Fixed income is fantastic for lots of things, but ‘income growth’ isn’t one of them. Fixed income is unbeatable if you are looking for security of income and capital. It is also does an excellent job of providing a portfolio with a buffer against volatility. But, fixed income is not the place to be if you are looking for ‘income growth’.
The income stream from fixed income depends on changes in interest rates, and as we know these move up and down in cycles. They do not continually rise over time.
Consider an investor who retired in 1985 with $100,000 and invested it all in 6-month deposits. At this time they could have earned a hefty 17.8% (source: RBNZ) on this money, giving them a pretty good annual income of $17,800 before tax. Assuming they spent all this income and weren’t able to add anything to their capital, where would they be today?
According to the RBNZ again, the 6-month deposit rate is currently 4.4%. Thus, our investors would today be earning only $4,400 from their portfolio. That represents a 75% drop in income.
As if that’s not bad enough, we haven’t yet factored in the impact of inflation. Accumulated inflation in New Zealand since 1985 has been 153%. Thus, the $4,400 they would now be earning would have the spending power of only $1,760. Put another way, their $100,000 would be worth $40,000 in today’s terms.
Nevertheless, many investors continue to have all of their savings in fixed income. Unless they are in a position to be able to compound a good proportion of their interest, or for some reason are exempt from tax, this is a dangerous strategy. It may feel safe, but it isn’t.
Equities provide returns in two ways, capital growth and dividends. Capital growth comes from a rising share price, while dividends are an income stream that is paid by the company to shareholders out of profits.
Good companies endeavour to not only pay a solid dividend but also increase this dividend over time. By providing this growing income stream, companies provide an excellent defence against inflation. The dividend growth achieved by US shares since 1964 illustrates this. Not only have dividends increased in absolute terms, but, importantly, the rate of growth in these dividends has also outpaced inflation.
At the end of 1964, America’s S&P 500 Index stood at 83.96. The dividend yield at this time was a reasonable 2.98% (calculated by dividing the total dividends of 2.50 by 83.96). Today the S&P generates a dividend of 21.91, which means that anyone who invested into the index way back in 1964 would today be earning a dividend yield of 26.1% on their initial investment (21.91 divided by 83.96). Importantly, dividends have grown at a faster clip than inflation.
Over this 40-year period, the dividends from the S&P 500 grew at 4.8% per annum while inflation rose by 4.3% per annum.
In this example, this investor has not only enjoyed a 9-fold increase in their income stream, but their capital has increased markedly as well. The S&P 500 today sits at 1,120. So, despite the crash of the blue chips in the late 1960s, an oil crisis in the 1970s, the 1987 crash, the tech bust of 2000 and the global financial crisis of 2008, this investor has seen their capital increase by 13 times since 1965.
This highlights another powerful benefit of income growth – it drives capital growth. Where you find one you will undoubtedly find the other.
As shown by the example above, simply investing in an index fund should deliver you solid income growth over the long term. The S&P 500 ETF (SPY) will deliver dividend growth that is very similar to the underlying index.
However, many companies have provided much higher levels of dividend growth than the market averages. Port of Tauranga (POT) has grown its dividend by an incredible 20%pa since 1995. Some of the leading American companies have provided their shareholders with continuous dividend growth over many decades. Some examples include Procter & Gamble, which has grown its dividend every year for 53 years.
Beyond direct investments, a number of investment trusts also have excellent dividend growth track records. Bankers Investment Trust (BNKR) has grown its dividend every year for 42 years. There are many examples beyond those few sited in this note, of both domestic and global companies, and investment trusts that offer good dividend growth.
The ‘perfect’ dividend-growth stock would have a track record of dividend growth, a clearly articulated dividend policy, a reasonable yield, a lower payout ratio (so that the dividend is nicely covered and the company is reinvesting profits to generate further growth), a strong balance sheet to provide comfort that the company can handle tough times, a good level of profitability (look for a decent return on equity and improving margins) and potential for earnings growth.
