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Equity Income Investing

An important part of an equity’s return is the annual income it provides. However, in my experience when talking to investors, most people only pay attention to an equity investment’s potential capital gains and ignore the investment’s income. In this post I will provide some historical information and my own opinion why I think this is a mistake.

To provide some perspective on how important income is to a stock’s total return, consider the research on total stock market returns provided by Morningstar/Ibbotson from 1926 through 2009. Morningstar/Ibbotson found the average annual return, assuming the re-investment of all dividends, was 9.8%. Of that total return, the Ibbotson data show, stock capital appreciation accounts for about 5.5 percentage points of the total return and dividends provide about 4.3 percentage points. This means that stock dividend income over this time period has provided almost half (44%) of the total return of the average stock. I think this has real world significance to the potential retiree when you consider today’s volatile markets.

I don’t need to tell anyone reading this blog that stock capital gains are anything but guaranteed. Stock dividends are also not guaranteed, but most companies based in the developed world are extremely hesitant to cut or discontinue a dividend payment. In fact, if a company does cut a dividend payment, this is a sign of real trouble. Cutting a dividend is one of the last things companies want to do because they know it will hurt their stock price. During the 2008-2009 financial crisis not a single company that I held stock in cut their dividend (I had sold all financial stocks before this period). A couple companies did freeze their dividend for a year, but none cut their dividend. However, many of the companies I owned suffered significant stock price declines during this period (and have subsequently recovered). This is why I like dividend paying stocks, because a big portion of the return is very stable. This stability was also a big factor of why I did not panic during the 2008-2009 financial crisis and this allowed me to increase my portfolio value during this period as I discussed in this post. I can tell you from experience, when you are receiving dividend checks every month, it is a lot easier to wait out market down drafts.

So the question is should you invest only in dividend paying stocks (as opposed to non-dividend paying stocks) as the best way to increase your retirement assets? Well, not necessarily, because non-dividend paying stocks (or more commonly referred to as growth stocks) can also deliver good overall returns. Growth stocks, rather than paying out dividends, use the funds to finance organic growth or, perhaps, acquire a complementary company in order to increase its profits. I think growth stocks can have a place in one’s portfolio.

However, as I moved closer to my retirement date, I have been buying almost all dividend paying stocks; I have even changed to a stock mutual fund that buys only dividend paying companies in my retirement account. This is not because I think growth stocks are not a good investment in the next few years. I really have no idea how they will perform. The reason is that I am more interested in reducing my equity risk exposure. In my earlier post where I recommended to “Do the opposite of what everyone else does” I briefly touched on the topic of “growth” investing versus “value” investing and why I practice the value investing style. It is a lower risk style of investing, and as it happens most value stocks are also dividend paying stocks.

Imagine, as you get closer to retirement, that you own a stock portfolio of large established companies that pay an average 3% to 4% dividend yield. Your portfolio would be generating cash flow every month. Wouldn’t you feel a little more confident about retirement than if you owned a portfolio of companies such as Google, Apple, EBay, Amazon, etc. that do not pay any income. These growth companies may end up being very good investments, but they can also be volatile. If you must periodically sell shares of these stocks in order to generate retirement income, you will constantly be struggling to decide what stocks to sell and when. Growth companies should be invested in your long term investment “bucket” to give them time to fulfill their growth prospects. I will be discussing the concept of “buckets” in future posts about retirement income withdrawal strategies.

Dividend stock investing is not a situation where if a dividend yield is good then a bigger dividend yield must be better. If you are buying individual stocks or stock funds that target sectors that pay high income, you still need to do research to determine the quality of the company or fund. Sometimes very high yielding stocks are lower quality companies. As a general rule a stock with a higher income yield such as a utility is usually a slower growing company (meaning that the income growth will also be slower). If a stock has a smaller or no yield, it usually has faster growing earnings. Generally, the total return of a stock will be the income yield plus its projected earnings growth rate. Examples of the typical yield, earnings growth, and total return in three different sectors are provided in the table.

As the top row in the table shows Apple does not pay a dividend, but has huge capital gains potential. The bottom row of the table is Entergy, an electric utility company. Entergy has a higher dividend yield of 4.8%, but the projected annual 5-year earnings growth is only 3% providing for an estimated 7.8% total return. Since Apple has the highest total return at 28% per year, it would appear that Apple or similar companies would be the best to invest in. This may be true, but the 28% annual return is a “projection,” it may or may not happen. There is risk here. However, the other two stocks pay a dividend that has been paid quarterly for over 30 years. It is likely these dividend payments will continue to be paid. This portion of their respective returns has very little risk. Also Heinz and Entergy’s projected 5-year earnings growth is more certain than Apple’s projected growth as based on each company’s earnings history.  So, although there are no guarantees, the lower total annual returns of 10.6% and 7.8% for Heinz and Entergy respectively is more certain than Apple’s 28% projected annual return.

There is always a trade-off between return and investment risk. The higher the potential return, the greater the return uncertainty and investment risk and vice versa. Each investor must make up their own mind on where they fall in this trade-off range when deciding on their investment allocation percentages. Younger investors can invest more heavily in growth companies like Apple, but I think it is best for investors nearing retirement to keep these growth companies to a small percentage of their equity allocation as this will lower your portfolio volatility. At this point in my investing life, I only invest in companies like Heinz and Entergy that pay a dividend. I am more interested in the relatively certain 8% to 11% return of these companies as I am now living on the income they provide.

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