Most investors seek to increase their wealth through their investing lives, and hence the word that resonates most clearly is ‘growth’.
For companies, this means making more profits, expanding the business, taking on more staff and so on. As the business’s assets increase, so does the ‘book value’, i.e. the value as seen in their accounts – their assets, minus any liabilities. Companies that want fast growth will re-invest all their excess profits back into the business to fund research, improve products and purchase new plant and equipment. If the number of shares in issue stays the same, the share price should rise as a result.
Businesses like this are unsurprisingly known as growth companies. They may be small companies that want to become big companies or large companies that want to become even larger. Companies like Amazon, Apple and Netflix are examples of relatively small businesses that have grown dramatically in recent years, and their share prices have reflected that.
However, where people and ‘intellectual capital’ are the company’s main assets, e.g. in-service industries, valuing the company becomes more complicated. At this point, the market takes over and thinks about potential profits and the share price adjusts accordingly. Changes in expectations (exchange rates, new products, economic conditions) mean the market recalculates what it thinks is a ‘fair’ price. Among a host of metrics, the most well-known is the P/E ratio, where the price is divided by expected earnings per share. If that number is above average for the market, or that company’s particular sector, the price is deemed expensive. Below average, and it could be considered ‘cheap’.
Investors can get carried away, and become overly optimistic (or pessimistic), as in the dot-com boom 20 years ago. P/E ratios as a whole climbed to unsustainable levels as expected earnings ultimately proved overoptimistic. At the same time, smaller companies can overstretch themselves and collapse – recent UK examples include Conviviality, the drinks distributor and café chain Patisserie Valerie.
Alternatively, investors can choose to invest in companies whose futures appear more sustainable. Shareholders can still be rewarded by share price rises, but they are more interested in having a share of the ongoing profits, delivered to them via dividends. While growth companies believe they can return more to shareholders by re-investing all their profits, other businesses retain shareholder loyalty (and attract new ones) by distributing some of the profits as dividends. The more successful the company becomes the more profit it makes, and the dividend increases accordingly.
A good example is Coca Cola. The epitome of a long-term investment, a single $40 share in Coke bought at its issue in 1919 would be worth over $430,000 today. However, had one taken all the dividends and instead of spending them, bought more Coke shares, your holding including share splits would be worth in the region of $10 million. Indeed, the company has increased its dividend every year for the last 56 years.
You might pay too much to access those future dividends, so again various metrics are used to ascertain ‘value’. One of these is dividend yield, i.e. to divide the share price by the dividend payout per share. If the share price is £1 and the dividend per share is 4p, then the yield is 4%. This is very attractive relative to the interest obtainable from bank deposits; however, there is of course risk involved, depending on share price volatility in the short-term, and the perceived longer-term health of the company. The yield might look high based on current dividends, but if the yield of similar companies was significantly lower, that might tell you something about the sustainability of the dividend – is it too high? Does the market think it is cut?
This approach, or ‘style’, is known as ‘Value’ investing – buying things which are under-priced because the market misunderstands the business’s potential, or where the dividend payouts are significant and likely to grow. Value and Growth stocks tend to go through periods where they have contrasting success; Growth has been the dominant investment style for the last decade as markets recovered from the financial crisis. However, in the longer-term value always wins out because by definition those shares are bought at a discount to their fair price, while growth stocks attract a premium price. Unfortunately, value can stay out of favour for very long periods. Consequently, the dividend stream becomes the deliverer of performance.
Investors looking to build their capital might be interested to learn that in the long-term, something like 95% of total returns is generated by compounding re-invested dividends. Coca Cola increased its dividend payout again in 2019, by more than the rate of inflation. Our 80-year-old Coke portfolio is paying out a gross income yield of over 3.5%, but on a portfolio value of $10m, in other words around $350,000 a year. This is a wake-up call for retiring investors, who are looking for income that will at least keep pace with inflation, and whose expectations for capital are rather more limited, i.e. to capital preservation.
Unfortunately, many investors in retirement are persuaded to reduce their equity holdings in an attempt to reduce risk, often without realising that alternative income-producing investments like bonds by definition provide fixed rather than growing income and have set prices at maturity rather than providing long-term capital growth potential. Trying to reduce risk can lead to investors’ sustainable income objectives not being met.
Of course, one can regard regular withdrawals of capital as “income”, and indeed for many investors, this is their only option where the ‘natural’ income cannot be accessed. As we’ve seen, both value and growth investing have various days in the sun.
Consequently, diversified income portfolios can hold funds which focus on both value and growth stocks, as well as income supporting risk diversifiers like Gilts and Corporate Bonds. A well-constructed income portfolio should include all of these constituents, providing long-term income growth, maintenance of spending power, and anticipating a firm foundation of capital protection.