Five steps to getting your equity income strategy back on track

For more than 15 years I have been encouraging investors of the critical need to think differently when it comes to generating income from equities compared to traditional income asset classes like bonds and cash.

However, there is an understandable desire to keep things simple when it comes to implementing client portfolios. As a result, the investment world is prevalent with the use of ‘rules of thumb’ and ‘assumed truths’.

The belief that ‘high dividend yield delivers high income’ is a simplification that receives widespread coverage in this income-starved market.
Educating our clients about the reality of this concept provides a valuable opportunity to demonstrate the value of seeking expert financial advice to assist with meeting their retirement income challenge.

Income from equities had been relied upon as one of the last sources of meaningful income following years of yield compression in the fixed income space. However, in the wake of this global pandemic, the income outlook is a major concern for many investors. Given the unimaginable extent of the dividend cuts across the market, equity income investors must explore new ways to generate sufficient income. In this article, we cover how to design a retirement income strategy that can potentially deliver reliable, consistent income through a multitude of market scenarios. 

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STEP 1: Step back from just thinking about dividend yields 

For a large number of investors, their equity income strategy is based on identifying the most attractive high dividend yield names to invest in.  

Most income investors will only invest in high dividend yielding stocks like Telstra and National Australia Bank (NAB). These stocks with higher dividend yields may be attractive in the short-term to meet your income needs but are these stocks effective at providing income over time? Take a look at the following four stocks. Which of the following stocks do you think delivered the highest income on a $10,000 investment between June 2004 and June 2019? You may find the results surprising!

Source: First Sentier Investors, Factset, IRESS

Look at the difference between yield and long-term income. Investors in the low yield stocks would have received significantly more income than those in high yield names. Investors need to look beyond dividend yields for better income and total return opportunities. 

Source: First Sentier Investors, Factset, IRESS

STEP 2: Think about income as a dollar concept, not a percentage (yield) 

We often see the terms yield and income used interchangeably when describing investment strategies. 

When developing retirement income plans, the discussion with the client is in dollars; how much savings do they have? What are their expected spending plans in retirement?

Yet we switch to percentages when thinking about investment strategies. Focusing on yield, which is simply the dividend income as a percentage of the current share price, is a classic example of this change.

But as you can see from the higher income delivered by Computershare and Ramsay Healthcare, they couldn’t be further apart. This difference even includes the income from franking credits. 

The clients’ world is all based on dollars – we need to think about their investment strategy the same way. I know this may sound counterintuitive to some, but thinking about dividend income on a ‘yield’ basis can deliver poor income on a ‘dollar’ basis over the long-term.  

STEP 3: Adopt a long-term mindset when thinking about income 

In the early years, stocks with higher yields will generate more income. But in the long-term, it’s a very different story. For stocks like Ramsay Healthcare, Computershare, and countless others, the low yield has been paid on a share price that has been growing over time.  

Source: First Sentier Investors, Factset, IRESS

These companies reinvested in their business rather than just paying out high dividends in the early years. Over time, companies that can achieve higher earnings per share typically deliver stronger share price appreciation – and a higher dividend per share growth. This results in potentially higher income – and total return – for the investor over time. This is the key to generating sustainable, long-term income. 

STEP 4: Embrace a total return focus 

By thinking long-term and understanding that longer-term earnings growth will underpin long-term dividend income, investors can embrace a total return approach to selecting stocks in their portfolio. 

Just think how powerful that is. A total return approach provides the flexibility to be invested in the right stocks, at the right time, at the right price during different market conditions. This approach can seek to deliver a diversified portfolio that can weather a multitude of market conditions and avoid the concentration problems experienced by many equity income strategies. 

This means your conservative equity income investors can continue to access the best investment ideas across the share market, even when there is a need for income. 

STEP 5: Understand the role options can play in your equity income strategy 

The steps so far focus on understanding how to deliver higher long-term income for your clients. But what if your clients want more income now? A carefully implemented options strategy can be used to balance short-term income needs with the generation of long-term total returns – and be delivered with smoother returns through the market cycle. 

In addition to the two traditional streams of income generated from dividends and franking credits, an options strategy can exploit share price volatility to generate a third stream of income called option premium income. 

This additional stream generates potentially higher income when the market is experiencing elevated volatility – particularly through the tougher periods where companies are forced to cut dividends. These three sources of income provide opportunities to generate above market income distributions through various market conditions. 

This strategy is commonly referred to as a ‘buy-write’ or ‘covered call’ approach. The benefit for income-oriented investors is that we can take back control of the investment universe. 

The investment opportunity set for these income investors no longer needs to be narrowly defined by stocks paying a certain level of yield. Income-focused investors can continue to access and be exposed to innovative, growth ideas where detailed, fundamental stock research suggests long-term wealth can be created. 

The use of a combination of stocks and the options to invest in these names addresses the needs of late stage accumulators and retirees for a balance between generating attractive long-term returns, lower volatility and higher, consistent income.

Income-oriented investors also tend be prefer more conservative investment strategies that place a higher focus on capital preservation and risk management. Investing in a small universe of high yield stocks, irrespective of market conditions, does not protect a portfolio from significant market declines. The ability to search a broader universe for companies that are better suited to the prevailing market conditions can help manage risk.  

The lessons for equity income investors are clear. Dividends cannot be relied upon as annuity sources of income. Understanding this and the need for a long-term, total return approach to income generation will be critical to getting your equity income strategy back on track.  

Rudi Minbatiwala is head of equity income and portfolio manager at First Sentier Investors.