Could a growing obsession with yield in some parts of the funds industry be distracting equity income investors from more important considerations? That is not to suggest yield is unimportant – only that it matters in much the same way knowing where you are at the start of a journey matters. Once you are on your way, however, knowing your destination and how to reach it become rather more material.
Yield – essentially the income an asset generates divided by that asset’s capital value – is an extremely useful thing to know on the first day you make an investment. If, for example, you are investing £100 with the aim of generating an income, it is helpful to know whether this could be £1 or £10 over the coming year. Clearly the difference between those two possibilities is a significant one.
Once you have made your investment, however, instead of worrying about its theoretical yield, you would do better to focus on the actual income being generated and any effect this may be having on your original capital. In essence, this is because yield is not a single number so much as a ratio made up of two other numbers – the aforementioned income and capital.
What that means is your yield can increase in two ways – one good and one bad. Yield will increase if your capital generates more income or it will increase if your capital shrinks. Clearly the latter outcome is one you would really much rather avoid and yet anybody who focuses on yield as a single number is going to miss this nuanced but important difference.
To illustrate our point, let’s say the day you make your £100 investment you do so with the expectation of generating £5 of income – in other words, a yield of 5%. Later on, however, let’s say your capital drops from £100 to £80 – yes, your yield improves from 5% to 6.25% (5 divided by 80) but of course the only thing that has really happened is you have lost £20 of capital.
Now let’s say your capital stays at £100 but your income grows from £5 to £6. In this scenario, your yield would be 6% (6 divided by 100) and yet, while that is lower than the 6.25% of the previous example, it is a significantly better outcome for you since you have actually ended up with more income and more capital.
Clearly an even better outcome would arise if your income increased from £5 to £6 and your capital doubled from £100 to £200. In this example, though, your yield would drop to 3%, which some people do see as a theoretical cause for wailing and gnashing of teeth – but, seriously, how despondent are you really going to be having seen your income grow and your capital double?
Here on The Value Perspective, we would argue very strongly that yield should only matter to investors on the day they embark on their income ‘journey’. After that, unless you are planning to spend your capital any time soon – in which case you really need to question if you should be investing in equities at all – yield is too simplistic and thus all but irrelevant.
Instead, your focus should be a separate understanding of your income – ideally a growing income – and what is happening to your capital. Finally, on a wider point, do be aware that whenever you have cause to analyse a ratio, it is vital to understand what is driving any change and, if a ratio is changing, that it is doing so for positive reasons.