A Strategy For Investors To Benefit From Capital Growth And Dividend Income

4th Jan '17 by tscott

6 comments 8409 reads

As a former investment manager one of the funds I used to manage was the ‘Stewardship Income Fund’. This fund had 2 main criteria: it had to invest in ‘dark green’ ethical stocks and it had to achieve a level of dividend income well in excess of the market average to qualify as an income fund. The dual restrictions of the fund meant it was not permitted to invest in up to 70% of the FT All Share Index as measured by market capitalisation. Such a limited universe deterred many potential investors but the fund did well by adopting an unusual and pragmatic investment strategy that, I believe, could be appropriate for private investors.

The approach the fund used was called the ‘Barbell Investment Strategy’. The strategy is more often used for bond portfolios by balancing holdings of long and short dated bonds. For stocks it is less common but is also used for portfolios to spread the risk between defensive, less risky holdings and more aggressive and speculative equities.

How the Barbell approach works

For the Stewardship Income fund the objective was to obtain the income of the fund from the safer/low risk end of the barbell (see chart below) which then allowed it to invest in stocks that paid below average or no yield but targeted capital growth at the other end of the barbell.

Typically, the income paying stocks were large, often FTSE 100 stocks, while the higher risk stocks were mainly smaller companies. With a portfolio that contrasted so much with the FT All Share Index it meant the performance of the fund was very different from the average fund or the index itself, in both directions! However, the returns compared well with other income funds, despite the restrictions, and interestingly it had a much lower beta than most other funds. This means that it was less volatile (or risky) as the barbell approach disseminated and, therefore, reduced the volatility of returns across the width of the barbell.

Meeting the needs of private investors

Since I have retired I have adopted this approach with my own investment portfolio. While not restricted in what assets or stocks I can invest in I, like the vast majority of private investors, have other constraints. Firstly, my limited savings mean that I cannot spread holdings across a large number of stocks, like an institutional fund, without making the holdings so…

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Brilliant Leader

4th Jan '17

I really enjoyed this article, thanks for putting fingers to keyboard. I wish I had read and absorbed the contents several years ago. My current approach to portfolio management is very similar (although it took me a while to get there) but now I have a name for it as well.

I have a very wide, diverse income segment which is not only large companies, the risk being mitigated by the number and diversity of holdings, although I do recognise the need to add more larger companies. I then have a more focused portfolio of growth stocks and a couple of special situation plays. I am now working on the optimum weightings of each segment and indeed, each holding. I have already seen how the "ballast" of the income segment reduces the volatility while allowing the growth stocks to perform (or not) and like you say, a fewer number of holdings to actively manage. I also like your idea of drip feeding sales of high performing growth shares to be recycled across the portfolio.

Thanks again
Simon

Fegger

Also really enjoyed your article and found it very useful . My current approach is informally similar and it has helped in relooking at this approach as I move towards needing income in retirement.

pka

Thanks for an interesting article with some good investment advice.

My one quibble with what you wrote is that I disagree with your assertion that: "Studies of stock market returns vary in the estimate of the contribution of dividend income depending on the market and dates selected but it is fair to say that over any long term period (50 years plus) it represents a 70%+ of overall return." This is a common fallacy. It is true that returns can be enhanced over a long period by reinvesting dividends, but that is because the reinvested dividends increase the capital base of the portfolio which can then benefit from both capital growth and income in later years. For example, if capital growth is, on average, twice dividend income each year, reinvesting the dividends will give the illusion over a long period that most of the overall return comes from dividends, whereas in fact it would still be two thirds from capital growth and one third from dividends.

tscott

Thanks Fegger and Crazycoops for the comments. One of the consensus views this year is that inflation is likely to rise faster than in recent years when it has been dormant fuelled by the decline in sterling and fall in real incomes. Next's trading statement today is a case in point as it will be forced to raise prices as its costs of production rise and other retailers follow suit. Therefore, finding good income stocks is even more of a priority. One point to remember is that the equity market is a real asset (unlike cash or bonds) and therefore should reflect the rise in inflation and strenghtens the case for equities over nominal assets like bonds and cash.

Hi pka, I think your point is fair over shorter term periods when the market is in a rising trend but over longer terms (ie several decades) there will many years and even decades when there is negative capital growth. The beauty of dividends is that they are always positive and in solid companies should rise at a rate of at least the rate of inflation. If this is added to capital returns over the long term it gives the total return for equities which is a slight premium to bonds (called the equity risk premium that compensates the investor for the extra risk of investing in shares vs. bonds)

Hi tscott, I don't disagree with what you wrote in your latest post. I was merely taking issue with the often-made but incorrect assertion that stock market growth over the long term comes primarily from dividends.

One should also remember that dividends can be cut even by solid companies in a recession - indeed many dividends were cut in the UK during the last bear market of 2007-8. So some people now prefer to buy high-income investment trusts rather than individual stocks, because investment trusts can use their revenue reserves to smooth the payments of dividends even in those years in which dividends from stocks are cut on average.

A strategy for investors to benefit from capital growth and dividend income

How the Barbell approach works

Meeting the needs of private investors

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Tscott

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