While “official” inflation measures are low, we all see the cost of things we need, like healthcare and power, rising at a rapid rate.
So what should investors who are planning for a long retirement think about when investing with a focus on income generation?
Typically, when thinking about portfolio construction and asset allocation, many investors have split their portfolios between income producing assets and capital growth generating assets. At first glance, it’s pretty easy to separate different types of investments between those where the primary goal is to generate income, and those where the primary goal is to generate capital growth. Examples of investments which sit in the “income bucket” include cash, term deposits, hybrids and fixed income, while the “capital growth” bucket is principally the domain of equity holdings.
Interestingly though, when you look at it, the real distinction between the two is not so much that growth assets such as equities don’t produce income – with the Australian stock market providing a dividend yield close to 6 per cent (including franking credits), they do that in spades – it’s more that the income style investments neither produce capital growth nor grow their income streams over time.
So what does this mean for an investor with a long-term view? The key implication is that when assessing the long-term income generating potential of an asset, you need to look beyond the current year’s income yield.
By way of example, consider a fixed income security offering a 6 per cent coupon yield and a typical stock offering a 6 per cent dividend yield. A $100 investment into either will deliver $6 income over the coming year. But what about in the future? This is easy with the fixed income security as, other things being equal, in 10 years’ time your investment will still be worth $100 and that will still generate $6 in income.
But what about the stock investment? The reason markets rise over time is that corporate earnings rise broadly in line with growth in the economy. If we assume the long-term capital growth of the market continues in line with historical levels at around 6 per cent p.a., then we could expect the value of the stock to be around $180 in 10 years’ time, giving capital growth of 80 per cent.
Over this period we would expect the company’s earnings to also have risen by a similar amount and, with it, the amount of dividends that can be paid to shareholders. On this basis, the stock could be generating over $10 in dividends 10 years down the track.
This comes back to basic economics where, ultimately, the capital value of an asset should reflect its underlying earnings generation and, in turn, its ability to generate income. The example clearly shows that assets which increase their income generating power over time will also grow in capital value over time.
So for an investor with a long time horizon, it’s important to make sure you have enough growth assets in your portfolio as it will be these assets which can generate an income stream which grows over time and protects against the effects of inflation. In this regard, a diversified portfolio of high-quality, financially-sound, dividend-paying stocks can form an important part of an income-seeking investor’s portfolio.
Stephen Bruce is director of Portfolio Management at Perennial Value Management.
