When I first started calling my investment philosophy The Income Factory several years ago, there was a lot of resistance from some readers who insisted that you could only achieve long-term growth of your income stream and/or your portfolio value if you invested in “growth” stocks of one sort or another. I discovered through numerous comment-string dialogues that much of the objection was due to a mindset that grew up on or was taught over many decades that “income investing” was for old people, retired people, etc., and that younger folks investing for a future retirement had to focus on “growth” stocks or “dividend growth investing” or indexing, etc. in order to reach their goals.

Surprisingly, many readers did not understand, or could not accept, the idea that achieving long-term growth of your income stream and/or your portfolio value depends on two separate but inter-related things:

  1. The total return you achieve in any specific period (e.g., a year), and
  2. Your choice whether to re-invest that total return (instead of spending it or otherwise removing it from your portfolio) so it can grow your income stream and portfolio value in future years.

Investors in the “accumulative” phase (e.g., younger investors – be they 25 or 60 – who are saving and investing for a retirement that may be years or decades in the future) generally reinvest their entire total return so their portfolio can grow at whatever rate of total return they manage to earn.

Investors in the “distributive” (i.e., spending) phase (e.g., retirees who have already grown their portfolios over many years of “accumulation”) typically choose not to fully reinvest their total return, but instead, use some or all of it to fund their current living or other expenses.

This seems pretty straightforward and obvious. What confuses or hangs some people up is the idea that:

  • “Total return” is made up of two equally important elements: (1) cash distributions (e.g. dividends), plus (2) market price appreciation or depreciation;
  • The calculation of total return is totally indifferent to what source that “return” comes from; for example, a 10% total return can be all cash, or all market price appreciation, or any combination (8% and 2%, 5% and 5%) that adds up to 10%; an 8% return can be 8% cash and 0% growth, or 0% cash and 8% growth, or 4% and 4%, etc.
  • Growing an earnings stream and/or portfolio value over time depends on reinvesting and compounding each year’s total return, and it makes no difference at all to the rate of growth what the source of that total return is.

That means it is immaterial to your portfolio’s growth whether the total return that you re-invest and compound to create that growth was earned totally in the form of cash distributions that you collected and re-invested or was all in the form of “organic” growth within the securities themselves which translates into market price growth even if they pay no cash dividends whatever. Or a combination, where the total return may consist of a dividend or distribution of 2%, 3% or 4%, plus further market price growth of another 4%, 5% or 6%.

In other words, “math is math,” as I have often written. Plenty can go wrong to keep an investment strategy from achieving its target total return. Growth stock investors might pick the wrong stocks, which fail to achieve dividend and price growth equal to their target level. High yield income investors might pick stocks, bonds or funds that fail to pay the high cash distributions they expect. But the point is that whatever combination of cash distribution and price appreciation occurs, that is the total return for the period. And it makes no difference whether it is received in cash or in price growth.

READ ALSO  Abenomics: Big Debts With Nothing To Show For It

Unfortunately, the investment media wittingly or unwittingly contribute to many investors’ misunderstanding by emphasizing and sometimes publishing market price movement as the only statistic in making comparisons between different asset classes and securities. This obviously understates the role that cash distributions play in creating the returns that so many investors actually receive and rely upon. I have described the historical reasons why growth rather than income has come to dominate so much of the media’s discussion of investment performance in recent decades. But as individual investors, we don’t have to fall for it.

Growing Our Portfolio Or Not

What we do with our portfolio’s total return (regardless of how we earn it) is what determines whether our portfolio will grow from one period to the next and at what rate.

A range of total returns of about 8-10% has historically been regarded as an “equity return,” because, according to most economic or financial historians, a diversified portfolio of stocks would have earned an average return somewhere in that general range over the past century or so. If we could achieve that, through whatever strategy we followed, it would be a very good result. That’s because the average investor usually fails to do that well, often because they try to time the market and end up zigging when the markets zag, or vice versa. Or else, they try to hedge or balance their portfolio with bonds and other more “stable” asset classes that end up, over the long run, depressing returns from what they would be if the investor had merely managed to buy and hold equity-like securities over the long term. I say “equity-like” rather than “stocks” or “equities” because there are other ways to earn “equity returns” without actually owning equity per se, as long-time readers of my Income Factory articles and/or book already know. (Check it out here and here.)

Our goal, over time, is to earn a total return that is equal to the historical equity return. Earning that “equity return of 8-10% per year (or even greater, if we are lucky) and then re-investing it so your portfolio has 8-10% more assets working for it each year will grow your income and portfolio value at a rate that doubles and re-doubles itself about every 9 years (at an 8% total return) or about every 7 years (at a 10% total return), according to the “Rule of 72.” Divide 72 by the rate of return that is being compounded to find out how many years it takes to double and re-double itself. A 10% return, re-invested and compounded, doubles itself in 7.2 years (i.e., 72/10 = 7.2), so it will double in 7.2 years, quadruple in 14.4 years, be 8 times its original amount in 21.6 years, and be 16 times in 28.8 years. The 8% return, doubling and re-doubling every 9 years (i.e., 72/8=9), takes 36 years to reach 16 times its original amount. Still impressive, and a more than sufficient growth rate for a patient but disciplined investor to accumulate a substantial investment portfolio.

READ ALSO  Low Interest Rates Are Earning More Than Pennies For PennyMac (NYSE:PFSI)

That’s the power of compounding. But it only works for an investor if they actually re-invest and compound each year’s total return, however it was earned.

One of the points of this article is that it doesn’t matter how we earn that equity return (i.e., whether from cash distributions or from price appreciation). The other point is that we have a choice of what to do with our investment portfolio’s total return. We can keep it in our investment portfolio so it compounds and grows the portfolio, or we can take out some or all of it and spend it. Our choice will probably reflect where we are in our investment life (i.e., pre-retirement, retired, etc.)

Whatever particular investment strategy an investor uses to earn the equity return that they reinvest and compound is not important. The key is that it be a strategy they understand and can commit themselves to. What torpedoes so many investors’ long-term results is not their choice of investments or strategy, but their failure to stick with it through the “thick and thin” of market ups and downs over many years. The Income Factory, by relying on reinvesting and compounding a constant “river of cash” that investors can see and touch, provides investors an alternative to traditional growth investing that makes it easier for many of them to “stay the course.” What many Income Factory adherents really like about it is knowing that they can increase their income stream faster than ever during downturns because they are reinvesting and compounding at bargain prices and higher-than-normal yields; where traditional growth investors may be sitting dead in the water, while collecting only a “trickle of cash” to reinvest and compound.

I have never suggested the Income Factory is a better strategy than traditional growth or indexing strategies, but merely that it is a legitimate alternative for those investors who prefer it for its psychological and emotional advantages as much or more than for its financial attributes. I was gratified that so many followers (10,000+ and climbing) eventually seemed to “get it,” and, when McGraw-Hill agreed to publish my book about the Income Factory, that so many big names in the income and dividend investing world (including some Seeking Alpha authors) ended up endorsing it (see them here and on the book jacket.)

Recently, I am seeing comments of the sort I encountered years ago and thought I had successfully addressed, from people questioning the “legitimacy” of cash returns as opposed to traditional growth returns as components of the total return calculation. Many of them have suggested that only total return based on “growth” is legitimate for creating long-term portfolio growth, and that cash returns are not “supposed” to be used as a source of growth. That somehow cash returns are only to be used for paying retirees’ nursing home bills or other expenses but are not really valid for growing younger investors’ portfolios.

This is an important issue to clarify and keep clarified as we go forward. Once we recognize that total returns from cash distributions are just as “real” as total returns from growth stocks and just as capable of creating long-term growth, that allows us to consider a host of other asset classes, like closed-end funds, secured loans, high yield bonds, BDCs, MLPs, REITs, etc. These asset classes routinely pay higher distribution yields than ordinary common stocks and are appropriate vehicles for achieving equity returns, whether our goal is income or growth. Unfortunately, many investors have also swallowed the idea that all high yields are equally risky just because a high dividend yield on a common stock may indeed be a sign that the payout is in danger. What is often ignored is that higher yields are typically the norm for other asset classes in the “fixed income” category, or even certain equities (MLPs, REITs, BDCs, some financials and utilities, etc.) which are designed and intended to crank out cash income at high levels, while producing lesser amounts of growth (or none at all).

READ ALSO  'Cash-For-Ballots' Fraud Uncovered In Ilhan Omar's Minnesota District: Veritas

I hope readers by now understand our main point, that “total return” is a completely separate calculation from “portfolio growth” over time. You can have a portfolio that earns 8-10% a year and use all of it to grow your portfolio, or you can spend it all to fund your living expenses in retirement, or you can split it and do some of both.

But your choice of what to do with it is completely separate from what the total return is. Total return is how much you earn – in cash and appreciation – during a particular period as a percentage of how much you had when you started that period. Whether you choose to use the total return to fund future growth is a separate decision.

Follow-Up Article: Closed-End Funds as annuities and/or growth vehicles

Thanks for laboring through what may seem like a fairly nerdy article. My real interest in explaining all this is because I want us all to be on the same wavelength as we build on these ideas in a discussion about closed-end Funds, their distributions and total return. Properly understood and appropriately selected, CEFs and their often high yields can be powerful vehicles both for growth during our accumulative years and for creating annuity-like vehicles in retirement. But it requires us to analyze and appreciate the true total return record and outlook for particular funds, so we can manage our own expectations. Hence the importance of defining terms and all being on the same page.

Anyway, that’s coming up in our next installment.

If you enjoyed reading this article but would like: 

  • Real-time alerts to model portfolios, changes to existing ones, and actionable investment ideas
  • Immediate access to all new articles and our library of articles going back ten years 
  • Direct dialogue and informal feedback 

Then please check out Inside the Income Factory A boutique subscription service whose members get to share ideas and participate in the dialogue and decision-making that goes into our model portfolios and our search for new investment opportunities. If you want to take your Income Factory investing up a notch, please click here to learn more.

Thanks,

Steve Bavaria

Disclosure: I am/we are long ALL FUNDS IN MODEL PORTFOLIOS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



Via SeekingAlpha.com