Alternative thinking – income investors should benefit from challenging conventional wisdom

By Nick Kirrage.

There are many schools of thought when it comes to income investing but, within them, there are some elements of conventional wisdom that income-seekers would do well to challenge – the first of which is that large, high-yielding companies are safe.

You might immediately point to BP as a glaring example of a large company that suspended its dividend although really that illustrates precisely the opposite point – were it not for the strength of BP’s balance sheet and its conservative approach to debt and financing, it would in all likelihood have gone bust after taking such an enormous hit.

Of course, BP did not go bust and has now reinstated its dividend. However there are a number of other businesses among the UK’s largest companies that appear cheap but have huge amounts of debt. Debt is actually rather perverse because it can help boost a company’s fortunes when times are good but, if something goes wrong – no matter how unlikely that event – it will only magnify the problem and may wipe a company out. With debt there is no margin of safety.

Another idea that needs challenging is that a high yield guarantees an attractive income. This is an issue because, as income investors, we are all looking for a reasonably attractive yield but there is a trade-off here, which involves avoiding companies that offer an attractive dividend yield but, for whatever reason, have no potential to grow that.

What income investors really need to identify is an attractive free cashflow yield as that is what pays the dividend. A business’s ability to grow its free cashflow yield informs its ability to grow its dividend and that is incredibly important over the long term. It is all very well a company paying a 6% yield today but, with inflation at 5%, it is vital that income also has the potential to grow.

As we have argued previously on The Value Perspective, one of the big issues for income-seekers in the UK is the concentration of yield among the largest companies. The top 10 stocks account for 50% of all dividends in the UK while the top 20 stocks account for 70%. Quite simply, there is no similar concentration in any other significant developed-world stockmarket.

Unfortunately, this forces many people to think that, unless they want to diverge completely from their benchmark index, they have to buy these stocks in order to generate a high income. However, we would argue the size of a company does not dictate the size of an income opportunity and those who are willing to move away from the benchmark will find their opportunity set significantly widened.

Sign up for our free email newsletter here, for your chance to win an Amazon Kindle 3G Wifi.

This entry was posted in Dividends, Income, Value Investing, Yield. Bookmark the permalink.
Subscribe Find an Adviser