I was recently flipping through the Annual Reports for a couple of American Funds-- namely the Income Fund of America (AMECX) and the Growth Fund of America (AGTHX). Some of the top holdings within the Income Fund included many of the expected income producers like Bristol-Myers Squibb (BMY), Chevron (CVX) and McDonald’s (MCD). Likewise, the Growth Fund was weighted heavily with common growth names such as Apple (AAPL), Google (GOOG) and Amazon.com (AMZN). Notice the 4-letter tickers. Interestingly, both funds had two commonalities between their top-10 largest equity holdings: Home Depot (HD) and Phillip Morris International (PM). A simple check to each of the fund’s objectives provided a reasonable explanation: The Income Fund looks first for income and second for capital growth, whilst the Growth Fund is focused solely on capital appreciation.
With such a large divide between “growth” investors and “income” investors, HD and PM made it clear-- why not both? Sometimes investors can become too focused on a minimum yield, say 4%, or vice versa-- on super growth. But it can be easy to overlook the idea that growth and income often go hand-in-hand. As a growth investor, assuming you don’t own shares of Berkshire Hathaway (BRK.A) and have Warren Buffett as your personal money manager, eventually you’re going to want some kind of dividend (See Microsoft (MSFT)). Likewise, if you have a reasonable dividend yield and you would like for it to continue, you’re probably not rooting for a bump in the payout ratio. Rather, the more efficient way to raise dividends in a sustainable manner would be to keep the payout ratio about the same while growing earnings. Without growth you have created a perpetuity, at best. Without income you’re subject to the irrational price fluctuations of the market, no matter the suitability of the underlying security.
Both income and growth are fundamental for selecting stocks, just as a wide economic moat is fundamental for a thriving business. True, retained earnings are quite necessary for both new companies and capital intensive industries. But for the established companies listed below, don’t be afraid to look for a balance between growth and income.
Home Depot (HD) - With a current yield around 2.9% this Home Improvement chain might pass under many income investors radar. But if the lagging housing sector can rebuild, HD is poised to benefit. Dividends have grown steadily since the late 1980s, despite a temporary freeze from 2007 to 2009. Given the current Price to Earnings ratio around 17.4 and consensus $2.73 average EPS estimate for next year, it could represent an 18% upside. Competitor Lowe’s (LOW) and its 49-year streak of increasing dividends would also benefit from a bump in housing, although its yield is lower and P/E ratio is higher.
Phillip Morris International (PM) - PM doesn’t seem like a super long term holding, but if you’re okay with the moral side of the business then there is an awful lot of inelastic demand out there. With a 4.1% dividend yield, near 65% payout ratio and a steady streak of increasing payouts, this cigarette company has at least been healthy for its shareholders. If you’re staying within this business, some might prefer Altria (MO) with its 5.6% current yield. But then again, MO goes up against tough U.S. critics and leveling demand, whilst PM enjoys a world of opportunities and more lenient governments.
International Business Machines (IBM) – Big Blue probably doesn’t catch the eye of too many income investors with its 1.6% current yield, but a massive purchase by Warren Buffett often warrants a second look. With its payout ratio around 23%, some might be clamoring to compare it to Microsoft, but I think IBM's low yield is more a resultant of price appreciation rather than cash hoarding. After all, IBM has increased its dividend for 16 straight years and its price has more than doubled in the last 3 years. True, this New York-based Technology mega big is near its all time high; but IBM has set its sights even higher with its “2015 Roadmap”. Buffett has bought in, and it could prove to be a $300 stock by 2015 given its goal of $20 EPS. This comes with simultaneous goals of $50 Billion in share repurchases and $20 Billion in dividends.
YUM! Brands (YUM) – MCD certainly hasn’t disappointed investors this year, so given the concept of this article, we might as well take a look at YUM! Brands’ 2% yield. YUM has not only paid, but also increased dividend payouts for the last 8 years, while maintaining a payout ratio slightly below 50%. Given a consensus 1-year EPS estimate of $3.23 and a P/E ratio around 22.6, this would represent about a 25% price appreciation. Although it should be noted that the P/E seems a touch high historically, and is above McDonald’s' ratio around 19, despite the recent run-up.
Nike (NKE) – Much like many of the other stocks mentioned, Nike’s current yield-- which stands at about 1.5%-- isn’t overly impressive. However, NKE has been making progress by increasing its payout for 10 consecutive years, while maintaining a payout ratio around 30%. NKE could afford to raise its dividend by 12% a year for the next 10 years, for a yield on cost close to 5%, without any earnings growth at all. Seventeen brokers come to a collective 1-year target upside of about 12%, while the most optimistic of the bunch sees a 33% gain.
Surely these are just a sampling of established companies that might have a solid balance between potential income and growth opportunities. Much like the “dividend growth sweet spot", where a certain level of current yield is required as to promote both attainable and sustainable dividend growth, it seems reasonable that one could find a comparative growth to income sweet spot. If you’re looking at just growth or just income, why not both!