Investors seeking income over capital in 2024, yet risk remains

Income as a source of returns from equity investments will be “more important than ever” in 2024, and increasingly expected by investors over capital growth, according to expert analysis from global equities and hedge fund manager Talaria.

Hugh Selby-Smith, co-chief investment officer at Melbourne-based boutique Talaria Asset Management, however, cautioned that while income from dividends may be seen as delivering reliably consistent returns for investors, particularly “when they need them the most”, they are also subject to the vagaries of the market and the wider economy.

Concentrating investments in a single sector, like the big four banks, no matter how safe these industries seem, may also increase the risk of an income drop.

To counter a potential income hit, Selby-Smith urged investors and portfolio managers to include a source of income within portfolios “that diversifies risk and does not result in markedly higher volatility”.

“This is not easy,” he stressed. “Investors will need to review their portfolios carefully to assess where income will come from, while at the same time ensuring they are well-diversified and not too reliant on unreliable factors such as dividend returns.”

Retreat to income

Selby-Smith explained that the rising interest rate environment has challenged equities investments, with higher policy rates “[dampening] economic activity while at the same time [increasing] financing costs for companies”.

“Against such a backdrop, as EPS [earnings per share] declines, income rather than capital growth will become increasingly important for investors,” Selby-Smith said.

Citing historical market trends, Selby-Smith noted several decade-long periods where “income comprised all of investors’ returns” – including, most recently, in the post-GFC 2000s.

“The ASX is no different. Between 2007 to 2020, point to point, all the returns generated by investors was from income. This is during a period that saw one of the largest resource booms, one of largest housing booms and one of the longest stretches of low interest rates.”

While dividends from equity investments and interest income from cash or bonds are seen as the “two most obvious sources of income returns for investors”, Selby-Smith warned that, in the current environment, these options may fall short of meeting investors’ expectations.

Risk to equities income

“As we saw during Covid, dividends can be cut and the risk of this increases as profits start to fall. Companies begin prioritising strong balance sheets with dividends being the first thing cut,” Selby-Smith said.

“Another risk of relying too much on dividends is investors run the risk of creating a portfolio comprised of companies in the same sector or region.”

Selby-Smith noted, for instance, local investors’ bias towards Australian banks.

“They produce high dividends, but there is little diversification benefit,” he said.

“Overreliance on dividends can lead investors to unwittingly develop a bias towards certain sectors, such as banks, resources and retail, particularly in Australia, which increases the risk in their portfolios.”

Cash, bonds not always reliable income generators

While cash and bonds have, in recent months, delivered relatively strong income returns, these asset classes can also prove volatile during periods of economic downturn.

“In August 2008, the RBA cash was 7.25 per cent. The following year the number was more than halved to three per cent. This reflects the volatility of income and how easily and quickly it can be cut.

“Again, the issue with interest rates is these tend to fall as the economy stalls with central banks cutting rates to stimulate economic growth.

“In both instances when investors need income the most, the risk to dividends and interest income rise.”