Tuesday, 9 April 2013

Investing for Income - Part 1


The Bank of England have kept the bank rate at 0.5% for the past four years. As a result, many savers and pensioners have been forced to move their savings away from the traditional cash savings accounts offered by banks and building societies and look around for alternatives. Some are turning to the stockmarket in their search for higher returns.

So, how to go about getting a better return - this was the question I was asking myself in 2009 and the answer seemed to be a combination of fixed income, individual shares and investment trusts. The attraction of the fixed income element - mainly PIBS and preference shares, is the immediate higher return - in 2009, some PIBS were yielding over 10% p.a. - however the downside to fixed income investments is the fixed rate of return which will be eroded by inflation over time.

To counter this and secure an income that rises each year (hopefully) a little ahead of inflation, it is essential to invest in equities. Therefore around 60% of my investments are split between individual shares and investment trusts.

In this first part, I will outline my strategy for securing a reasonable return of income using individual shares. Although the markets have seen a strong rally in recent months, it should be possible to secure a starting yield of around 4% without compromising on quality.

Using Shares for Income

Since I first acquired some shares in Abbey National BS in the late 1980s, I have liked the idea of holding individual shares - in the earlier years more for growth but increasingly in recent years the emphasis has been more towards income.

I have built up a portfolio of shares based on the following criteria -

Starting yield at least equal to the best current savings rates (at present around 2.75%) but not too high - a dividend of say 50%- 60% above the FTSE average might be my limit.

A record of rising dividends over the past 5 years (at least) and dividends covered by earnings of at least 1.6x, but preferably 2x and above.

Not too much debt (gearing) and if there is net cash on the balance sheet so much the better. Additionally, I look for companies that have a rising level of free cash flow - this is where the dividends will be paid out from.

Diversify - I select shares from different sectors of the market - industrials, mining, pharma, media, household, supermarkets etc. These will mainly be selected from the FTSE 350 but I am not averse to including the odd smaller company.

Finally, and probably something difficult to define - quality. Some companies will be better than others when it comes to generating a sustainable and growing level of profits and dividends over many years. The sort of share you can buy and hold forever. Sometimes it can be tempting to acquire an ‘average’ company with a higher yield, but for my money, over time, quality will always provide the better returns.

Quality Shares

My fellow blogger Miserly Investor recently posted an excellent article on the attributes of a quality company - here's a link

The main points for me are to identify companies than can deliver a sustainably high return of cash on capital employed (ROCE). Dividends are paid in cash so a company that has a record of rising dividends is likely to have a steady flow of cash coming into the business.

Another factor is the dividend payout ratio - the level of profits paid out in relation to the percentage of profits reinvested into the business. The lower - ideally below 50% - the better. If most of the profits are being paid out as dividends, this could indicate the dividend level may not be sustainable.

One other aspect I look out for as a sign of quality is some form of competitive advantage  - this could be in the form of a worldwide patent on a new product or more commonly, an attractive  brand which can maintain strong consumer loyalty and be rolled out globally. Warren Buffett coined the term ‘economic moat’ to describe a business’ competitive advantage that keeps other companies at a disadvantage. He said :

"The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors".

A good example of such a company in my current portfolio is Reckitt & Benckiser .

Buy & Hold Strategy

Over recent years I have assembled a portfolio of around 20 shares. I try to buy at a reasonable price and there have been plenty of opportunities to pick up quality companies over the past couple of years when markets have fallen quite sharply. The intention is to hold for many years and harvest the steadily rising dividends each year - I maintain a watchlist of possible additions but I will try to maintain the total number held at around the 20 mark. If one or two shares on the watchlist become a compelling ‘buy’, I will take a closer look at the shares in the existing portfolio to see whether any are showing signs of the story having changed since purchase.

Now the portfolio is more or less completed, there is not really much to be done - in fact, the hardest part of running the portfolio is doing nothing! Most of the income is withdrawn to cover living costs so there is now not much in the way of dividend reinvestment.

I will monitor annual reports and dividend news and tend to look at portfolio total returns on a quarterly basis. I use a spreadsheet to keep track of dividends and forecast yield. That’s just about it.

Costs

As we have seen (here), it’s important to keep costs as low as possible to maximise investment returns. With many of the shares, I will purchase an initial stake and top up to a ‘full’ holding at some later date. So, there is the initial purchase costs - typically £9.95 but which could be £1.50 using the regular investing option, and stamp duty of 0.5% - barring any takeover bids, that’s just about it. There are no annual management costs and also no platform costs from my online broker. Therefore maintaining an individual shares portfolio should be the most cost efficient way of holding equities for the long term - even cheaper than a Vanguard tracker!

In the next part I will take a look at the use of investment trusts for income and in the final part look at fixed income options.

3 comments:

  1. John,

    Great article, and thanks for the mention! I completely agree with the need for some assessment of 'quality'. I think a lot of new income investors start off indiscriminately buying yield - which is very easy to calculate of course - and then with a bit of experience and maybe a few failures later realise that we need to scratch a little deeper and do a bit more work to ensure the dividend is sustainable and will likely continue to grow for many years to come. Great quote from Buffett - now doesn't he have a way of making everything sound easy?!

    Cheers,
    MI

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  2. Hello MI,

    Thanks for leaving a comment - always happy to link quality articles! Makes you wonder why everyone seems to struggle with consistent returns when Buffett has set out his key to success over so many years.

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  3. We'd be interested in, say, the income shares of investment trusts because we can gift surplus income free of Inheritance Tax; we'd be prepared to take some capital loss on the chin (though we'd be happier with merely a lack of capital gain). Please bear us in mind when next you comment on this topic: I doubt if we're alone.

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