Investing in High-Quality Businesses for yield
One of the most common questions we receive is "where do I get my income from?" The idea of needing yield to generate retirement income has led to countless losses by investors "chasing yield" during times of lower rates. A far better method of investing is to understand what generates the yield: the earnings of the business.
Not all earnings are equal. You can have a high yield on a low net margin business, and the margin can disappear quickly during a market cycle. Often, a far better way to invest is by buying high-margin businesses and trimming the necessary shares to pay for your retirement.
Investing in High-Quality Businesses
Focusing on earnings (and margins) is superior to just yield for several reasons:
Sustainability: High yields can be deceiving. A company might offer a high dividend yield, but if its earnings are unstable or declining, that dividend is likely to be cut. Sustainable income comes from sustainable earnings. A company with consistently high margins is more likely to maintain and even grow its earnings, which in turn supports a reliable and potentially growing dividend.
Risk Management: Companies with low margins are more vulnerable to economic downturns, increased competition, or rising input costs. When things get tough, these companies are often forced to reduce dividends or even go out of business. High-margin businesses have a buffer; they can weather storms better and are less likely to drastically cut payouts.
Growth Potential: High-margin businesses often have a competitive advantage, whether it's a unique product, a strong brand, or efficient operations. This advantage allows them to reinvest profits back into the business, leading to future growth and potentially higher dividends down the line. Simply chasing yield often means investing in mature, slow-growing companies with lower total income over a 10 year period.
Total Return: While yield is important, it's only one component of total return. A company with strong earnings growth may have a lower yield, but the stock price is likely to appreciate over time, providing capital gains. A strategy of trimming some of the growth may be a better strategy than investing in a low quality business for a potentially temporarily higher yield.
Trimming the Growth Strategy
This is a smart approach. It allows you to:
Control Income: You determine how much income you need by selling the appropriate number of shares.
Benefit from Growth: You still participate in the potential upside of the company's stock price appreciation.
Flexibility: You can adjust the amount of income you take as needed.
Key Considerations
Diversification: Even with high-margin businesses, diversification is crucial. Don't put all your eggs in one basket.
Valuation: Don't just buy a high-margin business at any price. Make sure the valuation is reasonable. Overpaying can erode your returns.
Taxes: Be mindful of the tax implications of selling shares.
Reinvestment: Consider reinvesting some of the proceeds from selling shares to further fuel growth.
Company Analysis: Thoroughly research the company's financials, competitive landscape, and management team before investing. Understand why they have high margins.
Franking Credits: The franking credit system in Australia allows tax benefits to dividend investing. It is important to compare net returns after tax factoring in franking credits. Unfortunately, many an Australian company with high dividends and franking credits proven to be poor investments. AMP, Telstra, NAB and Woodside are good examples of higher yielding Aussie companies with chequered pasts.
In Summary
A focus on earnings and margins is a much more prudent approach to generating retirement income than simply chasing yield. It prioritises sustainability, risk management, and growth potential, leading to a more secure and potentially more rewarding retirement.
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