Smart Income: Redefining The Search For Yield by Vikas Gupta – Executive Vice President & Chief Investment Officer, ArthVeda Capital

There once was a time when dividend paying stocks were recommended to widows and orphans, pension funds, and trust funds as safer, steady income providing investment vehicles. However, as stock dividend yields began to decrease over time, income-oriented investors turned to bonds to achieve the desired income in their portfolios.

Today these investors are faced with a dilemma. The default option for an income yielding portfolio is a fixed income portfolio.  However, in the aftermath of the global financial crisis, bond yields have gotten bogged down in historically low territory, and are currently stuck around the 2% range. Given these historically low bond yields, it makes sense to once again look at dividend or equity income strategies.

There are two ends to this spectrum. At one end is the high yield equity portfolio with little or no growth opportunity but offering yields in the 5% range today. In this category, there are many relatively popular dividend strategies that focus purely on high yield and tend to invest in sector specific, highly leveraged structures like MLPs and REITs. Such a strategy, while delivering high yields, is extremely risky as the leverage and sector concentration may not be suitable for large allocations by most income seeking investors.

At the other end is the dividend-growth portfolio with a low current yield (2 to 2.5%), but with a promise of a growing dividend stream. By following this strategy, investors would achieve steady returns, but would have to wait for almost ten years to earn the 5% dividend yield attained in the above example.

As a result, investors who are seeking steady income from an equity portfolio face the unattractive quandary of either choosing high current yield while sacrificing growth and taking on significant risk, or choosing growth and sacrificing yield.  Fortunately there is a solution to this quandary, a strategy we call “Smart Income” that offers a new perspective on how investors can search for yield in an equity portfolio.

Smart Income follows a proprietary strategy called Smart Alpha™ that selects stocks that have large and stable business models, have safer balance sheets, have a value-creating capital allocation track record, and are available at a discount to intrinsic value.  We refer to this pool of stocks as Investment Grade Equity. The Smart Income portfolio is created by selecting the 50 highest dividend paying companies from this pool.  Theoretically the portfolio would grow in net asset value (NAV) at a rate commensurate with the weighted return on equity (ROE) of the portfolio companies if no distributions were done.

Typically, dividend growth portfolios consist primarily of stocks retaining around 80% of their capital and distributing 20% as dividends, while high-dividend yield portfolios consist primarily of stocks retaining around 20% of their capital and distributing 80% as dividends.

Alternatively, an investor holding shares in a company not distributing any dividends but retaining 100% of the return on equity would not get any income as dividends; however, their capital held as retained profits should result in increased book value. This increase in book value would, in the long run, be reflected in the form of increased share prices. Additionally, if an investor has paid a fair price (or lower) for the company initially, the future returns will be equal to (or higher than) the growth in book value.

In this scenario, the investor in a corporation which retains 100% of the profits can sell a portion of their shares to generate income. If they want a 5% income, they can keep selling 5% of the stock holdings in that company on an annual basis.  This new way of accessing yield is the basis of Smart Income and this strategy can work as long as the return on equity of the company is greater than 5% since the company’s share price should grow in line with the return on equity in the long run. Thus, the capital remains intact or growing while providing a 5% yield from capital gains.

Our Smart Income strategy on aggregate encompasses a broad range of stocks that have retention rates varying from nil (i.e. paying everything out via dividends) to 100% (i.e. retain all profits). Net-net, to illustrate the payout feasibility and internal working of the strategy, we observe that over the long run our flagship Smart Income index – ArthVeda Smart Income Total-cap US 50 Divine Dividend Index– has delivered a 15% p.a. return of which 5% cumulative yield is paid out on an annual basis. Of this 5% distribution, 3% is sustained via Smart Income’s stock dividend yield and the remaining 2% stems from underlying book value growth. In the short run (i.e. quarterly basis), selling part of the portfolio to generate part of payout not accounted for by pure dividends could potentially eat into capital gains/capital, though the book value progression should remain intact on account of the high quality investment grade equity. Further, over the long run, the capacity of Smart Income’s book value to provide for part of the 5% yield can be gauged by its historical long term growth of 12% p.a. (commensurate with the total returns of 15% p.a.) and median ROE of 20% which is more than compensatory.

Although, in any particular quarter or year the share price growth would not be precisely equal to the growth in book value, in the long run (over a 5 to 10 year period) the share price should grow in the same proportion as the book value.

As Ben Graham, author of The Intelligent Investor, the definitive text on Value Investing, famously stated: “In the short run the market is a voting machine, but in the long run the market is a weighing machine.”

This is corroborated academically by Nobel Laureate Robert Shiller in his 1981 paper which shows that while the market prices cannot be predicted in the short-term, over a longer period of time the trajectory becomes clearer.  What we can infer from Graham and Shiller is that in the short term, growth in the share price could deviate from the growth in book value, but that in the long term, growth in the share price is likely to be in line with the growth in book value.

Further, if the return on equity is higher than 5%, an investor would have to sell a smaller portion of the portfolio each quarter since the company’s share price should be growing at a higher rate as well. The remaining portion would theoretically continue growing and not only would the investor generate a 5% return but a higher percentage of the portfolio would continue growing capital.

There has long been a misconception that one can only use income that is distributed by a company through dividends; however, using a Smart Income strategy, equity income can be generated even from a non-dividend paying company as long as the company is profitable.

As mentioned above, smart income strategy follows Smart Alpha™ strategy and selects 50 highest dividend yielding stocks from the Investment Grade Equity pool. Technology, Consumer goods and Industrials are a few sectors which we like. While in the Tech sector, we are bullish on Qualcomm, Western Digital, Cisco and Intel, we like Cummins, Caterpillar, CSX

1, 2  - View Full Page