Alternative thinking – income investors should benefit from challenging conventional wisdom

2nd December 2011 by The Value Perspective

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 inherently safe.

There is an enormous concentration of dividend yield in the top 20 UK stocks. These companies are amongst the largest and most well known businesses in the country, but that doesn’t necessarily make them safe. To our mind, safety is about indebtedness, for whilst all businesses can have an accident or fall on hard times, it is usually the companies which have too much debt that never recover.

BP is a great example of this, though not in the way you might think. BP isn’t an example of big stocks being unsafe, but in fact one of a prudent balance sheet ensuring survival. 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 from the Macondo disaster.

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. Debt is no respecter of size or reputation. With too much debt there is simply 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 payout.

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 major 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 the income opportunity and those who are willing to move away from the benchmark will find their opportunity set significantly widened.

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