Unconventional wisdom: Why I choose income investing despite its shortcomings
The trade-offs are real – here is a checklist I use to find shares worth holding anyway.
Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.
Unconventional wisdom: Why I choose income investing despite its shortcomings
For whatever we do, even whatever we do not do prevents us from doing its opposite. Acts demolish their alternatives, that is the paradox.
- James Salter
The easiest way to fail at investing - and life - is to think that choices don’t come with trade-offs.
The investment industry tends to minimise trade-offs. The reward is front and centre while the risk is buried in the fine print.
I didn’t choose income investing because it is the perfect strategy. Instead, I’ve decided that I can live with the downsides to gain a set of advantages that align best with what I want out of life.
It is counterproductive to ignore shortcomings and pretend a strategy is without flaws. Success comes from accepting those trade-offs and sticking with a strategy long enough to capture the benefits.
The shortcomings of an income strategy
Consistently pursuing any investment strategy means accepting periods of underperformance. During these periods it is hard to stay the course.
The media is filled with short-term ‘winners’ and fund managers rush to release new products to take advantage of the latest trend. This creates pressure to follow the herd and chase performance.
Income strategies tend to underperform during momentum driven bull markets. This underperformance is particularly acute during speculative phases fueled by hype.
Conversely, an income approach tends to outperform during periods of market stress. Investors gravitate towards dividend paying shares in bear markets and the nature of the companies that pay dividends – larger, more mature and in better financial shape – generally makes them more resilient.
Like most narratives this view of income investing is simplistic. Digging deeper into the data uncovers the nuance that leads to long-term success.
The advantages of an income strategy
The strengths of an income strategy are apparent when looking beyond the short-term cyclical nature of markets.
Annually a fund manager in the US puts out a study called The Power of Dividends: Past, Present, and Future. The study provides an in-depth exploration of US dividend shares.
S&P 500 shares are divided into multiple categories based on their dividend policy. The categories are not mutually exclusive. The return for each category of shares between 1973 and 2025 is as follows:
To see if the same patters are evident in the Australian market I ran a similar analysis across the 179 ASX listed shares in our coverage universe with a ten-year return history.
I eliminated the no-change in dividend policy category given the small sample size of four companies which met the criteria. Below are the results:
Like any analysis there are limitations. The returns do not include franking credits. According to ATO the average annual franking credit rebate yield on the All-Ordinaries index was 1.25% over the last decade. This is a fair estimate of the benefits of franking credits for dividend paying shares and the overall index return.
All returns are influenced by survivorship bias. By using our current coverage universe shares that have done well and attracted investor interest are likely included while unsuccessful companies never make the cut.
A pattern emerges in the US and Australian data. Companies that increase their dividends over the long-term tend to significantly outperform the average company.
This illustrates the tendency of sentiment to drive short-term performance while fundamentals influence long-term outcomes.
Growing dividends over the long-term requires long-term earnings growth. These are the companies that rise above the competition and deliver for shareholders throughout the cycle.
The lesson isn’t dividend paying shares are inherently attractive. It’s that companies that consistently raise their dividends tend to create shareholder value.
Here are some of the characteristics I look for when finding candidates for my own portfolio.
Standing up to the competition
Before considering buying any share you need to understand the competitive environment the company operates in. I start with the customer. Figure out what influences their purchasing decisions and why they would choose the goods and services of one company over another.
Is it price, quality, confidence or are other factors at play? Are there substitutes or could a customer cut back or forgo a purchase altogether?
Barriers to entry that limit competition and switching costs help successful companies maintain their advantages longer.
Comparisons to competitors provide context. A company that consistently generates higher profit margins and returns on invested capital may indicate a sustainable competitive advantage.
I like to read the Economic Moat section of our analyst reports. Sometimes I agree with our analysts and sometimes I don’t. But reading their in-depth description of the competitive environment is an invaluable input into my decision-making process.
I use Morningstar’s moat sources as a framework for this process and consider if there are switching costs, network effects, cost advantages, intangible assets or efficient scale.
External factors that influence how a company performs
Personally, I like more predictable companies as income investing is a slow and steady long-term approach. I tend to write off whole industries that are too cyclical or too complicated / opaque for me to understand. This is why I don’t invest directly in resource companies or banks.
I try and think through all the internal and external factors that influence how a company will perform. The fewer factors beyond the control of management the better.
There will always be surprises – both good and bad – but more mature companies with established and diverse product lines and strong finances tend to be more predictable.
Valuation
I’m past the days when I try and build a discounted cash flow model. That doesn’t mean the price you pay for a share isn’t important. As an income investor I tend to look at historically high current dividend yields as a proxy for valuation.
Ideally the market is ignoring dividends and focusing on the latest trend. This is an environment where I can buy great companies that aren’t popular right now.
But often it is a company specific reason and I need to determine if investors have overreacted to a perceived issue. I try and develop a thesis on why investors are overreacting while remembering that the market is often right.
I aim for ten percent growth in income as a margin of safety to try and outpace inflation. I look at the current yield and the growth needed to reach my ten percent goal. For example, if a company has a 3% dividend yield I need 7% dividend growth if I reinvest that dividend.
This is where earnings growth comes in and I use the 7% figure as a starting point to evaluate the prospects for the company over the long-term. A higher yield means I need less growth.
Dividend sustainability
I’m looking for growth but at a bare minimum I’m trying to avoid a dividend cut.
The first dividend red flag is the payout ratio of dividends to earnings. If it is too high any drop in earnings can lead to a dividend cut.
The payout ratio doesn’t work as well in Australia compared to the US. Payout ratios are generally significantly higher in Australia, and local investors tolerate fluctuating dividends more than in the US.
For Australian companies I consider the payout ratio in relation to the opportunities to use funds to grow the business. If I need higher future growth to hit my ten percent target the company can’t starve itself of capital to support the dividend.
I also look for companies with a reasonable level of debt. This differs by industry as more predictable cash flows can support higher levels of debt. However, excessive debt is risky and I want companies in strong financial shape.
I like to read the capital allocation section of our analyst reports to get their perspective on the company’s payout rate and financial strength.
Final thoughts
Considering trade-offs is just as important when picking an individual investment as it is when deciding on a strategy. Investing remains more art than science.
When I was younger, I was drawn to formulas and narratives that offered the ‘perfect’ investment. With experience I’ve come to accept that investing is an exercise in compromise.
Higher yields come with lower growth. High returns require accepting more uncertainty. Consistency means shifting from contrarian to conformist as markets cycles change.
In our constant search for what works we often forget that success comes from avoiding what doesn’t. Trying to find the ideal investment strategy in an imperfect world is a recipe for disappointment.
Define success in your own terms and embrace trade-offs where the downsides are acceptable and the strengths align with your goals.
Every act demolishes its alternatives. Investing is no different.
Share your thoughts and email me at [email protected]
Want to learn more about income investing? On Tuesday 25 August I will be doing a webinar on picking income shares. Sign-up here.
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What I’ve been eating
If you read the origin story of enough dishes a common theme emerges - something is accidentally added into something else and a new dish is born. Legend has it a widow’s daughter spilled coconut milk into a pot of rice. When the widow came home, she asked her daughter what she was cooking. The daughter replied ‘rice, mother!’ or, in Malay, ‘nasi le, mak’.
Nasi lemak is rice cooked in coconut milk and pandan leaf with fried anchovies, egg, cucumber and sambal. At Cocunut Club on Beach Road in Singapore you can add several things to your nasi lemak – I’ve tried the fried chicken and beef rendang and both are excellent. I try to stick to the hawker centres for lunch but this place is well worth a detour.
