Why Compound Income?

This is the first of a three part write up where I look at the background to my investment approach. This part is about why I focus on yield when buying shares and why compounding the income from them is a good idea. Part two will explore what other factors I take into account when selecting income stocks. Part three will look at how I go about constructing an income portfolio and achieving diversification.

So Why Compound Income?

Some investors chase story stocks and growth stocks which they hope will show them either a big and or quick profit. However, they often end up over paying as a result and getting disappointing returns when things don't turn out as they hoped. Though I'm sure many will be able to point to individual growth stocks or speculative  E & P stocks they have made a fortune on in a short space of time, I prefer to take a more tried and tested value approach to get rich slowly. Now I know many a reader, if they haven't clciked away already will be thinking boring. But as James Montier pointed out in his book on Value investing:

As Paul Samuelson said, ‘Investing should be dull. It shouldn’t be exciting. Investing should be more like watching paint dry or watching grass grow.'

Plus as Warren Buffet said:

"Investing is simple, but not easy."

So I prefer to keep things simple and based on the history of where returns have come from (dividends) and what has worked (value). In addition I like to screen for Quality and Financial Security, but I will leave the discussion of those and explore value metrics more fully in part two. 

When I started my investing journey having read around the subject I learned of the value effect which, despite having been identified decades ago, still seems to be going strong to this day. Great background evidence to this was produced by Tweedy Browne (see what has worked link above to download the evidence) and pages 30 to 35 for the research on high yield. They have also produced a separate paper on High Dividend Yield Return Advantage examining the empirical data.

The second thing that had a great influence on me was what was then called the Equity Gilt Study which in those days was produced BZW or Barclays De Zoete Wedd. This showed the returns to various asset classes over the years and demonstrated that the best long term returns come from shares and that most of the returns from shares in the long term come from dividends. This publication is only available to clients these days, but professors Elroy Dimson and Paul Marsh, who I studied with at the London Business School, have also produced a similar study in recent years and written a book called - Triumph of the Optimists: 101 Years of Global Investment Returns.  Or better still you can download a copy of their 2013 Yearbook. This still shows a similar picture and this is where the data for the graph which features on Compound Income↑ blog comes from. Another great source of background commentary and data on these ideas is also contained in Stockopedia's book How to Make Money in Dividend Stocks which is well worth a read if you have not seen it already.

Consequently when I first started investing on my own account in the early 1990's, when self select PEP's first became available, it made sense to me to focus on yield to maximise returns by compounding the dividends in a tax free environment. In those days you were also able to reclaim the 20% tax credit that existed at the time - oh happy days. Thus to sum up why I compound income by buying shares with dividends and yield it is because:

1) In the long run that is where most of the returns come from (see p56 2013 yearbook above for UK data) and also with real growth in dividends it can protect your capital and income from inflation in the long run. So to my mind it therefore makes sense to focus on yield. 

2) Value and yield outperform in the long run (see Tweedy Brown links above) and  since yield is a successful value factor, by focussing on it I force myself to have a natural value bias in my portfolio.

3) Yield can act as a buy and sell discipline.

Finally to conclude this part with what I have found to be true in my experience over the years, I'll finish with some extracts from the Tweedy Browne Yield paper:

"Professor Siegel also coined the terms “bear market protector” and “return accelerator” to describe how dividend reinvestment during stock market declines can dramatically lessen the time necessary to recoup portfolio losses.

The following conclusions can be drawn:
1. Over the last 100 plus years, an investment in a market-oriented portfolio that included, most importantly, reinvested dividends, would have produced 85 times the wealth
generated by the same portfolio relying solely on capital gains.
2. There is substantial empirical evidence to support a direct correlation between high dividend yields and attractive total returns.
3. Three of the studies found that the best returns were not produced by the highest yielding decile or quintile, but rather by the next highest yielding one or two deciles, or the next
highest yielding quintile.
4. At least one study demonstrated that the returns associated with market-beating high dividend yield stocks were also less volatile in terms of the standard deviation of returns.
5. In several of the studies, high dividend yield stocks also sold at low ratios of price-to-book value and/or price-to-earnings.
6. The return advantages of high dividend yield stocks held for equity securities in both the U.S. and throughout the world.
7. At least one study found that high dividend yield stocks outperformed other value strategies as well as the overall stock market return in declining markets.
8. The reinvestment of dividends from high-yield stocks can dramatically shorten the time necessary to recoup losses in declining markets.

It seems clear, at least from the studies contained herein, that stocks with high dividend yields have enjoyed interesting return advantages over their lower yielding counterparts."

 So there you have it the background to my approach which is simple but not necessarily easy to implement or stick with in the long run. In the next part, I will pick up on some of the findings from the research above plus other papers to detail the factors I use when selecting income stocks. So thanks for reading, if you got this far and until next time - good luck with your investing.