Out with the old: Why income investors must be on the right side of change

It has been a difficult year for income investing, as many companies have announced cuts or suspensions to dividends. But there are opportunities for investors willing to do some digging to find resilient businesses, says Richard Saldanha.

Out with the old: Why income investors must be on the right side of change

2020 has proved challenging for many investors, as they come to terms with the impact of COVID-19 on society and business. The year has proved particularly difficult for income investors, with many companies understandably looking to preserve capital and protect jobs, in some cases suspending or cutting dividends.

But despite the coronavirus disruption, some things haven’t changed. The fundamental objective of income investing – finding cash-generative businesses with strong balance sheets, meaning they can grow their dividends sustainably – is more relevant than ever. And, as low interest rates persist, income investing still holds the promise of attractive returns.

Investors need to ensure they are not overpaying for desirable characteristics

The hard part for investors is to ensure they are not overpaying for these desirable characteristics. In that sense, maintaining discipline on valuation remains key. This is one reason why the traditional distinction between value and growth stocks is a red herring. All investors like to think they are investing in companies at an attractive valuation – hence meeting the value criteria – that can also deliver capital growth.

Rather than pigeon-holing companies as value or growth stocks, investors would be better off focusing on the fundamental characteristics of the businesses they invest in. In gauging a firm’s long-term resilience, investors must consider not only its cashflows and balance sheet, but also whether it is well-placed to benefit from the ongoing changes occurring in its industry and the wider world.

Right time, right place

So which trends should investors be monitoring? Consider the rise of the so-called FAANG stocks (Facebook, Amazon, Apple, Netflix and Google), whose strong relative financial and share price performance is often cited in discussions around the growth-vs-value divide. These companies undoubtedly play a pivotal role in our lives, and in many cases may benefit further from the COVID-related increase in remote working and the shift to e-commerce.

Having an income focus does not mean investors cannot participate in long-term structural growth trends

These firms are usually thought of as growth stocks. But having an income focus does not mean investors cannot participate in the long-term structural growth trends that have been driving Big Tech this year; it’s a matter of finding the right opportunity at the right price.

Take cloud computing as an example. This technology has been a meaningful driver of the financial performance of the likes of Amazon – with its Amazon Web Services platform – and Microsoft, which has seen significant uptake of its own cloud offering, Azure. Income investors may assume this trend is out of their reach, but there are dividend-paying companies in the sector such as CoreSite, which owns and operates a large network of US data centres, with customers including Amazon, Microsoft and Google.

The rise of electric vehicles (EVs) is another significant trend. EVs are set to play a crucial role in helping companies and countries around the world meet stricter carbon emissions requirements. We are now seeing governments – particularly in Europe, but also globally – direct stimulus to the industry via incentives and scrappage schemes that are directly targeted at increasing the adoption of EVs and helping bridge the affordability gap for consumers. The stratospheric rise in Tesla’s share price this year illustrates the strong investor interest in this area. But while Tesla doesn’t pay a dividend, other carmakers do, including German auto giant Volkswagen, a company that boasts dedicated EV platforms and scale.

Meanwhile, media providers have seen a massive surge in demand for their content as people look for ways to entertain themselves at home during lockdowns. While the likes of Netflix would sit outside income investors’ usual hunting ground, there are alternatives such as Comcast, which owns a vast amount of content through its NBC and Sky divisions. It recently launched a streaming service, Peacock, to compete with Netflix and others. In addition to its impressive content library, the company is also one of the biggest broadband providers in the US.

Investors must ensure sustainability remains at the centre of their investment process

While tracking these developments, investors must ensure sustainability remains at the centre of their investment process. A key factor in any investment decision is how sustainable a company’s practices are – and this is even more relevant for investors who rely on long-term dividends for income and capital growth. During the COVID-19 pandemic, companies with unsustainable business models and poor social and governance practices have seen their businesses and share prices significantly impaired.

By keeping sustainability in mind, and by selecting companies that stand to benefit from structural growth tailwinds – including the rise in cloud computing, electric vehicles and streaming – investors should be able to build diversified portfolios that fulfil their income requirements over the longer term. At times like these, a focus on resilience and the future should pay dividends.

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