Why Compound Income?

20th Jan '14 by jjis

3 comments 10824 reads

This is the first of a three part write up where I look at the background to my investment approach. This part is about why I focus on yield when buying shares and why compounding the income from them is a good idea. Part two will explore what other factors I take into account when selecting income stocks. Part three will look at how I go about constructing an income portfolio and achieving diversification.

So Why Compound Income?

Some investors chase story stocks and growth stocks which they hope will show them either a big and or quick profit. However, they often end up over paying as a result and getting disappointing returns when things don't turn out as they hoped. Though I'm sure many will be able to point to individual growth stocks or speculative E & P stocks they have made a fortune on in a short space of time, I prefer to take a more tried and tested value approach to get rich slowly. Now I know many a reader, if they haven't clciked away already will be thinking boring. But as James Montier pointed out in his book on Value investing:

As Paul Samuelson said, ‘Investing should be dull. It shouldn’t be exciting. Investing should be more like watching paint dry or watching grass grow.

Plus as Warren Buffet said:

Investing is simple, but not easy.

So I prefer to keep things simple and based on the history of where returns have come from (dividends) and what has worked (value). In addition I like to screen for Quality and Financial Security, but I will leave the discussion of those and explore value metrics more fully in part two.

When I started my investing journey having read around the subject I learned of the value effect which, despite having been identified decades ago, still seems to be going strong to this day. Great background evidence to this was produced by Tweedy Brown (see what has worked link above to download the evidence) and pages 30 to 35 for the research on high yield. They have also produced a separate paper on High Dividend Yield Return Advantage examining the empirical data.

The second thing that had a great influence on me was what was then called the Equity Gilt Study which…

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Mark Simpson

20th Jan '14

I like dividends. I want to invest in companies that throw off so much cash that they cannot re-invest that back into their business at their already high returns on capital so they return the excess to shareholders.

However the line that's often used to justify buying high yield stocks:

1) In the long run that is where most of the returns come from (see p56 2013 yearbook above for UK data) and also with real growth in dividends it can protect your capital and income from inflation in the long run. So to my mind it therefore makes sense to focus on yield.

isn't really correct. What has happened in reality is that equities have yielded c10% nominal return of which c5% has been dividend yield and c5% nominal growth. Inflation has average 4%. Now since this is price inflation people apply this to the price changes and say that dividend yield has generated 5% return and price changes 1% - however really this is an arbitrary choice. I could say that 4% of my re-invested dividends are to overcome the effect of inflation and then I get price changes responsible for 5% return and dividends 1%. Neither is of course correct since in reality you can't split the returns in this way. the best statement is probably that 'dividends and price changes have both been important sources of historical equity return'.

Even the statement that dividend yield is an important source of historical equity returns doesn't imply that a subset of the market will outperform when chosen based on yield criteria. For that you have to look at the studies where people have tested the subsets of the market based yield criteria. Dremen did this in Contrarian Investment Strategies and while he found that high yield did predict out-performance the effect was only about half of price-earnings or price-book selection criteria.

So while your yield based approach has some advantages a purely yield based approach is unlikely to be optimum unless combined with other criteria.

jjis

Thanks for your reply which makes some good points. On inflation and real returns I see where you are coming from as the real returns have been around 5% globally. The professors on page 11 of their year book break that down as 4.1% yield, real dividend growth of 0.5% and price/dividend expansion (re-rating) of 0.4%. They therefore they seem to be saying the yield is a real yield as dividends have grown ahead of inflation.

On your final point I agree that focussing on yield alone is probably not optimal and I do indeed use other factors when selecting my stocks which I intend to expand on in part 2.

Cuthbert C

21st Jan '14

Danger

thank you for your succinct response

T

Why Compound Income?

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Jjis

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