April 28, 2018
Lately, I’ve seen some confusion in the Financial Independence community, about different investment strategies.
After deciding they want to invest in shares, some are unsure if they should invest for growth, or income. It’s a big decision after all.
Now, many of you will already have in your mind which side of the fence I sit on. But others may actually be surprised at my answer.
Simplifying, most of us investing in the sharemarket for early retirement are following one of these philosophies…
Index Funds: Based on owning a portion of the entire market, being globally diversified and having the majority of our returns come from capital growth.
Dividend Investing: Following an approach like Peter Thornhill advocates. Basically, owning a large basket of dividend-paying companies, being somewhat diversified (though not necessarily globally), and focusing on our dividend income.
(See my in-depth interview with Peter Thornhill here)
Now, when some people are trying to choose which one they prefer, there’s some incorrect assumptions I’d like to clear up.
Firstly, I wrote an article relating to this topic before. So feel free to go back and read my post on Dividend Investing, to see what I had to say. Grab a cuppa, because that’s a long one!
Today’s version is a bit different…
That’s not quite true.
The Thornhill approach is not really about buying high-yielding stocks.
Either way, it’s about investing for a growing dividend stream over time, rather than depending on price growth from the market.
As I’ve mentioned before, this way your investment returns and retirement income is much more focused on fundamentals (being company earnings and dividends) as opposed to share prices, which are more volatile and unpredictable.
In most cases yes, but not all.
Investing in the old LICs, such as AFIC, Argo and Milton, is a very passive endeavour. Indeed, the LICs themselves do very little buying and selling. Most of the time, they’re simply passing on the dividends they receive from the portfolio.
Because many people in the market have different goals and preferences, we shouldn’t assume they’re all trying to swing for the fences.
Making a decision to hold only dividend-paying stocks is a preference I have. And it might mean we earn a return that’s similar, or maybe even less than the market average, but with a higher dividend component.
In any case, the old LICs aren’t that much different to holding VAS – the Vanguard Australian Shares Index Fund. VAS still has a very wide variety of dividend-paying stocks, along with a bunch that don’t pay out any dividends.
Since LICs operate as a ‘company’, they can retain earnings and this allows them to pay out a more progressively increasing dividend over time. So even if they receive lower income for a year or two, they can usually still pay us the same level of dividends due to this structure.
This is part of the appeal of LICs, along with some other things, which I wrote about here.
In fact, my strategy (well, Thornhill’s) is incredibly reliant on growth. But it’s growth in company earnings and dividends that matters to me, not capital growth from share price movements.
Perhaps I should’ve used the proper term before. The true name for this strategy is Dividend Growth Investing.
As the name suggests, it’s a strategy wholly focused on dividends, that grow, over time. So even though the up-front income or yield is still important, without growth, this strategy would be terrible.
You know why?
Because living on this income stream means it needs to increase steadily over time with inflation, ideally, a bit more than that. So if the dividend payments stayed the same, your income is actually shrinking in real terms, as the cost of living slowly goes up.
While the growth doesn’t need to be much, 2-3% would suffice, the growth is essential!
Over the long term, the Australian market has had roughly the same returns as the US. Historically, the US has experienced higher growth with lower dividends. And our market has paid higher dividends, with slightly lower growth. Both having solid growth, adding up to the same returns since 1900.
Importantly, growth is crucial for all sharemarket investors. Whether we realise it or not, we’re all hoping for the same thing. For all those companies and the market as a whole, to generate higher earnings into the future.
Without higher earnings, dividends won’t grow. And without higher earnings, share prices won’t grow.
So no matter your preference, clearly, we’re all barracking for the same team!
I think it’s really the wrong question. Why do income and growth investments have to be different?
Instead of focusing on income or growth…I focus on income growth.
Readers know I’ve chosen the dividend approach, but it’s not about yield or growth in isolation – it’s both. And to label it properly, it’s Dividend Growth Investing.
To repeat: It simply means investing for the purpose of a growing dividend stream, rather than primarily capital growth or total return.
If company earnings grow, so do dividends, and therefore the capital value (share price) will eventually follow. It’s about not relying on share prices, but rather the growing income.
So the point being, if your income is growing faster than inflation, who cares what the share price is doing?
Yes, most definitely. You’re employing a winning long-term income strategy already!
It’s merely a mindset shift. Instead of focusing on share prices, simply start focusing on the growing dividends your index funds are paying out.
Notice how you receive those regular payments, which increase almost every year, regardless of what the market is doing.
The dividend payments from US and Australian corporations should rise steadily over time, rewarding investors, and providing a wonderful growing income stream to live on.
So, those two strategies I listed above, are not really that different from each other. Indeed, two people could have the same portfolio and think of themselves as following a different strategy.
There’s another thing to consider.
In general, when investing in sharemarkets – a high yield investment will likely mean low dividend growth. And a low yielding investment, will mean high dividend growth.
Notice how I didn’t say capital growth? Because it doesn’t bloody matter. It’s just a distraction, so forget about it. The price will follow the company earnings and dividends over the long term.
Anyway, we need to decide how much income/growth we want.
Unfortunately, there’s far too many variables to please everyone. For people on a higher tax rate, investing for a lower yield but higher dividend growth rate is more appealing.
Or, if we have a very long way until retirement, the higher growth rate can work out better.
Some of us will have a low income spouse. And some readers may have a different situation or even be retired, so tax is not a burden.
For those of us investing solely in Australian shares, franking credits cover the vast bulk (if not all) the tax payable. Because of this, many of us are happy to accept a lower rate of dividend growth, for a solid income today.
Whatever we do, we should look to invest with a long-term income stream in mind.
Let’s pretend for a moment. Say we have an 7% return locked in for the next 15 years (a reasonable journey to Financial Independence).
Let’s take an Australian LIC, with a dividend yield of 4%, fully-franked, and dividend growth of 3%. We’ll assume a tax rate of 37%. Not the highest, and not too low – seems fair.
This dividend yield after-tax on day one is 3.6%.
Putting $10,000 in here would provide $360 yearly income, after tax.
After the 15 years, that first parcel of shares, is earning $561, after paying 37% tax. The income grew by 56%. Not too bad.
But remember, in retirement you’ll likely be paying very little tax. Under current rules, the excess franking credits will be refunded, meaning a boost to income.
For this example, we’ll use the Vanguard International Shares Index Fund (VGS).
Right now, the yield is 2.3%. We’ll assume tax of 37%, and dividend growth of 5%. This gives us a total return of just over 7% per year.
On day one, the income from a $10,000 purchase is $230, or $145 after tax.
After 15 years, the yearly income on this parcel of shares is now earning $301, after paying 37% tax. The income has grown by over 100% in this scenario because of the higher growth rate. But it still hasn’t caught up to the first example.
Now, some of you may be saying it’s not a fair example, due to the franking credits for Australian shares. So, let’s even discard the franking credits for a second.
The first $10,000 would earn a dividend of 4%, or $400. Less tax of 37%, leaves $252.
After 15 years, the yearly income would be $623, or $392 after paying 37% tax. Still quite a bit ahead of the high-growth option.
Let’s say that for the next 20 years, International shares were going to have a total return of 9% per annum. Made up of 2% dividend yield, plus 7% earnings/dividend growth.
With a growth rate of 7%, the dividend income would double in roughly 10 years. And after 20 years, dividends would have doubled again.
This means, after 20 years, your yield on cost would be around 8%, because the dividend income has doubled twice. You with me?
Now, let’s say Australian shares were going to have a total return of 7.5% per annum. Made up of 4% dividend yield, plus 3.5% earnings/dividend growth.
With a growth rate of 3.5%, the dividend income would take roughly 20 years to double. So after this time, the investor would be earning around 8% yield on their initial investment.
I’m also ignoring tax in this scenario, which would actually boost the result for Aussie shares, because of franking credits.
So what does this tell us?
Well, even with a higher total return, and twice the rate of dividend growth, it takes roughly 20 years for the income from International shares to catch up with the income paid by Aussie shares.
Of course, for investors who aren’t fussed with income, this wouldn’t matter. But for those of us who are trying to build our dividend income for early retirement, this is a big deal!
You can do a few scenarios with the numbers for yourself. But I come away with the following…
Most of us are aiming to become financially independent relatively quickly – at least within a decade or two. So, I think investing for a decent yield, which grows, makes the most sense.
Obviously, it’s easy (well, I think so) to get excited about the dividend income on offer here in Oz. And with the strong yields and franking credits, it makes for a solid income on the road to, and during, early retirement.
And it’s more tax efficient than you might expect.
That’s not to say you shouldn’t invest in International shares. You should, if you want to. It just takes a while for that income to get going, that’s all.
Depending on your time-frame and personal tax rates, you may be better or worse off investing overseas. But it also provides more diversification, since your dividends will be sourced from many, many more companies.
Although there’s variations on the name, the most accurate name is Dividend Growth Investing. Mostly, for simplicity, I called it Dividend Investing earlier on. Same same 🙂
Hopefully this post has helped explain my thinking a bit more. And we should now have a clear image in our mind what this income-focused strategy is all about.
Further, if you find any folks unsure of whether to invest for income or growth, now you know what to tell them, or at least, where to point them. In my mind, the answer is we should invest for income growth.
Whether you’re an index fund investor, or a pick-your-own-stocks type investor, you can still use this strategy. Because it’s merely a mindset shift. And a welcome break from the zig-zagging, headline-grabbing, erratic movements of share prices.