Investment Office Logo

Income: A dangerous love affair

Beauty is only skin deep, as the saying goes. Francois de Bruin explains what this piece of wisdom means for yield-hungry income investors.
Francois de Bruin Fund Manager, Sustainable Income & Growth and Head of Listed Real Estate
Aviva Investors,  11 May 2021

In the initial stages of romance, physical appearance carries a disproportionate weight in assessing the attractiveness of a partner. Anyone who has been in love will attest to the fact that finding someone they see as beautiful can cover a multitude of shortcomings. Without knowing anything about personality, character or behaviour, physical beauty can be wildly alluring.

For investors, few things are as attractive as a high level of income. To start with, it can never be negative and only ever makes a positive contribution to total returns. It fuels the fire of long-term compounding when re-invested. It is also paid in cash and often with a frequency that covers either persistent expenses or perhaps an overseas holiday or luxury indulgence. It therefore comes as no surprise that many investors focus disproportionately on the dividend or coupon when making investment decisions.

But as Shakespeare put it, “beauty is but a vain and doubtful good; a shining gloss that vadeth suddenly”.

Experienced income investors will attest to high income yield being merely the tip of the iceberg. Instead, investors should focus on the more enduring qualities of an asset to assess whether the pursuit is worthwhile.


Quality of income

The appeal of dividends to existing and potential shareholders frequently leads to short termism. Management teams are lured into maintaining dividends while potentially forfeiting attractive growth opportunities. Or worse, critical capital expenditures are sacrificed, jeopardising long-term competitiveness. As a result, dividend cut announcements are often accompanied by statements of prolonged capex burdens as companies try to correct the negligence of the past.

Almost all investor relations sections of company websites have a section on dividends. Amounts, dates and history of distributions are all clearly labelled. Investors should beware of such selective promotions and, as a starter, seek to understand the pay-out ratio (percentage of earnings distributed). Deeper metrics include but are not limited to: leverage employed to generate income; level of free cashflow generated per share; and the number of new shares issued over the same period.

Sadly, parts of the asset management industry have also fallen prey to the optical income-illusion act. In the globally common Luxembourg-SICAV fund structure, it is permissible to pay distributions to investors from both capital and income. The result is many funds claiming attractive high single-digit or even double-digit yields, while the underlying assets have little potential to produce income.

The last decade’s secular bull market has masked much of this. However, the risks of distributing capital as income could prove fatal if future returns do not match those of the past. A steadily declining price in the income share class is a useful red flag.


Growth of income

Perhaps counterintuitively, one of the best ways to ensure longevity in income investing is to focus on sources of growth. Starting with top-line revenues, a healthy blend of pricing and volume growth are indicative of healthy company fundamentals. Attractive operating margins and cost discipline over time will likely give rise to attractive and sustained earnings beyond any structural market tailwinds. Strong cashflows and dividend growth for prolonged periods are also highly desirable.

Indeed, many companies do not generate yields that would see them classified as traditional income investments. Yet the effective yields of their dividends have grown so handsomely that many long-term investors have come to depend on their distributions, even as the company focuses on growth. For example, the prospective dividend yield on Visa has never been more than one per cent, yet anyone who invested ten years ago currently receives an effective yield of close to eight per cent on their initial investment, with healthy prospects for sustained dividend growth.

Another important factor to consider is share buybacks, in particular how they are funded. Share buybacks are another way management teams reward shareholders, as they reduce the number of shares dependant on future earnings and thereby grow the per share claim for remaining shareholders. However, with yields at historic lows and credit in abundance, many companies have raised debt to buy back shares. This dilutes the future earnings quality of the business. Fast forward a few years and, while the purpose of the debt will be all but lost in corporate memory, the burden remains as real as it was when the buyback was initiated.


Sustainability of income

As in the case of true beauty, investors should look beyond traditional measures before committing. The rise of environmental, social and governance investing has served as powerful force for emphasising not only the importance of shareholder interests, but all stakeholders, including employees, suppliers, customers and communities. The beauty of youth is quickly eroded if met with persistent bad habits, whereas perpetual beauty is the result of disciplined stewardship and integrity of process. Whether investors are investing for dividends or coupons, poorly aligned management teams or material environmental or governance risk factors could easily derail promised distributions.

With the rise of apps and tools in modern dating, we’ve become accustomed to filtering out large numbers of candidates based on high-level, often backward-looking information. This is common in sustainability and income investing too, where many have opted for a simple screen to remove potential investments from their universe.

However, companies or assets with low ESG scores can be overlooked, even if the future trajectory looks distinctly different from the past. For this reason, active engagement with senior management is key. This gives investors the opportunity to understand why companies behave in a certain way, but also for companies to understand the values and outcomes most important to their shareholders.

Income, whether in the form of interest, coupons or dividends, is indeed a beautiful thing. For it to have more lasting appeal, investors should look to understand the quality and sustainability of the underlying cashflows and, wherever possible, seek sustainable growth to support the yield for years to come.