Income, as we all know, is very important to many of your clients, especially those approaching, or in retirement. It’s just as important as growth. Here Matthew Williams, Portfolio Manager of our Industrial Share Fund, illustrates how your clients can achieve growth in both income and capital by investing in industrial shares. He also explains why they should look beyond yield when choosing the best way to invest for income.

Income and yield

When your clients seek an investment that provides them with high income, they often select the one that provides the highest yield. Yield is calculated by dividing the income from an asset by the value of the asset.

For example, if your client made a $100,000 investment in a one year term deposit and was paid $6,000 in interest over the year, the yield would be 6%.

Over time the yield can vary as income and values go up and down.

Comparing yields

The yield on different types of investment also fluctuates. The chart below shows the yield on industrial shares compared to term deposits. It suggests that a person seeking income during the 1980s would have opted to invest in term deposits as the yields were much higher than the yields on industrial shares during that period.

Yield does not tell the whole story
Yield on term deposits and industrial shares from December 1979 to 2009

 Source: Peter Thornhill, Motivated Money. Industrials measured by the S&P/ASX 200 Industrials Accumulation Index and prior to April 2000, the All Industrials Accumulation Index.

Only in the early 2000s did the annual yield on industrial shares exceed the annual yield on term deposits, and then only modestly as term deposit rates came down. The annual yield on industrial shares remained fairly flat over the whole period. The reason for this is that the dividends paid by companies increase roughly in line with the value of their shares.

For example, if your client invested $100,000 in industrial shares at the end of 1979, by 1996 the portfolio had increased in value to $657,080 and over that year paid $33,000 in dividends, so the yield was 5.0%:

1996 yield=	$33,000	= 5.0%
	$657,080

Similarly, in 2006 the yield was 5.1%:

2006 yield=	$75,640	= 5.1%
	$1,473,830

This comparison of yields does not tell the whole story. The important thing to note from these calculations is that although the yield stayed almost the same, the amount of income paid in 2006 was more than double that paid in 1996. So income and yield do not always go hand in hand.

This is a pattern shown in the following chart which plots the dollar amount of income and the capital value of the two investments over the past 30 years. Clearly, the total income earned from industrial shares over the period far exceeds the total income earned from term deposits, even though the initial investment was the same.

Income tells a different story

$100,000 invested in industrial shares and term deposits from December 1979 to 2009
 
Source: Peter Thornhill, Motivated Money. Industrials measured by the S&P/ASX 200 Industrials Accumulation Index and prior to April 2000, the All Industrials Accumulation Index.

The ‘yield trap’

As Peter Thornhill explains in his book ‘Motivated Money’, this highlights a paradox: the lower-yielding industrial shares pay higher long-term income, while the higher-yielding term deposits pay lower long-term income.

This ‘yield trap’ is particularly evident with industrial shares, but it also occurs with credit securities and other investments that have both increasing income and capital value.

What about Perpetual’s Industrial Share Fund?

When we conduct the same analysis using our Industrial Share Fund instead of the industrial shares index, the pattern is even more pronounced. The following chart shows the growth in the dividend component of distributions and the growth in the capital value, compared to the interest and capital value of term deposits over the past 20 years.

Perpetual Industrial Share Fund has been a source of income and growth

$100,000 invested in Perpetual’s Industrial Share Fund and term deposits from December 1989 to 2009
 
Source: Perpetual and Reserve Bank of Australia. Methodology: Income drawn down annually. To calculate Dividends, the net realised capital gains portion of WealthFocus Industrial Share Fund distributions, excluding capital gains tax, have been reinvested. These reinvestments have been made at the application price, taking into account buy spreads. Dividends (and the benefits of imputation credits) have not been reinvested and are expressed as an annual payment of the same timing as the term deposit. Results are net of fees. Past performance is not indicative of future performance.
 
If your clients had invested $100,000 in our Industrial Share Fund at the end of 1989, they would have earned over $170,000 from dividends by the end of 2009. However, if these same income-seeking clients had invested in term deposits they would have earned around $120,000 in interest.

Imputation credits

When you consider that your clients would have derived additional income from imputation credits, and that the capital value of their investment would have increased more than five-fold over the period, the benefits are clear.

How we invest for income

When we select stocks for our Industrial Share Fund, we don’t chase high-yielding ones as this is not necessarily advantageous. Our investment process is based on comprehensive internal company research using four filters – sound management, conservative debt, quality of business and recurring earnings. Valuation is a very important part of the process, which means that dividends, prices and ratios are all part of the mix.

Key takeouts

There are three important things to take away from this analysis. Firstly, the ‘yield trap’ means that comparing annual yields of different investments is not the best way to select the highest income-generating investment. Secondly, industrial shares, and in particular our Industrial Share Fund, can provide your clients with high income and capital growth over the long term. Finally, the income generated from the Fund is tax effective due to imputation credits.