What is investing for income?
A few weeks ago, I was talking to an investor about my approach and described myself as “primarily a value investor with a dash of income investor on the side”. Over the course of the following conversation, I went on to talk through my approach to investing for income, which I’ll recount here, as well as expand on some of the principles I use to generate income.
The original concept behind income investing is a simple one. Using capital to generate a positive return, or income, which can be paid to an investor to cover expenditure. Having said this, there is no reason why the income generated cannot be used to compound the portfolio by reinvesting dividends back into the portfolio. This is, for the most part, exactly what I do, but it’s always useful to know that an extra stream of income is available in the event of job loss or sudden illness.
My approach to investing, the value/income approach, is generally considered to be suitable for low-risk, cautious investors who like the idea of investing but are nervous about volatility and the potential for permanent capital loss. In addition to this, I also find income investing to be relatively undemanding in terms of time required to make it work, especially compared to high growth or early stage investing.
Setting your income goal
Coming back to the conversation I had a few weeks ago, this investor was approaching retirement, and despite having saved a reasonable pot of capital over their working career, had never been a significant investor other than a small pension they had saved into and not really paid much attention to. The conversation we had was around how to invest their capital to generate an income – after all, when they retired, the salary is going to stop!
My first question was whether or not this person had spoken to a financial advisor. As someone that enjoys talking about – and writing about – investing, I’m always conscious of the fact that I’m not a qualified financial advisor. My own opinions on their abilities aside, it is a legal requirement that any individual giving financial advice be suitably qualified and regulated. After all, advising pensioners to YOLO (You Only Live Once) all their money into Dogecoin, NFTs, or even loss-making entities like WeWork or Peloton is likely to result in very real financial losses.
Secondly, ascertaining roughly how much income they are going to need is also a good step before making any financial decisions. The basic principle here is that the less income you need relative to capital value, the less risk you need to take to meet your goals. After all, if you want to generate £25,000 a year in income, but only have savings of £100,000, you need an annual income equivalent to approximately 25% of your pot every year. To be blunt, the odds of actually achieving that are pretty much nil, which means that every year, you’ll have to spend some capital, making it gradually more difficult to achieve your goal each year.
In reality, I would expect this person to totally deplete their savings within a decade of retiring, presuming that there are no additional sources of income and barring and unusual windfalls like a sudden inheritance, lottery win, or fluke investment return.
Planning your income requirements is something that takes a bit of time but the basic principle is to analyse your expenditure and determine what falls into the categories of being absolutely necessary or discretionary. An absolute necessity is the purchase of food, but that amount and quality of that food is discretionary. Likewise, payment of your water bill and council tax is a necessity, but funding a foreign holiday is discretionary.
Once you’ve totally all of your income and grouped it into one of these two buckets, you can determine your baseline required income, and a stretch income for luxuries and discretionary expenditure.
Thirdly, don’t forget to include additional sources of income. Most of us have private pensions and hopefully a state pension to rely on in old age, in addition to any income generated from an investment portfolio. By including these in your calculations, you are hopefully some way towards achieving your baseline required income.
Finally, consider whether you want to increase your income over time. Inflation is a very real monetary phenomenon and means that over time, the prices of most goods and services increases. As such, if you spend £100 a week on groceries, that same basket of food will probably cost you more after ten years meaning that unless your income has also increased, you will either have to buy less food or reduce the quality of it.
Income strategy: capital gains vs dividends when investing for income
Once you’ve set your income target, the next step is to determine how you intend to generate it. Generally speaking, there are two main sources of income in a portfolio – capital gains and dividends.
Capital gains are profit generated from the sale of an asset that is worth more at the time of sale than purchase. For example, if you purchase £10,000 of shares and sell them 12 months later for £12,000, you have generated £2,000 of capital gains. Capital gains are never guaranteed – the value of shares can decrease as well as increase over time – and the timing of such gains are also uncertain. For example, some investments I have made have generated little to no capital gain over six months before going on to increase 50, 60 or 70% over the course of a few years.
Dividends, on the other hand, are capital payments received from a company and are generally paid on a regular basis. Many companies pay their dividends on a quarterly basis and some even have what is called a “progressive dividend policy”, which effectively means that they seek to increase their dividend payments over time.
Unlike capital gains, which can be difficult to time, dividends provide a steadier and more reliable source of income. Of course, the focus of an investor should never solely be on the dividend, as a dividend needs to be paid from income and profits generated by a company (called a “covered dividend”). If a business is loss making and still seeks to pay a dividend, they must use cash reserves, sell assets, raise debt, or issue equity. In the short-term, this may seem acceptable to some investors, but over the long-term, an “uncovered dividend” (i.e one not paid from income) will result in the balance sheet of the company degrading over time. If this situation continues long enough, the company is eventually forced to reduce, or even halt their dividend, usually causing a fall in the share price and leaving an investor with no income and potentially even a capital loss.
My preferred source of income has always been dividends, which should be well-covered be earnings, and preferably progressive. Over time, my portfolio has yielded between 4-7% a year, meaning that for every £100k invested, an investor would receive £4-7,000 in annual income.
When a company releases a Regulatory News Service announcement (RNS, for short) regarding their results, they also usually make an announcement about the value of their next dividend, as well as confirming what date the shares will go “ex-dividend”. The ex-dividend date is effectively the cut-off point after which the register of shareholders entitled to receive a dividend becomes fixed – meaning that an investor that buys the shares after this date would not be entitled to the next dividend payment and it would instead go to the previous owner that held the shares before the ex-dividend date.
In addition, some company also pay “special dividends”, which work on the same principles but are effectively one-off payments to mark special events such as an exceptionally profitable year or disposal of a large asset. Unlike regular dividends, which are generally expected to be paid on a regular basis, special dividends are irregular and not to be relied on. Think of them a little like a bonus in relation to your regular salary.
Selecting income investments
There are many aspects and features of an investment that make it a potentially suitable candidate for somone investing for income, but over time, I’ve come to select the following as a rough checklist to consider when researching new ideas:
- Portfolio Diversification – It is vital that new investments avoid exposing your portfolio to over-concentrating in individual themes or sectors. In the UK, financial sector shares such as life insurers and banks often have significant yields but simply going out and buying 20 banks, insurers and asset managers would result in a heavily concentrated portfolio that was intensely exposed to interest rate, default rate and other sector-specific risks.
- Initial Yield vs Income Growth – Initial yield is the starting yield an investor should expect when first making an investment. If an investor makes an investment at 100p a share in a company that pays a dividend of 5p a year, the initial yield would be 5%. With inflation a very real concern over time, investors should consider whether they want that income to grow and if so, by how much. Personally, I like to see companies increasing their dividends by 3-5% per annum, if not more, to at least match inflation. To do this, a company needs to have strong “dividend cover” and to be able to grow earnings with inflation over time.
- Dividend Cover – Dividend cover is simply a measure of how many times a declared dividend can be paid out of earnings and is calculated by taking the company’s net income and dividing it by the declared dividend. If the cover is more than one, it indicates that the dividend can be paid from income. Generally speaking, a cover of two or more indicates strong cover, with anything below 1.5 indicating a potential for reduction or low growth. A cover a one or less indicates a high likelihood of financial distress being caused by the current dividend and a potential for balance sheet degradation over time.
- Strong Balance Sheet – Linked to dividend cover, a strong balance sheet is essential for an income stock. As an investor, you are reliant on the company’s dividends, and if so, you need to know that the company is strong and stable to continue paying these. As a general rule, I like companies with low levels of debt relative to earnings, and preferably net cash (which either means they have no debt, or that the cash on their balance sheet is greater than their debt). I also take time to read through the accounting notes, keeping a sharp eye out for significant unfunded pension obligations, lease commitments and off-balance sheet transactions, all of which have the potential to cause challenges for a business.
- Dividend History – one of my oldest investments, Chesnara (LSE:CSN), started paying a dividend 20 years ago, and has increased it every year for 19 years since then. In addition, the company regularly talks about the importance they place on their dividend payments, and in particular, their “progressive dividend policy”. This gives me a strong degree of confidence in the management to avoid having to cut the dividend at a future date. Even better, such a track record indicates that the company continued their policy through tough times, as well as smooth waters, having continued through the 2008/09 financial crash. A great candidate for anyone investing for income.
- Understandable Business Model – if a company ticked all of the previous boxes but was engaged in a business I couldn’t understand, I would likely avoid it. For example, one popular income play in recent memory was Hipgnosis Songs Fund (LSE:SONG), which was buying catalogues of music royalties and using the income streams from these to pay dividends. I know absolutely nothing about the valuation of song royalties, have no professional experience in the music industry, and as such, little to no ability to determine whether the company was accurately valuing the catalogues or simply selling a good story. As such, I had no reservations in walking straight past the business – there are plenty of dividend paying companies I do understand!
This list isn’t entirely exhaustive but gives me six easy to understand principles when investing for income. Having reached the end of this article, I’ve decided to expand this with two further pieces, one on how to manage an income focussed portfolio, and another on resources for screening for income investments. Best get writing!