Yield and income - same, same but different.

In recent years, expected returns and income from traditional income asset classes have been low following years of global yield compression. As a result, investors have increasingly looked towards growth assets, like equities, to meet their income requirements. The standard strategy has been to target an equities mix that tilts towards higher yielding investments to match the desired portfolio yield target. This simple approach is often adopted because the terms yield and income are habitually used interchangeably when describing investment strategies - yet there are important differences!

In the chart below, we have split the attractive long-term income stream generated from Australian shares into two groups depending on their grossed-up dividend yield at 30 June 2003. We then look at the level of dollar income (the absolute level of income delivered in dollar terms) generated across the two groups since then. The green bars show the dollar income generated from stocks with the highest yields (top 50% of stocks), while the blue bars show the dollar income generated from the bottom 50% of stocks.

^{Source: Colonial First State Global Asset Management, FactSet.
Income and capital over 15 years calculated assuming a total investment of $100,000 equally weighted across all index constituents of the S&P/ASX 100 index as at 30 June 2003 that have the required 15 year price and dividend history (57 stocks). Data to 30 June 2018.}

Interestingly, investors that targeted above-average yield stocks would actually have been worse off from a dollar income received perspective over the long term, even after accounting for the benefit of franking credits. Those with a keen eye might have observed that the high yield cohort produced higher levels of income in the first few years of the investment. That’s true, and it’s understandable that some investors prioritise this given the immediacy of their income needs. But the investment challenge for most investors is longer term in nature, including the generation of income over potentially long time periods in retirement.

What has produced this counterintuitive outcome? As the blue line in the chart shows, the lower yielding cohort collectively rewarded shareholders with a much higher level of capital growth. The lower yielding stocks’ delivery of greater long-term dividend income was not attributable to their dividend policy or yield, but rather their significantly higher total return, comprised of both dividend income and capital growth. Importantly, when it comes to income generation from shares, each year’s capital return provides the base upon which the following year’s income return is generated. This is the key to long-term dividend income growth. In short, strong total returns drive attractive income from equities over time. As noted by Rudi Minbatiwala, CFSGAM’s Head of Equity Income, “Maximising income and after-tax total returns from equities over the long term requires investors to consider yield and growth together, rather than focusing on yield alone.”

Stock examples might help to reinforce this message. Had an investor bought $100,000 worth of ‘high yield’ Telstra shares in June 2003 they would have received $136,201 in dividend income (including franking credits) over the following 15 years to June 2018. If instead they had purchased $100,000 worth of ‘low yield’ CSL shares in June 2003, the investor would have received $333,312 in dividend income. Why? Because CSL’s capital return has been 27.45%pa versus Telstra’s meagre -3.19%pa – helping to build a much larger base over time from which a lower yield can still derive a superior level of dollar income.

Does all this imply that the dividend yield concept is flawed? Certainly not. Dividend yield is designed to be a valuation metric that should be used in combination with other valuation metrics. The concern is that investors instinctively rely just on dividend yield as a proxy for future cash flow generation, despite the fact that it is the interaction of both income and growth that drives income from equities over time.