Investing for income

By Centauri78

This article isn’t about property, but I thought since I’d written about property shares and REITs previously, this may be relevant to some of our readers.

While I am a proponent of investing for income, one thing that irritates me to no end when I read it in articles written by income investors is the concept of yield over original cost.

I read an article a while back by an ex-financial advisor. In it, he was saying how while he was still a rookie, he advised his client to switch from a low-yielding share to another counter having a higher yield. The client refused, saying that while the yield is low, it is actually giving her more than her original buy price each year, or more than 100% yield over original cost! The author, unjustly shamed, took this “lesson” and presented it as a truth of income investing.

My pet peeve is that this shouldn’t be how this game is played. I think yield should always be calculated based on current price and not on historical price. Sure, the share is giving the client an annual dividend of more than her original buy price, but imagine if she sold the share that was giving her 2% yield and bought another share that paid her 3% per year. That will give her an extra 50% more over her original cost price per year. Of course, this particular person’s reason may be that she doesn’t understand other businesses as well as this company, but that’s a minor problem, since there will almost definitely be other similar businesses paying out better dividends. Or alternatively, at such low yield, she can cash out and buy long-dated Treasuries that is giving the same interest, but without the risk. Either way, the original share is likely no longer the best choice for her.

As part of my portfolio strategy, specifically the income-producing component, I prefer the use of yield targeting. Why hold on to a 3% yielding share when I can go for a 6% yield?

My method is to first shortlist good companies, and then establish a baseline yield for each company based on the industry it is in. I aim to buy shares in companies that are at or above the baseline yield. Once purchased, I would then set downside and upside targets for the yield and review the investment if and when it reaches either level. Of course, we are talking about the share being a simple income-producing share. If it has significant growth potential, then that’s a different story.

For example, let’s say I bought XYZ company shares at $1 and it gives me an annual dividend of $0.10. That’s a yield of 10%. I will then proceed to set the yield target for review. Let’s say I choose 5% for the downside target. This can be due to price rising faster than yield (usually good) or yield decreasing (usually bad). When current yield then reaches 5%, I would review to see whether it still makes sense to hold. If there is expectation of recovery or increasing dividends in the future, it may make sense to keep the share. However, if the reduced dividend is structural, then it may be time to bail out.

Similarly, if the share reaches my upside yield target, it is due for a review. If the yield increased because of justified impairments in the business itself, then it may not be worth holding. However, if the company has hiked dividends because their growth potential has peaked, it may be worthwhile to continue to hold the share as the business reaches maturity and turns into a bona fide cash cow. In fact, if the business was not impaired, it may even be time to add to the position.

In summary, calculate yield based on current prices, not original cost. Set high and low hurdle target levels for review of the company. Lastly, if the business has changed, you need to do a review and determine whether the share is still right for your portfolio. Happy investing!

Centauri78 is not a licensed financial advisor. The information contained here is purely personal opinion, and whilst I make every attempt to ensure the accuracy and reliability of the information, this information should not be relied upon as a substitute for formal advice or as basis for investment.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s