Income Portfolio

Most people usually think they understand what we are talking about when we consider an income or yield portfolio. Experience has taught me that this is not the case. Even amongst professionals there is much misunderstanding of what is the objective of income funds and what can be expected of them

In this note I will discuss several aspects, including, why create one, who should use them, the basic characteristics of the typical portfolio, as well as the risk/return expectations. The note is not meant as advice and please consult an advisor. These are my views after some time investing in the area and managing various funds.

What are we talking about here?

The “reason for being” of an income portfolio is based upon two foundations. Firstly, long term interest rates look to remain very low, at the time of writing, below inflation, even before tax considerations. If risk free returns like term deposit rates were 6-7% the need to enter income strategies become less of an issue.

Secondly, an income portfolio focuses on creating an income stream that will be significant. That has implications that must be understood at the outset. The aim is to create an income stream that is significant, stable and at a level of risk that is as low as can be reasonably constructed in the available market securities. That is, we want a low level of risk. If we assume that there is no free lunch in financial markets, as there usually isn’t, the price paid by investors for adopting this strategy for lower risk is lower capital growth. The aim is to receive the bulk of returns in what should be much more secure income as opposed to the volatile capital growth aspect of shares.

Who should be interested in these strategies?

The easiest way to approach this question is to identify those that are unlikely to be interested in income strategies. These fall into a few categories. They largely comprise, very active investors, very wealthy investors and young investors. For active investors, by that I mean active in the market every day, they are probably searching for more risk and higher returns and are turning over their portfolios. Hopefully they have an active risk strategy in place as they do this. Although they may also hold a few “boring” income stocks as filler, income is not a priority. Young investors have a long duration investing timeframe. They most likely will have much more wealth in the future than now and they also most likely have a job and therefore an alternative income stream. They would most probably be better served looking for capital growth and taking on more risk, as they have the time and the ratio of current wealth to future earnings in low, so can recover a huge meltdown. The last subsector is the very wealthy. The reason for this is that at a certain level of wealth, risk is reduced and income needs can be delivered by a broad investment portfolio that favours much more growth. For example, $1m invested in yield at 7% gives $70k, which is regarded as an income stream to comfortably cover modest living expenses. While a portfolio of $2.5m in the broader market which yields around 3% generates $70k income. The wealthy can get income without sacrificing growth, obviously a good outcome.

The remaining investors interested in yield are those that have relatively limited financial resources, or want a risk profile skewed towards the more certain returns that dividends generate rather than the volatility and uncertainty offered by growth shares. They don’t want to be exposed to volatility inherent in making a decision to sell shares, realising capital to supplement income. Or selling shares for income at a poor time.

Investors can, of course, mix and match with less of an income portfolio being held as youth, activeness and wealth become more important for each individual. The point of this section is to highlight that the security of dividend income does come at some cost to growth in capital (usually) and this should be expected.

Constructing a portfolio

The portfolio should start with scanning those stocks with high earnings yield and less volatile earnings and therefore more secure income flows. The other important point to make here, and this is something not really in the equity investors handbook, that IMHO, investments should be spread across many securities, more like a fixed interest portfolio than an equity portfolio. Concentration is the friend of targeting extra alpha but that is not the game here. Spreading out investments reduces risk and that is what is required in this case. Remember the aim is to replicate the income returns of a TD not to strongly grow the income stream with the extra risk that entails, a rate of underlying growth at the inflation rate is acceptable.

There are several sectors that lend themselves to an income portfolio and will make up the backbone of the portfolio. These are the real estate or property-owning companies, utility companies, infrastructure companies, banks and to a lesser degree the insurers. To these investments, importantly, should be added a diversifying group of conservatively financed, high yielding, industrial companies that have relatively stable businesses and dividend yields. The diversification is very helpful.

The main two aspects to avoid in choosing stocks for the income portfolio, are excess debt and obsolescence. Debt can be useful up to a certain point then as it increases further, becomes a negative and potentially a big negative. The level of debt a business can sustain depends on the underlying business but comparing debt levels with peers and for the same company over several years can give you an idea whether it is an issue for a particular stock. My experience is err to the conservative side, leave the risk for other strategies you may employ. Keeping risk at low level and preferring a lower but more certain return is key, eg buying a 5% yield instead of a much more risky 6% return, is highly recommended.

Obsolescence is the other area I would avoid. The reason is that if a business is dying it will often show a great current yield but, over time, that return becomes more risky. In this strategy we want low risk not more. Some instances of obsolescence are easy to identify, such as the decline of newspapers, others are much more problematic. Opinions will vary but if in doubt, avoid, or have a modest holding.

Overall I would not baulk at holding over twenty companies in this strategy. If you see a great candidate put it in and spread the risk. Even 30-40 stocks or more are fine, IMHO.

Building and staging a Portfolio.

One of the most frustrating aspects of being a professional money manager is having investors turn up in volume at the wrong time in the cycle for a certain strategy. Often investors turn up after a period of excess returns and then are disappointed when returns normalise over the next few years. Timing a cycle is not easy but cycles do exist and can have serious impacts on returns for several years due to the entry point of an investor being unfortunate. The best outcome may be to stagger entry across time and across investments unless there is no choice. Of course, investors do not always have that luxury.

Imagine if you had invested in yield in early 2017, the next three years saw many holdings not only fall in capital value, not a big concern for yield but not a desired outcome, while dividends were cut as well, due to the Royal Commission into the banks and wealth mangers and then the pandemic. Timing can be important but difficult to accurately anticipate. Diversify by sector, stock and timeframe.

The negative impact of dividend cuts and share price pressure caused by the Royal Commission and the C19 pandemic have caused some managers to redefine income investing to be more of a total return strategy. The issue was addressed earlier in this note, but be aware that growth has done much better than yield/value over the last three years (2017-20) to an extent that we have rarely, if ever, seen before. IMHO the strategy is not broken despite the tough last few years, and there is a good possibility of mean reversion and therefore better returns.

Some have recommended good growth stocks for income portfolios. The issue is the lack of immediate income. Starting with a yield of 1%, the growth company would have to grow at an exceptional rate for many years to reach a yield of 5-6%. The return will hopefully come from capital growth a more uncertain path, as discussed earlier. Income strategies are for putting cash in your bank account from the start.

More on Stocks Constituents

I would consider the following stocks when putting together a portfolio, the list is not exhaustive. Disclosure, I own many of these shares.

REITS/UTILITIES/INFRASTRUCTURE

Possible inclusions, APA, AST, SKI, GPT, DXS, SYD, HPI, WPR, ALX, TCL, AZJ, BWP, CLW, CQR, SCP, SCG, VCX, SGP.

At the time of writing the themes that are worth considering here are,

1.      The size of Office and Shopping centres exposure in your portfolio, given their place in the future world, are they becoming obsolete?

2.      Coal carrying, is it obsolete?

3.      TCL is really low yield but has a growth aspect to it. Not for some.

4.      Higher interest rates may impact capital values, diversification in other sectors that are little impacted is required.

5.      Collect a good diversified mix, do not unconsciously concentrate in one macro exposure.

Banks/Insurers

CBA ANZ WBC NAB IAG SUN and possibly some regionals such as MYS/BEN/BOQ although they are higher risk, so consider that when weighting them in a portfolio. Issues are that banks are becoming less relevant in our lives and the longer-term growth outlook is modest at best. They remain core to the economy but are under ongoing regulatory scrutiny and some structural change. Banks do deliver a large source of franking in the Australian market and it is difficult to envisage a yield fund with no banks. Moving the weightings over time with a long term view and as risk/return varies is recommended. For example, we saw the banks trading at close to Net assets backing (very cheap) even as the threats of the C19 pandemic were clearly reducing, an opportunity to add. Insurers are more marginal as they are more volatile, IMO.

Other Diversifiers.

WES, TLS, SGR, AMC, BHP, RIO, WOW, COL, TAH, ORG, MPL.

When looked at over several years, it can be seen that certain stocks and sectors come into and then out of favour. The income strategy would take advantage of these movements, be slow to increase those out of favour and the inverse, while continuing to keep diversity of income. Avoid excess debt and obsolescence. A coupe of comments. The inclusion of a couple of resource stocks may raise eyebrows, and resources have such volatility, that some may think they play no part in an income fund. There is some credence to this argument. IMHO we want diversification that spreads risk and doesn’t increase risk in a portfolio context. The above stocks are really diversifiers, that is, the macro factors that adversely impact the other sectors eg, interest rates for REITs/Utilities, could or should be favourable to some of these stocks. Therefore, there is some balance and smoothing in returns which is what we want in this strategy. Of course, obsolescence and excess debt should always be considered and avoided.

SUMMARY

The main points I am attempting to make here are

1.      Income portfolios can be an important holding for a specific type of investor.

2.      Stay diversified, IMHO the more the better. We are not picking winners here we are securing a reliable income stream, quite different, less risk, lower upside and lower downside.

3.      Have realistic expectations about capital growth in this style of funds, rotate slowly, watch out for obsolescence and debt. Look for new diversifying additions to the fund. Review each stock at least twice a year.

4.      Only allocate a proportion of your wealth to income strategies. Put as little as you can in income to derive a secure income flow (cover expenses) and put the rest in growth startegies.

5.      Be aware of the value of franking.

When last measured Xmas 2020, my income holdings were overall about 10% above cost, yielding about 5% on cost, and about 7% on cost including franking. The fund could reasonably expect a modest yield pick up as bank dividends normalise through 2021/22. Those metrics look about right to me, ie within reasonable expectations. Addendum-- June 2021 about the same metrics.

Hope this helps someone. Happy to share my current income portfolio if any one is interested.