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Why income investing is not straightforward

Adopting a natural income style to income investing may seem logical, but there are those who believe fluctuations in yield and inflation make this approach appear, well, bonkers

Why income investing is not straightforward

We all have a natural grasp of natural income. All you do is buy some shares and bonds (and perhaps some property) and use the dividends from the former and the coupons from the latter as income. Meanwhile your initial investment remains largely intact, in the form of the market price of the shares and the face value of the bonds.

Simple. Or is it? ‘Simple’ can mean something that is very straightforward; on the other hand, it can refer to an approach lacking in intelligence.

Sadly, the natural income style of income investing meets both of these definitions. As Abraham Okusanya, director at research firm FinalytiQ, said in a recent blog: ‘This approach is bonkers.’

Yes, ‘bonkers’ seems an appropriate synonym for the second definition of ‘simple’.

Okusanya gives several reasons to support his point:

  • Dividend and bond yields fluctuate significantly over time.
  • Once adjusted for inflation, natural income yield, if used for retirement income, is very unlikely to meet the financial needs of investors.
  • Proponents of natural yield offer little evidence for its effectiveness.

Bumpy ride

We at Citywire decided to test this theory out for ourselves, using a simple (meaning straightforward) approach. The chart (below) shows natural income earned on a £10,000 initial investment in each of the past 20 years for three Lipper sectors: Bond GBP, Equity UK Income and Real Estate UK.

It does, indeed, show the significant fluctuations identified by Okusanya. Real estate, for example, yielded more than 7% in 1997 but less than 3% in 2007. And, as the income earned is nominal, its real value could be significantly eroded by inflation.

But why can income investors not save some income from the good years to use in the bad years? Would this straightforward adjustment not make the natural income strategy an effective one for income investors?

We put this point to Okusanya. ‘I agree some kind of self-managed buffering, keeping a bit back in good years and spending it in bad years, can help,’ he said. ‘But would it be effective?’

William Meadon, co-manager of the JP Morgan Claverhouse investment trust, agreed. ‘Private investors could smooth the fluctuating income,’ he said. ‘But you must pick shares that won’t cut dividends. You need the discipline to tuck income away and you need spreadsheet and accounting software to track it all.’

Chris White, manager of the Premier Monthly Income fund, added: ‘You want to find companies that can provide a good combination of capital growth, income and income growth.’ Needless to say, this is not easily achieved.

Other factors

White said income investors must look not just at dividend yield, but ‘at underlying cashflow, dividend cover and balance sheet strength’. That, presumably, is before you get to valuation ratios such as price-to-earnings, price-to-book value and price-to-sales.

Meadon, meanwhile, advocates a total returns approach, with income drawn down from these total returns. This involves combining growth shares (for the capital base), defensive stocks (such as utilities) and dividend-paying stocks at sub-market yield but with prospects to grow dividends more than the markets. ‘It’s blending these three together that hopefully gives you growth in capital and income.’

Okusanya added: ‘This is not impossible. I’m just pointing out the flaws in the thinking with regards to simple natural yield.’

Inadequate income

In the current low-yield environment, even if they do make the right stock selections, income investors can still struggle to secure adequate income. Meadon said: ‘In a low-interest world, almost everyone will have to dip into capital to some extent, as equities are yielding less than 4%.’

When it comes to income investing today, then, things are far from simple.

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