Compounding of returns for the long term
If you are an income seeker, frozen interest rates at historic lows mean real losses for many savers in bank and building society deposits which fail to match inflation.
The most popular forms of income investment are bonds (which are also known as ‘fixed interest’ investments) and cash, both of which pay a regular, consistent rate of interest either annually, twice a year or four times a year. You can also obtain an income from shares in the form of dividends, and many equity funds are set up solely with the aim of generating a stable income. Importantly equity income funds often aim to achieve not only stability, but an increasing income in the long term.
Income stocks are most usually found in solid industries with established companies that generate good cash flow. They have little need to reinvest their profits to help grow the business or fund research and development of new products and are therefore able to pay sizeable dividends back to their investors. Examples of traditional income-generating companies would include utilities such as oil and gas, telephone companies, banks and insurance companies.
You should remember that these investments do not include the same security of capital which is afforded with a deposit account.
10 income investing tips
1. Sustainable long-term dividend growth – Investing in businesses when the growth potential is not reflected in the valuation of their shares not only reduces the risk of losing money, it increases the upside opportunity.
2. Inflation matters – Always bear in mind the detrimental effect of inflation. Corporate and Government bonds offer higher yields than cash but returns can be eroded by inflation. Investment in property or equities provides a vehicle to help achieve an income that rises to keep pace with inflation.
3. Consider international diversification – A small number of UK companies account for some 40 per cent of UK dividend payouts. This compares with over 100 companies in the US, for example, that provide the opportunity to increase the longevity of dividend growth.
4. Patience is a virtue – Investing for income is all about the compounding of returns for the long term. As a general rule, those businesses best placed to offer this demonstrate consistent returns on invested capital and visible earnings streams.
5. Reliability is the key – Select sectors of the equity market that do not depend on strong economic growth to deliver attractive returns to investors.
6. High and growing free cash flow – Look for companies with money left over after all capital expenditure, as this is the stream out of which rising dividends are paid. The larger the free cash flow relative to the dividend payout the better.
7. Dividend growth – In the short term, share prices are buffeted by all sorts of influences, but over longer time periods fundamentals have the opportunity to shine through. Dividend growth is the key determinant of long-term share price movements – the rest is sentiment.
8. Cautious approach – Profits and dividends of utility companies are at the whim of the regulator. Be cautious of companies that pay a high dividend because they have gone ex-growth – such a position is not usually sustainable indefinitely.
9. Investment diversification – The first rule of investment is often said to be ‘spread risk’. Diminishing risk is particularly important for income-seekers who cannot afford to lose capital.
10. Tax-efficiency – Increase your net income by using an ISA (Individual Savings Account). ISA income is free of taxation, thereby potentially improving the amount of income you actually receive. ISAs are also free from capital gains tax, allowing you to switch funds or cash in without a tax charge.