Why quality of income is as important as quantity

I’ve written before to advocate the acquisition of income-producing assets. With the collapse in interest rates around the world, yields have fallen, and artificially inflated demand for dividend-paying stocks over bonds and cash savings.

Investors have a range of passive income vehicles to choose from. This diversity can make choosing the right one a daunting proposition, but simply chasing the highest yielding shares, funds and bonds is likely to end in tears.

Why Dividends?

High-quality equity dividends are like to rise over time as companies increase prices with inflation, maintain profit levels and in theory protect their ability to pay dividends. Of course, not all dividend-paying companies are the same.

Some are mature, slow-growth firms with strong cash flows and a conservative, predictable approach to dividends. Their stocks tend to react consistently with bonds when interest rates change. Others are growth-oriented companies, usually with more aggressive expansion plans. These firms tend to mark their success by raising dividends but are also more prone to volatility, competition and other changes in the market.

Why high-yield might not be the best option

 

Some investors chase the highest possible pay-out, seeking above-market returns and considering little else. In my opinion, this is a huge mistake, and I consequently focus on assembling a portfolio of higher-quality companies that aim to maintain a balance between income and long-term capital growth.

Yields of eight, nine and ten percent might initially seem attractive, but they usually reflect a return from investing in a risky company that has unsustainable debt levels, unstable revenues or some other reflection of poor quality.

By simply pursuing high yield, investors can fall prey to dividend traps. These are companies that are promising dividends that they cannot afford. Industry shocks, changes in banking covenants and other market changes often lead to these companies slashing their dividends, and the company then suffering a share price drop as yield-seeking investors and tracker funds dump the share due to the reduced dividend.

By contrast, investing in companies that have consistently raised or maintained dividend payouts over a period of 10 or more consecutive years means that I am more certain of my income and the stability of my overall portfolio. In practical terms, this is worth far more to me than the significant risk generated by chasing yield.

Conclusion

The companies I invest in usually have better profitability characteristics and lower debt than their high-yield cousins, and consequently are superior investments, despite their lower yield. By pursuing quality and ensuring strong diversification, I protect my portfolio and the income which it income.

Chasing yield might seem attractive, but in truth, it’s likely to lead to a portfolio stuffed to the gills with risky, unstable and unreliable companies. These companies face a significant risk of dividend cuts, erratic revenues, share price volatility and even total collapse. They’re the stock market equivalent of sub-prime mortgage lending. So the next time you see a share yielding 10%, stop and ask yourself…do you really want to contaminate your portfolio with all of that?