For Those in Peril on the Sea: Income vs. Capital

After all, interest and dividend payments are generally less volatile than the prices of the securities from which those income streams are derived. So, doesn’t that mean investing for income is “safe”, or even “prudent”, compared to investing for growth? Surely, I am being responsible as long as my portfolio generates enough income to cover my spending, and I’m not “dipping into capital”.

Alas, it’s not that cut and dried.

Background

The distinction between “income” and “capital” has deep roots in trust and common law. Wills are often structured to split an estate between two groups of beneficiaries: so-called “income beneficiaries” (typically the deceased’s spouse), who are entitled to the income earned by the estate for a certain period of time (typically till such a beneficiary’s death); and so-called “remaindermen” (typically the deceased’s children), who are entitled to the estate’s remaining capital after the income beneficiaries have been looked after. It shouldn’t surprise you to learn there is no small amount of effort expended in the estate world to keep track of which dollars are “income” and which are “capital”.

As a consequence of this long history, the income-vs-capital paradigm has morphed and migrated elsewhere, including into the worlds of personal finance and investment management. In the personal finance realm it can be as benign as “live within your means” or “don’t spend more than you earn” by restricting your lifestyle spending to that which can be met out of salary or employment earnings (to say nothing of spending less so you can add to your savings), and “preserve your capital so it can grow over the long-term”. More succinct is the expression “don’t encroach on capital”.

However, when this distinction between income and capital seeps into the investment realm and seeks to control how a portfolio is structured and invested, it can easily become problematic. It becomes so because of the potential pressure for a portfolio to be invested in such a way as to generate some target or minimum level of investment “income”.

But what is income?

This begs a seemingly simple question: what is meant by income? The answer is not so simple. Is it just interest and dividends? Or does it mean income for tax purposes, which would include interest, dividends and half of realized capital gains (i.e., the portion subject to tax)? What about the other, non-taxable half of capital gains? What about returns of capital that can form part of the periodic distribution of cash to investors? Though they have the patina of income, returns of capital aren’t included in taxable income. If they are to be included, then what about unusual, one-time lump-sum returns of capital? What about a corporate reorganization that results in a spin-out of shares in a subsidiary of an existing portfolio holding? Do the received shares in such a “spinco” represent income always, never, or only if the spin-out is a taxable event? You begin to appreciate that deciding what’s income rather than capital can become as tortured as searching for the illusory line between what’s a vegetable and what’s a fruit.

This definitional conundrum completely ignores the not-small matter of regular share buybacks. As we have written previously, there are plenty of profitable businesses that return their surplus cashflow to shareholders through regular open-market share repurchases in addition to regular dividends. The cash so distributed, however, only lands in the hands of those shareholders who tender their shares to such buyback programmes. But shareholders who do not tender benefit indirectly because, following the buyback, they own a slightly larger proportion of the business. Should this form of distribution get factored into the analysis? If so, how?

Troubled Waters

But these challenges are just the beginning. Because capital gains are taxed more gently than interest and dividends (whether Canadian or foreign), skewing a portfolio’s mix of returns away from growth and more heavily towards current income comes at a cost to the investor: a higher tax bill, both in the near term (as income taxes on current income must be paid at least annually) as well as over the lifetime of the portfolio. To put it in nautical terms, we’re now running against a stronger tide.

As if the higher tax bill isn’t enough, distorting a portfolio to hit an “unnaturally” high income traps the portfolio manager between competing interests. If forced to avoid non-dividend-paying stocks altogether, skew a bond portfolio in favour of high yield or high coupon bonds, or over-indulge in equities with high dividend yields, the manager inevitably risks sacrificing some potential growth in exchange for current income. This pits the interests of the income beneficiary(ies) against those of the capital beneficiary(ies). Portfolio managers (and trustees) with responsibilities to both types of beneficiaries can all too easily find themselves drifting into the shoals of conflicting fiduciary duties.

But this isn’t the biggest problem. Rather, there is the very real potential that a portfolio structured to “reach for income”, and whose value is consequently (and precariously) dependent on that high current income, suffers a devastating drop in value if there is a “break” in the income stream. The experience with BCE over the last 12 months is instructive in this regard. A stock that was worth nearly $47 a year ago, when it was paying dividends that totalled nearly $4 a year, has since collapsed more than 35% in value AND cut its dividend by more than 55% to $1.75. BCE is merely an apt recent example. The anticipated “safety” of focusing on income has led investors to flounder on the rocks.

Safer Seas

Rather than be slave to the income-vs-capital distinction, a more productive approach is for the portfolio manager to strive for attractive total returns, without particular regard to whether those returns come from (i) regular income like interest and dividends or (ii) investments that offer appealing prospective price growth. If the resulting portfolio can achieve a long-run total return of, say, 6% to 7% annually, the holder who withdraws only 3% to 4% ought to be able to do so confidently for decades. The portfolio manager is able to fund such withdrawals first out of cash from accumulated investment income, and second from the proceeds of appropriate and selective trims of the portfolio’s holdings. With this approach, withdrawals are met while leaving the portfolio at least as well invested and diversified as before. There is no mental “tug of war” between needing to sell a security to fund a withdrawal versus wanting to hold onto it because of its high dividend yield.

Moreover, and most importantly, this approach puts dividends (and stock buyback programmes) in their proper place as a tool of investment decision-making: as an indication of management’s dedication to delivering returns to shareholders, a signal of management’s confidence in the sustainability of the business’s profitability and cashflow, and a discipline on management’s allocation of capital. Indeed, there is persuasive evidence that a focus on dividend growth, not on a particular level or rate of dividend income, results in portfolios that achieve not only higher long-term returns, but also returns that are less volatile than, and less correlated with, those of the equity market generally.

By taking this approach to the role of income, a portfolio review is less likely to be accompanied by the funeral hymn alluded to in the title above.