is only worth £10,234* today. If the money had been moved to the average UK equity income fund it would be worth £25,669.”
2 GREATER RISK = GREATER REWARD?
Justin Modray, founder of Candid Financial Advice, a recently-launched independent financial adviser (IFA), warns that, aside from shopping around for a better savings account, there’s no magical way of earning more interest: a higher income means taking on greater risk.
“If you can’t afford to lose money then taking risk is probably a bad idea, but if you can afford to risk some money, or already have a portfolio of investments, then other sources of income stack up well versus cash.”
* 9 March 2009 to 9 November 2015. IA Money Market and IA UK Equity Income sectors
3 CAPITAL PROTECTION
This doesn’t mean to say that, by steppingup the risk scale, you could end up losing your shirt: protecting capital is an essential part of any fund manager’s role.
However, equity income managers tend to be more cautious in their choice of stocks, typically looking for those that will provide steady capital growth rather than stellar returns.
For example, during the technology boom in the late 1990s and at the turn of the millennium many income managers avoided speculative technology companies. For a while these funds lagged the stock market as money flowed into the tech sector, but the strategy paid off as investors in equity income funds were shielded from the worst of the subsequent crash.
DEFINITION: defensive stock
A defensive stock is one that provides relatively constant dividends and stable earnings regardless of the state of the overall stock market or wider economy. For example, blue chip pharmaceutical and tobacco stocks are often described as defensive in nature, because people don’t stop needing life-saving drugs or quit smoking when the economy is going through a bad patch. That means these companies aren’t likely to suffer a huge drop in earnings – and will still have cash to hand back to shareholders.
4 LOWER VOLATILITY
While income funds might not shoot the lights out, income-based investing can act as a prop to performance when equity markets are in the doldrums or experiencing huge swings in volatility, as they did in August and September 2015, for example. That’s because many high-yielding stocks – the type that income fund managers tend to hold – are defensive in their nature. A company paying a good and rising dividend often communicates strong financial wellbeing, since dividends ultimately come from earnings and profits. And they are less likely to be dumped wholesale in difficult markets, because the income helps to compensate investors for any loss of capital value. In short, income investing produces an overall total return that is less volatile than the equity market as a whole.
5 SUPERIOR PERFORMANCE
In fact, investing using income as a guide to investment selection almost invariably produces long-term outperformance. Just look at the total returns from the FTSE 100 and FTSE All- Share indices compared with the IMA UK Equity Income index. Over one, three and five-year periods, stocks designed to generate an income have outperformed.
6 POWER OF COMPOUNDING
No other investment has endured quite like equity income. The attractions of equity income remain the same today as they have always done, a key one being the power of compounding. Income investing exploits the benefits of compounding – the earning of returns on returns already made.
In fact, reinvesting income is one of the biggest determinants of returns over time. Say you had bought £100 of gilts in 1899; your investment would be worth just 75p today in real terms if you hadn’t reinvested the income, according to the Barclays Capital Equity Gilt Study 2015. With reinvestment, you would have £457 in today’s terms.
The argument is even more powerful for equities. If you invested £100 in the UK stock market in 1899, it would today have grown to £184 in real terms without the reinvestment of dividends – but a mammoth £28,261 with reinvestment.
You don’t need to invest for more than a century to reap the benefits. The chart below shows the effect of income reinvestment on returns over five years. The blue line shows total returns for the FTSE All-Share index over that period, while the green line includes highlights the extra returns generated by investing for income and reinvesting those dividends.
FAST FACT: compounding A return of 7% when reinvested doubles capital in ten years. A return of 10% when reinvested will accomplish the same goal in seven years.
7 DIVIDEND GROWTH
Dividend growth over the years is vital for income-seeking investors, particularly those facing a long and hopefully fruitful retirement, and many income funds are focused on growing dividends.
Income generation is a hot topic in the financial press, but it is going to become an even more important issue in years to come as the retiring baby boomers inflate the income-seeking population, not just in the UK but throughout much of the developed world and China.
Let’s use a simple example to illustrate the importance of dividend growth. Say a 60-year-old invests £20,000 equally across two income funds. They both yield 5%, so give a starting income of £1,000 per year each.
Fund X increases its payouts by 5% per year, while fund Y manages to increase payouts by 10% a year. By age 75, 15 years later, the significance of this difference is all too clear. Income from fund X, which grew at 5% per year, has risen to almost £2,080 per year; income from fund Y, which grew at double the rate, has soared to £4,180 per year – more than twice as much.
8 INVESTMENT DISCIPLINE
As companies with strong financial wellbeing attract investment, the price goes up and the dividend yield comes down. At this stage an equity income manager will often sell, looking to reinvest in the next high-yielding opportunity. Equity income managers’ strategy therefore causes them to buy shares when they are cheap and sell when they are expensive – one of the cornerstones of successful investing.
9 CAPITAL GROWTH
It is equally important to grow capital where possible. Many income fund managers aim to identify value in areas other investors have overlooked – another key driver of performance.
The tobacco sector is a prime example of an unloved area in which some income fund managers saw potential at the turn of the century. They were handsomely rewarded: between 2000 and 2011 British American Tobacco’s share price surged by more than 780%. With dividends reinvested, the total return was 1,529%. Again, some income fund managers are focusing their attentions on medium sized and smaller companies. Historically such companies were expected to reinvest profits in the business rather than paying them out to shareholders, but canny managers such as Miton’s Gervais Williams are finding valuable income opportunities among these smaller, faster-growing enterprises.
DEFINITION: cyclical stock
A cyclical stock is one that is sensitive to business cycles and whose performance isstrongly tied to the overall economy. Cyclical companies tend to make products or provide services that are lower in demand during economic downturns and higher in demand when the economy is buoyant. Examples include car manufacturers, retailers and house-builders.
10 INFLATION PROTECTION
If your capital doesn’t keep pace with inflation, then its value is clearly being eroded. In other words, it is losing value in real terms. Inflation has not been much of an issue in recent years, but over the longer term it is likely to rise again.
Say, for example, inflation is running at around 2% (the Bank of England’s target rate). If you are a basic-rate taxpayer (paying income tax at 20%), then you’d have to achieve a return of 2.5% on a taxable savings account just to stand still. If you are a 40% taxpayer, you’d need a 3.33% return, and if you’re a 45% taxpayer you would need to earn 3.64% on your cash for it to keep pace with inflation.
Some investments, such as index-linked gilts, promise to beat inflation, albeit not by much.
As dividend-paying shares often offer a growing income plus the potential for capital growth, they can boost your chances of netting an inflation-beating return. In the last three years the average fund in the equity income sector has grown 38.21%- more than six times the rate of RPI inflation of 5.7% over the same period, figures from Chelsea Financial Services show. (Three years to 9 November 2015. FE Analytics UK IA Equity Income, Index UK Price Retail Index).