Investing for income: the ultimate growth machine

While investors seeking regular returns are often more advanced in years, those looking for wealth can be younger and less risk averse. But combining both strategies can be beneficial too, as investing for income also generates growth.

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Private investors are often divided into two apparently opposing camps – those looking to generate growth, and those seeking income.

Growth investors tend to be younger and more aggressive, as they are looking to build long-term wealth for their old age.

Income investors are typically older and more cautious, as they want to protect the investment gains made in their younger years while generating an income to fund a comfortable lifestyle in retirement.

However, these camps aren’t as opposed as you might think, because one of the best ways of generating growth is to invest for income.

You do this by investing in top companies that pay dividends, regular payouts made to shareholders as reward for holding their stock.

Many investors overlook these dividends, as they are typically just a few cents or pence per share, but over the years they can roll up into big money.

The key is to reinvest those dividends back into your portfolio for growth, rather than taking them as income. That way you benefit from the miracle of compound interest, as reinvested dividends gradually accumulate more shares, which earn you more dividend income, year after year.

Chris Beauchamp, chief market analyst at the online trading company IG, which has offices in Dubai, says investing for dividends has become more popular as the income on cash and bonds has slumped since the financial crisis. “You can get income of anything between 2 and 7 per cent a year from top blue-chip companies quoted in the UK, US, Europe and emerging markets, far higher than on most other investments,” he says.

Often the returns from your income can dwarf those from capital growth. Take the UK’s FTSE 100, which is full of dividend-paying global stocks such as the oil majors BP and Royal Dutch Shell, miners BHP Billiton and Rio Tinto, and international banks such as Barclays, HSBC and Standard Chartered.

The FTSE 100 currently trades 12.8 per cent higher than 10 years ago, but with dividends reinvested the total return is a far healthier 64 per cent, according to figures from online investment platform AJ Bell.

Investors who had targeted individual income stocks may have generated a much more spectacular return.

Global cigarette giant British American Tobacco’s share price grew 238 per cent over the decade, but with reinvested dividends the total return is an even more impressive 412 per cent. It currently yields 3.22 per cent.

Similarly, mobile phone operator Vodafone yields a generous 5.66 per cent. Its share price grew just 42 per cent over the past decade, but the total return is 150 per cent with dividends reinvested.

Defence manufacturer BAE Systems grew 38 per cent over 10 years but delivered a total return of 117 per cent including dividend growth.

You can invest for dividends either by purchasing individual company stocks, through a low-cost exchange traded fund (ETF) or an actively managed mutual fund:

Dividend stocks

The longer you invest for, the longer you have for those dividends to roll up and compound interest to work its magic.

Dan Dowding, a director at investment advisers AES International in Dubai, quotes figures from investment house Woodford Asset Management which shows how dividend income is the ultimate growth machine.

“£1,000 [Dh4,706] invested in the UK stock market in 1926 would have appreciated at a compound annual growth rate of 5.4 per cent a year and grown to just over £100,000 today. With dividends reinvested, it would be worth £7.8 million,” he explains.

The best dividend-paying stocks tend to be large, established, cash-generative and often multinational businesses, that aim to increase their dividend year after year. For example, British American Tobacco has increased its dividend at an annual compound growth rate of 9.9 per cent a year, and Vodafone by 4.8 per cent.

This allows you to lock into a rising income – and rising growth prospects.

The key figure to look for is the yield, which is calculated as the annual dividend payout divided by the share price.

However, Mr Dowding says you should never simply plump for the highest possible yield because a dizzying dividend may reveal a company in trouble.

In December 2015, yields at global commodity companies Anglo American and Glencore topped out at 14 per cent and 12.5 per cent respectively, as their share prices and profits collapsed in the face of dwindling demand from China.

That level of generosity simply wasn’t sustainable, and shortly after both companies took the axe to their dividends. Today, Anglo American yields nothing, while Glencore pays just 0.93 per cent.

Mr Dowding says one way to check the safety of a yield is to look at the company’s dividend “cover”, which shows how many times over it can pay a dividend from its profits. Cover of two times or more is ideal. Anything below one is a concern.

Some companies have a distinguished track record of increasing their dividends year after year. For example, top US companies Coca-Cola, Johnson & Johnson, Procter & Gamble, Emerson Electric, 3M Corporation and Cincinnati Financial increased their dividends for an incredible 50 consecutive years or more.

Mr Dowding says the best dividend payers tend to be listed on the UK and US markets. “London-listed stocks have historically paid the higher dividends”.

He tips Shell, which yielded 7.15 per cent at time of writing. The company is renowned for never having cut its dividend since the Second World War, although if the oil price stays below US$50 for an extended period, that proud record could be broken.

Vodafone is another favourite, currently yielding 5.66 per cent, and although cover is currently thin at just 0.4, this is expected to improve as profit rises, and the yield is forecast to hit 6.3 per cent by 2019.

Mr Dowding also likes the London-listed pharmaceutical group GlaxoSmithKline, which yields 5.11 per cent and utility National Grid, which yields 4.33 per cent.

He also picks out five US stocks, all familiar, established names with slightly lower yields than their UK rivals: Johnson & Johnson, which yields 2.68 per cent, IBM (3.42 per cent), Microsoft (2.36 per cent) and Cisco Systems (3.33 per cent), and ExxonMobil (3.75 per cent).

Chris Beauchamp at IG suggests UK-listed consumer goods companies Reckitt Benckiser and Unilever, which both have strong long-term dividend track records. “You might also try some European companies, where top dividend payers include insurers Allianz, Axa and Zurich Insurance, pharmaceutical companies Bayer and Roche Holdings, motor manufacturer Daimler and Finland’s Nokia.”

Exchange-traded funds

Buying individual company stocks may be too risky for many individuals, but there is a low-cost method of spreading this risk.

Mr Dowding says the simplest and lowest risk way to benefit from the compounding miracle of reinvested dividends is to buy a low-cost tracker ETF fund. “These may track an index, such as the FTSE 100, which currently yields approximately 3.6 per cent, or the S&P 500, which yields 1.97 per cent.”

Alternatively, you could buy an ETF that invests in a basket of attractive dividend stocks, such as iShares Core High Dividend ETF, which currently yields 3.50 per cent, and iShares Core Dividend Growth ETF, which yields 2.17 per cent.

These invest in top US companies such as ExxonMobil, AT&T, Verizon, Johnson & Johnson, Chevron, Pfizer, Procter & Gamble, Philip Morris, Coca-Cola, Cisco, JP Morgan Chase and Apple.

If you want a spread of international stocks you might consider the DJ Global Select Dividend Ucits ETF from UBS, which invests across Australasia, Europe, the US, UK and Canada, and currently yields 4.35 per cent. Top holdings include US internet company CenturyLink, broadcaster Sky Network Television and UK builder Carillion.

Another option is the iShares Stoxx Global Select Dividend 100 Ucits ETF, which tracks the 100 leading dividend-paying global stocks from the Stoxx Global 1800 Index, and currently yields 3.94 per cent. Top holdings include Shell, UK budget airline easyJet and the National Australia Bank.

Mutual funds

You might also consider investing in a mutual fund, where the active fund manager selects a portfolio of income stocks on your behalf.

Mellissa Gallagher, a director at Allianz Global Investors, recommends Merchants Trust, which has increased its dividends for the past 34 years. “Fund manager Simon Gergel invests in a diversified portfolio of large, well-established and well-known UK companies, and currently yields 5.66 per cent,” says Ms Gallagher.

Merchants is an investment trust, a special type of London-listed fund that can be traded like a share. They have a long pedigree and three have increased their dividends for an incredible 50 consecutive years: City of London Investment Trust, which currently yields 3.73 per cent, Bankers Investment Trust (2.21 per cent) and Alliance Trust (1.86 per cent).

Phil Smeaton, chief investment officer at global wealth advisers Sanlam, tips the Schroder Income Maximiser Fund, run by Thomas See, which aims to pay the maximum possible income and currently yields 7.17 per cent a year.

He also tips the other UK-focused income funds, CF Miton UK Multi Cap Income, Royal London UK Equity Income and the Threadneedle UK Equity Alpha Fund.

Those who want exposure to Europe might consider BlackRock Continental European Income Fund, which invests in companies such as Zurich Insurance Group, Spanish telecoms company Telefonica, and Italian transport infrastructure company Vinci. It currently yields 4.08 per cent. Jupiter European Income, which yields 3.10 per cent, and Liontrust European Income, yielding 3.86 per cent, are also worth considering.

Sheridan Admans, investment research manager at UK stockbroker The Share Centre, tips the Guinness Asian Equity Income, which gives you exposure to high-quality dividend-paying companies in the Asia Pacific region. “Fund manager Edmund Harriss takes a long-term view and invests on a high conviction basis with typically 36 positions in his fund,” says Mr Admans.

The fund currently yields 3.76 per cent and has delivered a total return of 61 per cent over the past three years.

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