How Do You Harvest Your Returns?

Fiona Clark, 16 August 2012

I’ve always been a total return kind of girl. For me, a dollar is a dollar. I don’t really care where it comes from as long as it’s after tax and wasn’t earned from illegal or environmentally unfriendly activities. But recently I read an article by Tim McAleenan that made me question my investment “values”. By using a lovely farming analogy, Mr McAleenan explains why “many long-term dividend growth investors are very reluctant to sell shares to produce income, even if it is possible that the end result is financially the same. They view selling shares as the equivalent of eating the seed corn that should continue to be left for a later harvest.”

According to Mr McAleenan, a dollar is not, in fact, a dollar. In his words: “The difference between selling shares to produce income and letting the shares produce income is not a moot point. When an investor owns 250 shares of Exxon Mobil (XOM) and chooses to only take the $570 in annual dividend income, that investor is choosing to exercise his or her right as a minority owner in the oil giant to receive a share of the profits. If the investor sells six or seven Exxon Mobile shares to generate the same amount of income, he or she is choosing to reduce his or her part ownership in the business to meet the income needs of today (and thus reduces his or her dividend income by about $15 annually). One strategy eats a bit of the fruit naturally produced, the other nibbles at the seed corn to reduce the output of future harvests.”

So is there really a difference or is it more of a case of a “You say tomato…” issue reflecting people’s personal beliefs. (I’m staying with the farming theme here.) Certainly, income based investing has received a fair amount of interest (pardon the pun) and the performance of high-yielding companies reflects the attraction of this approach. The S&P/ASX Dividend Opportunities Accumulation Index outperformed the S&P/ASX 300 Accumulation Index by more than 5% last financial year, without taking into account the potential higher franking credits. But this very outperformance potentially creates additional risk for investors looking for income from their share portfolio. As my colleague Shih Thin Wong comments in this article, the search for income has crowded out some of the value and it is getting more difficult to find opportunities in the high yielding sector. This doesn’t necessarily mean you should avoid it altogether, but it’s important not to jump in without looking at the full picture. Try to remember these two key rules

  • Don’t be tempted to overlook price and focus solely on yield. Even if income is your primary goal, if your capital erodes your future income will drop too.
  • Keep in mind the company’s ability to sustain the dividend. Sometimes the estimated future yield is just that – the share price may have fallen to reflect the market’s lack of faith in future dividends or perhaps the company/industry is undergoing a structural shift that makes future dividend strength unlikely.

While I find Mr McAlleenan’s argument interesting, I can’t say it’s led me to jump the fence. But perhaps I’m a little closer to it, looking over at the corn fields on the other side. At Prime Value, we understand the different approach and we offer two funds, one focussing on returns through growth (with some income) and the other with a greater focus on return through income, to cater for both “types” on investor. So what type are you?