Several years ago, I decided that every investment I would make from that point onwards would have some form of income component. I made that decision after selling a stock that I had owned for around a decade, which had produced a slight capital loss but, after accounting for the impact of inflation, had produced a significant real loss. Holding that equity for 10 years without any return made me realize how important income can be over the long run, especially when investing in equities with a value perspective.
When I make the distinction between value and growth here, I’m not referring to high-growth stocks, which tend to be momentum plays. I am referring to companies that are long-term investments, acquired at appropriate multiples of earnings or other metrics. In comparison to growth stocks, momentum stocks are more likely to stagnate and not produce positive capital returns over the medium to long-term if we, as investors, get our sums wrong.
Protection against unforeseen risks
More often than not, value investors acquire more equities when they’re facing some short-term headwind which has impacted growth and market sentiment.
It can take years for this headwind to dissipate, which means investors usually need to wait around for several years to see how the situation evolves. If it does not evolve as we expected, it may make sense to sell the equity.
It’s during this period that equity income can be so valuable. Even if it is just 1% or 2% a year, the additional return can really transform the performance of an investment.
And there are other reasons why I now focus on companies with some sort of income or capital retard component when looking for investments. These capital returns give us some idea of how management will treat investors and how they will return capital from operations.
A company that does not pay a dividend might have better things to spend the money on. That’s perfectly alright, but sometimes I may not agree with where the money is going. I may prefer the money to be returned to me as an investor rather than thrown away on vanity growth projects.
A secure capital allocation policy
How management is using capital and returning capital to investors can provide an invaluable insight into capital allocation policies and how they treat their investors.
Under a standard capital allocation framework, companies should look to invest in the business first with excess capital, then reduce debt and finally, when all of the above is complete, return capital to shareholders. This is not a set template, but there is always going to be a balance between returning capital and investing in the business.
Companies that are returning too much capital, or borrowing to invest and return money to shareholders, do not have the best capital allocation policies. This could be a strong indication that management does not have the best interests of shareholders at heart.
It is also important to acknowledge that the investment environment over the past decade or so has been pretty abnormal. Over the long term, and I am talking about the past five decades, equity returns have been split roughly 50-50 between income and capital growth.
In the past decade, this mix has shifted towards mostly capital growth as high-growth tech stocks have taken over the market. This might change if we have a prolonged economic downturn and if interest rates rise substantially, pulling money out of "high growth at any price" tech companies.
In this environment, income stocks may perform better than their growth counterparts. If equities tread water for five years, investors will want some form of returns. Dividend income can provide those returns.
Not all investors are going to be comfortable with this strategy. Still, I think that in the current environment, it is worth considering the impact of equity income on overall returns in the long run.
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