Why Income Investing Works
When most people think about the stock market, they think of buying and selling shares in the hope of a quick-fire profit. And if you get it right, you can no doubt make money this way.
The reality is that, while you might win a few trades, you’ll lose just as many. On top of that, you’ll most likely drop more money on your losing trades than you gain on your winning trades.
It’s easy to enter the market. But how do you know when to get out? That’s the tough bit which brings most traders undone. If you’ve ever watched a profitable trade turn into a losing one, you’ll know what I mean. I’ve done it myself.
With income investing, you approach the market from a different angle. It’s about looking at stocks as if you’re buying the business, not just hoping that the share price will go up. That is, what they do, how profitable they are, and their prospects for the future.
Let me give you an example. If you were looking at two different businesses to buy, which one would you choose? Let’s say they both cost the same, but the first business made a $10,000 profit, and the second one didn’t make a cent.
Unless you’ve got the necessary skills to make the second business profitable, you’d probably choose the first business. Why would you buy a business that doesn’t make any money when you could buy one that does?
It’s the same with the stock market. While some traders take their chance to cash in on the latest hot sector, the heavyweights in the market rely on something else. Something tangible — income.
How income investing could really boost your wealth
The difference between punters and the professionals is simple. The pros can’t afford to rely on chance. If you were running a multimillion-dollar fund, you probably wouldn’t punt on the latest hot tip, because it would simply be too risky.
The pros understand the real driver of stock market returns is income, not just capital gains.
That’s why they invest in companies that pay consistent and ever growing streams of income, in the form of dividends, to their shareholders year after year.
This is the crux of income investing.
As the profits of a business increase, so too does its value. Let me give you an example, using the most widely held stock In Australia.
Commonwealth Bank [ASX:CBA] listed on the ASX in 1991 at $5.40. Over the next 12 months, it paid out 40 cents in dividends — a very handy 7.4% yield at the time.
Fast forward to today and CBA is trading at $75. Last year, it paid out $4.20 in dividends for a 5.6% yield. That’s a tenfold increase in the size of the dividend!
What did the share price of CBA do over this period? It increased near 14-fold. Why? Because as the cash generated by CBA grew, so did the share price. The share price tracked upwards with the growth in dividends over the same period.
This basic investment tenant has withstood multiple financial crises and other global events, as the price of CBA shows.
That’s because there is something real underpinning the company’s share price — income.
Think about the dotcom crash, or any other major corrections, like the mining stock crash here in Australia. Share prices can float in the stratosphere. But unless they start justifying the lofty valuations with cold, hard cash, they’ll eventually come crashing back to earth.
That’s the point I want to reiterate. It’s the income that companies make, and the dividends they pay to their shareholders, that ultimately determines the value the market puts on them.
That’s all well and good, but how do you go about finding income stocks?
Three things to help you pick an income stock
There are a number of things to look for when deciding which dividend-paying shares to buy. Although a company’s dividend history doesn’t guarantee its future distributions, it can often act as a guide. The key things I look for are:
- Stability — you want to establish that a company pays a dividend regularly. Most blue chip companies pay out two dividends each year — an interim, and then a final, dividend. A company that has a long history of paying consistent dividends is going to be more valued than a company whose history is sporadic.
- Growth — you want to establish that a company has increased its profits and dividends consistently over time. Not up one year and down the next. Fund managers will avoid stocks they can’t rely on.
- Dividend yield — this is the amount the company has paid out in dividends over the last 12 months, calculated as a percentage of the current share price. For example, a company trading at $10, which has paid out $1 in dividends, has a dividend yield of 10%.
The dividend yield is usually where most people start, but on its own it isn’t enough. While past dividends show how much a company has paid out to its investors, it doesn’t guarantee that it will continue to do so.
Perhaps business conditions have deteriorated, or the company’s profits are slipping. Investing in a stock based on historical dividends, only for it to cut the size of its dividend, is called a ‘yield trap’. It’s something every income investor wants to avoid. Why? Because you’re not going to get the return (dividends) you anticipated.
Beyond the company itself, you’ll also want to take a look at the sector it operates in. Is it growing or contracting? As an example, think of the big drop in commodity prices we’ve seen over the last couple of years. Would you want to invest in that sector right now?
You’ll also want to take a look at the overall market as well. Although the majority of companies follow the overall direction of the market, there are always companies that trade against the general trend.
At Total Income, this is where I hunt out the best dividend paying stocks. Not just the big dividend payers you might be familiar with, like the banks.
There are also lots of smaller companies that pay out really juicy dividends as well. And can do so irrespective of which way the market is trading. They even pay their dividends quarterly, and in one in case, monthly. If you’d like to find out a bit more about some of these opportunities, then please check them out by taking a look here.
Editor, Total Income