Which investment strategy has proven to provide the best risk/reward balance for the income-seeking investor over time? You may be surprised.
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Yield or Growth?
By Greg Peel
The biggest challenge for retirees relying on their investments to provide income has, since the GFC, been a low interest rate environment stretching much further than was anticipated at the time. Investment in traditional safe income producers such as term deposits and government bonds simply do not offer a sufficient income stream.
This has forced investors into the stock market to a greater extent than they would otherwise feel comfortable with on a capital risk basis. Bank deposits and government bonds are considered “risk free” on a capital preservation basis. As the GFC proved, clearly equities are not.
The challenge for super investors is therefore to find the most comfortable balance between risk and income. To that end such investors will steer clear of growth stories that may be exciting but of little value, and of great risk, if that company does not pay dividends or pays only negligible dividends. The primary target must be dividend yield.
Yield stocks can be divided roughly into two categories: high yield and yield growth.
The first category contains those stocks paying a high dividend yield but offering minimal dividend growth. It includes stocks that for one reason or another have been beaten down, but as a result, yields on offer are very attractive. These are known as “value” plays.
The second category contains those stocks that pay a modest dividend yield but offer greater growth potential. These tend to be companies operating in industries that exhibit low cyclicality – they tend to plod along regardless whether the economy is performing well or not. They may not grow fast but they do grow, and they offer reliable cash flow to underpin dividend payments. These are known as “growth” plays.
It should be pointed out here than many an investor fails to appreciate that a quoted yield at any time, be it historical (looking back over twelve months) or forward (looking ahead over twelve months), is based entirely on today’s share price. The yield the investor actually receives is based on the share price paid on purchase.
Thus a stock showing a historical yield of 10% will not be paying 10% if the investor bought ahead of a large fall in share price. A stock showing a forward yield of 4% could be generating 7% for an investor who bought a year ago, ahead of a steady share price climb.
Which should the super investor target in order to provide the income required to fund lifestyle into the future?
That is the question asked by Rosenberg Equities’ deputy head of research, Michael G. Kollo PhD, in a paper entitled Hunting for Yield or Hunting for Growth?
To begin with, Kollo points out it is unfeasible to believe an investor can find one stock that fits into both categories – paying a sustainable high yield but also offering reliably solid growth. But we can consider that there is no clear border between the two. There is a grey area between the two extremes. Kollo’s research works on the basis of choosing between one style of portfolio over the other.
The research looks at the performance of two portfolios of equivalent capital investment, number of stocks and capital weighting over history, representing our two categories. The prime measure of performance is that of realised income – the yield the investor generates (based on starting price) multiplied by the amount of capital invested.
The point of realised income is that one can boast about what a portfolio is worth on paper today based on today’s share prices but for those reliant on income, that capital must remain the driver of income throughout the typical ebb and flow, and occasional boom and bust, of stock markets. Kollo makes the point that surprisingly, realised income is rarely discussed or reported by the wealth management industry.
The research considers four criteria: providing realised yield; capital risk; dividend payment risk; inflation risk and growth.
Which of the two portfolios provides the greatest realised yield?
We know that the answer is not immediately high yield because dividend yields are higher, because over time dividend growth can provide yields greater still. And at this stage we should point out the research is US-based, which is why the numbers look low compared to what we’ve become used to in the Australian market.
At the starting point of 4% dividend yield for high yield and 2% for growth, high yield delivered minus 2.2% dividend growth and growth delivered plus 6.7% dividend growth over time. Thus on a realised yield basis, high yield delivered 3.9% and growth 2.2%.
In other words, you’re better off going for high yield to begin with, because the market is paying up for growth potential and that’s why growth stocks offer lower yields.
Which of the two portfolios offers the least capital risk?
High yield stocks have a reputation for higher volatility. Companies with higher earnings growth, and so dividend growth, are assumed to be in better health and thus more able to withstand shocks than their lower growth, higher yield counterparts. But looking at the past twenty years, the research finds that on an investment horizon of three years or more there is little difference in capital deprecation over periods of downturn.
The conclusion is that over a longer investment horizon, higher yielding stocks do not increase capital risk meaningfully.
Of course in order for this to be the case, those high yields have to be sustained. Which brings us to the next question:
Which of the two portfolios offers the least dividend risk?
This is a good time to suggest investors ignore historical dividend yields and focus only on forward yields as forecast by stock analysts. A stock may look fabulous because it offers an historic 15% dividend yield but that yield is based on last year’s dividend divided by today’s share price, and that company may be at risk of going out of business.
Or at the very least, it will cut or suspend its dividends in order to weather whatever storm it is being battered by, macro or micro, meaning little or no yield for this year. Such stocks are known as “value traps”. But perhaps analysts are confident the company can address its issues and maintain dividend payments – herein lies the risk.
The research picks an obvious period of time – 2008-09 – to assess how many companies in either portfolio cut their dividends. One assumes the high yield portfolio would have been more prone.
And it was – 48% of high yield companies cut their dividends. But 45% of growth companies cut as well. And 30% of companies in both portfolios cut by 50% or more. Both types of companies, Kollo concludes, have shown an equal willingness to make major cuts to their dividends during periods of extreme stress.
Which of the two portfolios offers the greatest inflation risk?
Inflation risk is one of the greatest arguments for holding growth stocks given dividend growth is required to offset the impact of inflation on the investor’s purchasing power. High yield is all well and good until inflation erodes the purchasing power of income over time.
Over the longer term, equities have produced returns that have exceeded inflation in most decades, the research finds. In the instances they have lagged, equities have rebounded by an even greater extent in the subsequent period.
Between the two portfolios, we’d expect high yield to provide a surplus return over inflation initially but for that to gradually erode to a deficit. We’d expect growth is at risk of lagging inflation initially but would move into surplus over time. Indeed the research has found that the crossover – the point at which the returns of both portfolios equalise with respect to inflation – occurs at seventeen years.
In the two most extreme scenarios of stagflation (falling economic growth, rising inflation) and stagnation (falling economic growth, falling inflation), the growth portfolio provides a zero or negative real return for a significant portion of the investment period. High yield provides a significant excess return before gradually eroding over time.
If we assume that a super investor would feel more comfortable with the bird in the hand in such circumstances – excess income in tough economic conditions -- then the high yield portfolio is preferred.
The Conclusion
“We find that the High Yield strategy delivered consistently higher income,” Kollo concludes, “by virtue of its higher delivered yield, than the Growth strategy over the short to medium term. Some simple analysis suggests that under adverse economic scenarios, the High Yield strategy provides greater utility for investors due to excess cash flows in the early years.
“Capital risk is approximately equivalent for the two strategies, while cash-flow risk in terms of cuts to dividends during a crisis is also near-identical. In sum, our analysis suggests that a higher yield, lower dividend growth strategy provides a superior delivered income experience with equivalent risk for investors.”
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