I’ve long argued that income investors need to balance income growth and current yield in a portfolio. It is understandable that income investors gravitate towards the highest yield shares. But this approach can be short-sighted.

Many non-retired income investors would benefit from a focus on the future income streams that can be generated. Growing income faster than inflation is the pathway to financial independence as purchasing power increases over time. Retirees also need to focus on growth. Retirement may last decades and growth is needed to sustain - and ideally increase – your standard of living.

In the spirit of trying to help investors solve this challenge of balancing high yields and growth I’ve put together a list of shares and ETFs. I may write about investing for a living, but I also invest for my own future and invest for my retired mother. This is the approach I take.

I’ve come up with shares and ETFs that I grouped into two categories:

  1. Shares and ETFs with higher current yields and lower expected growth
  2. Shares and ETFs with lower current yields and higher expected growth (part 1)

Current income and the potential for growth is a balance. In today’s article I’ve identified higher yielding shares with lower potential for growth.

For the shares and ETFs with higher current yields, I’ve come up with a target of 8% annual income growth over the next 5 years. As a reminder, my target was 10% annual income growth for the shares and ETFs with lower current yields.

A portfolio with a mix of both will more than double purchasing power over the current inflation rate of 4% in Australia. An investor will do even better if the RBA gets inflation back to the target range of 2 to 3% annually. Growth in income of 8% over 5 years assuming inflation is 3% would increase purchasing power close to 27% in inflation adjusted terms.

Some are domestic shares and ETFs and some are global shares. I have not included the benefit of franking credits in Australia which will provide a further boost to the income for local investors. I’ve assumed that income is reinvested over the 5-year period but also showed the growth rates for investors currently spending the income generated.

As always, these are shares and ETFs that I think are attractive given my own circumstances and you should only consider them if they meet yours. I’ve outlined why I think these shares and ETFs are attractive and have disclosed if I own any of the securities mentioned.

Where to start

I’ve long proposed that every investor should have an investment strategy that sets criteria for selecting investments for their portfolio. I believe the structure of formally documenting investment criteria significantly contributes to achieving investment objectives.

I am interested in generating a sustainable and growing income stream. We can break down each of these components of my investment approach into criteria I use to select investments:

Income: This is simple. I want investments that generate income. This eliminates anything that doesn’t generate income. The yield of my portfolio should be higher than the overall market. If not, I would just buy the index.

Sustainable: Sustainability of income is more complicated. But we can walk through some specific attributes. I don’t want a company whose earnings could fall significantly because they may not be able to maintain a dividend. That eliminates cyclical companies and companies that do not have moats and may succumb to competition over time. I want companies with medium or low Uncertainty Ratings. The Morningstar Uncertainty Rating assesses financial strength and business risk. Strong finances and low business risk are both positively correlated with a company’s ability to maintain dividends over time. I also want a lower payout rate which represents the amount of earnings paid out in dividends. I avoid excessively high payout rates that approach 100%. A high payout rate means that a drop in earnings could put the dividend in jeopardy as earnings may not be able to cover the payments to investors. I tend to buy larger companies that are well established with a diverse set of products and services. That provides more predictability of future outcomes.

Growth: Companies with growing dividends also need to grow earnings. It is impossible to predict the future but moats or sustainable competitive advantages play a role here. Holding competition at bay gives the company the ability to protect market share.

Why are there so few Australian companies on the list?

A quick glance at the list and it is obvious that there are more American companies than Australian. The simple answer is that I struggled to find high yielding shares that are expected to grow their dividends over the next 5 years. The point of establishing criteria for selecting securities is to have standards. That is what I did. While the Australian market is known for high dividends I also want to see growth – even for the higher yielding shares.

An exploration of some of the top dividend payers on the ASX is illustrative of this issue.

We forecast dividends to drop meaningfully over the next five years for the large ASX miners as represented by BHP, Rio Tinto and Fortescue.

We forecast the dividends for the big 4 banks to only grow between 2 and 4% per annum over the next 5 years. None could clear the 8% hurdle rate I set.

I ran through other high yielders on the ASX under our coverage universe. Our view of maintaining, let alone growing, dividends was not optimistic.

5 attractive opportunities for higher yields with moderate income growth

Transurban Group (ASX: TCL)

Transurban Group is an owner/operator of toll roads in Melbourne, Sydney, and Brisbane. It also owns toll roads in Virginia and Montreal.

The shares are currently yielding just under 5% and are expected to grow 4% annually over the next 5 years. Transurban has a wide economic moat due to efficient scale via the unique and difficult to replicate roads they operate.

Our analysts view the balance sheet as sound and while the dividend payout ratio is close to 100% of free cash flow it is consistent with the assets held. Cash flow growth is based on growth in traffic volumes and regulated toll increases based on CPI increases and / or previously agreed schedules. The Uncertainty rating is medium reflecting a low level of business risk and the predictability of traffic.

I currently hold Transurban in my portfolio.

Contact Energy (ASX: CEN)

Contact Energy is a diversified and integrated energy company. It owns a fleet of hydro, geothermal, and gas-fired generation assets, which produce close to 25% of New Zealand's electricity. It also retails electricity and gas to nearly half a million customers.

The shares currently yield 3.69% which is a bit lower than I would normally look for in the high dividend category. However, growth over the next 5 years is forecast at more than 7.5% a year.

Contact Energy has a narrow Morningstar economic moat rating. It generates solid returns on invested capital thanks to cost advantages from its fleet of low-cost hydroelectric and geothermal power stations.

We view the balance sheet is sound. The company has moderate revenue cyclicality which normally supports higher debt levels. Yet Contact keeps their leverage ratios relatively conservative.

The dividend growth will be underpinned by increases in wholesale electricity prices that are flowing through to customers, cost savings initiatives and the commissioning of new low-cost geothermal power stations.

I currently hold Contact Energy in my portfolio.

Philip Morris (NYSE: PM)

Bring out the ESG pitchforks. Philip Morris International is a global tobacco company with a product portfolio primarily consisting of cigarettes and reduced-risk products, including heat-not-burn, vapor and oral nicotine products. The company operates in markets outside the United States.

The shares currently yield 5.20% and the dividend is expected to grow at just over 3.5% annually for the next 5 years.

The tobacco business has been in a long decline since smoking peaked in the early 1960s. That doesn’t mean that tobacco companies haven’t been great investments that have generated lots of cash to reward shareholders.

Philip Morris International possesses a formidable franchise in the tobacco industry due to an aggregation of intangible assets and a cost advantage. Tight government regulations have made barriers to entry almost insurmountable and have kept market shares stable. This has led our analyst to reward Philip Morris with a wide economic moat.

Given the current regulatory environment we believe that most business risks are predictable hence the Medium Uncertainty rating. We believe the balance sheet is sound and the 75% dividend payout ratio is lower than tobacco peers which provides the flexibility for research and development in non-cigarette product lines.

I currently hold Philip Morris in my portfolio.

Brookfield Infrastructure (NYSE: BIP)

Infrastructure assets are attractive for income investors. The assets have long lives and predictable cash flows that often adjust based on inflation. That is exactly what we want in a dividend.

Brookfield Infrastructure Partners owns and operates quality, long-life assets that generate stable cash flows, by virtue of barriers to entry or other characteristics that tend to appreciate in value over time. It focuses on acquiring infrastructure assets that have low maintenance capital costs and high barriers to entry. The company's segments consist of Utilities, Transport, Midstream, and Data.

This is the only member of my list that Morningstar doesn’t cover but I’ve owned it since 2013 and have been pleased with the results. The current yield is 5.61%. The dividend has grown at an 8% annual rate over the past 14 years.

There are three themes that Brookfield is pursuing as part of their strategy. They are looking to buy infrastructure assets that support digitisation, decarbonisation and deglobalisation. This has led the company to purchase data centres, energy pipelines, energy storage facilities, rail networks and toll roads.

The dividend payout ratio is a conservative 68% of cash flow and many of the assets that they acquire have the moat like qualities that accompany unique and difficult to replicate infrastructure assets.

I currenlty hold Brookfield in my portfolio.

Kinder Morgan (NYSE: KMI)

Another infrastructure company with hard to replicate assets and predictable cash flows. Kinder Morgan is one of the largest midstream energy firms in North America, with an interest in or an operator of about 82,000 miles in pipelines and 139 storage terminals. The company is active in the transportation, storage, and processing of natural gas, crude oil, refined products, natural gas liquids, and carbon dioxide.

The shares are currently yielding 5.60% and our analyst expect the dividend to grow at a compounded annual growth rate of 2.75% over the next 5 years. Given Kinder Morgan’s scale it is hard to move the needle on the dividend, but the combination of the yield and estimated growth rate exceed my goal of 8% annual income growth.

We award a narrow moat rating as Kinder Morgan has assembled a set of energy infrastructure assets that we believe would be very difficult to replicate. Its pipelines and storage facilities are moaty assets, as the challenges of constructing a competing pipeline confer near-monopoly status on pipeline operators.

Management has strengthened the balance sheet in recent years and the company generates healthy amounts of cash that support both the dividend and a share buyback.

I currently hold Kinder Morgan in my portfolio. 

How does this all come together

In the first and second parts of this article I’ve identified 12 different ETFs and shares for income investors. I own 11 out of 12 so no matter what happens I have a stake in my view that these are attractive opportunities for income investors.

For most investors this is too few holdings to build an entire portfolio. But the purpose of this exercise was to identify opportunities that I believe are attractive right now based on the hurdle rates I’ve set of 8% income growth for the picks with higher current yields and lower expected growth and 10% income growth for picks with lower current yields and higher expected.

As I write this the latest inflation reading came in showing price increases have hit a six-month high. Another reminder of the importance for all income investors to focus not just on current yields but also future growth.

Below is the final list and to hold myself accountable I will track income growth on this list over time and will add to it periodically.


As always, please drop me an email with any questions or comments at mark.lamonica1@morningstar.com.

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