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Growth Over Income

George Clapham, Managing Partner

All investors, both young and old, should consider growth and income when framing their investment strategy. However, it is the outlook for growth which ought to carry the most weight. Too much emphasis on income can be risky, as high dividend yields typically precede earnings downgrades, dividend cuts and thus lower income levels.

Whilst the events of GFC are starting to become a distant memory, this period (2007-2009) was a sound reminder on what happens to higher yielding assets, such as property, banks and infrastructure– (all leveraged sectors that pay out the vast majority of earnings) when turbulent times arrive.

These asset classes performed far worse than quality industrial sectors both in terms of preserving capital value and maintaining income. The Australian REIT sector, for example, lost 75% of its value from late 2007 to early 2009 and distributions were scrapped. Banks cut dividends by 25% while our largest infrastructure stock Transurban, cut its distribution by 60%. I also note banks, property trusts and infrastructure assets have not changed their stripes dramatically – these sectors all retain high pay-out ratios and high levels of debt as a proportion of income. The average pay-out ratio for Australian REITS for FY2017 was 88% leverage (DEBT/EBITDA) 4.3x, about double that of most industrial companies. Likewise, the Australian infrastructure sector averaged 82% with a leverage ratio of 5.7x. The payout ratios for Australian banks averaged 77%.

Growth companies in well-structured industries with a strong competitive advantage will deliver both – income and capital growth. Let’s just take the income side of a growth stock, such as CSL and compare the accumulated income from holding CSL over the long term to that of holding your typical income or yield stock, like TLS.

TLS paid out its first dividend in February 1998 of 9.14 cents (adjusted for stock issues), whilst CSL paid out an interim dividend of 2 cents (adjusted) in April that year. Based on the CSL share price back then ($3.78) the dividend yield was a miserly 1.6% whilst TLS yield was 5.1% (share price $3.59). Thus, an income fund would not have bothered buying CSL.


Source: ASX/ Arnhem

TLS paid an annual dividend of 31 cents for FY2017, but that distribution is expected to fall to an estimated 22 cents in 2018 due to a need reduce its payout ratio from 100%. CSL’s annual dividend was 175 cents in FY2017 and is forecast to increase ~10%. If you purchased a $1000 of TLS shares and $1000 of CSL shares at the beginning of 1998 and held those shares to today, CSL has paid you $3,285 of dividend income whilst TLS has paid you $1,091. So the growth stock has delivered more than three times the income of an “income” stock. Not only that, the income from CSL has almost covered your original purchase cost of $1,000 of CSL shares. Of course, the difference between the capital appreciation of CSL and TLS is enormous, as $1000 of TLS shares purchased in early 1998 is worth $989 today whilst the equivalent amount in CSL shares is now worth $4450.

This article has been prepared by Arnhem Investment Management Pty Limited ABN 17 129 606 775, AFSL 332484. It has no regard to the specific investment objectives, financial position or particular needs of any specific recipient. You should seek your own professional advice in relation to any financial product referred to. You should also obtain the product disclosure statement relating to any financial product referred to and consider the statement before making any decision about whether to acquire the financial product.

This article, including the information contained herein, may only be copied, reproduced, republished, or posted if done so in whole with original disclaimer included.
© Arnhem Investment Management, 2017