Smart Investor: Must you choose between growth and income?

Many investors view growth and income as either/or. In other words when investing you can choose to either invest in companies that offer good growth potential, perhaps because their net profit has grown year on year for the past 5 years. Or invest in companies that offer a decent income in the form of a dividend; usually the preserve of established companies that apparently have less scope to grow.

However is it that simple: should growth and income be viewed as mutually exclusive? And how can the smart investor maximise the potential for growth and income in his portfolio?

The first issue to tackle is a definition of the two terms. Income is fairly straightforward; it is paid in the form of a dividend and is expressed as a percentage of the share price. Examples include National Grid and United Utilities. Growth is more difficult to define because it could refer to things such as increased net profit, increased turnover, increased market share, increased net assets or even an increased share price. Examples include Tullow Oil and Admiral Group.

What type of growth?

This poses a number of questions around the topic of growth, most notably what type of growth actually matters? As the old saying goes; revenue is vanity, profit is sanity and cash is reality. In other words a growing revenue and market share is of little use if it is not translated into net asset and profit growth; otherwise it will not increase the intrinsic value of the company.

Of course many readers will instantly respond to the question of mutual exclusivity by stating that income and growth are directly linked to risk; with income being seen as lower risk and growth as higher risk. This is a widely accepted viewpoint and many would argue that it carries some weight in terms of splitting a portfolio into lower and higher risk; income and growth. However this often allows for weaknesses in the companies selected to be overlooked because they offer either a good dividend yield or are growing at an impressive rate.

Instead every investment decision should be based on its growth and income potential combined. That way all aspects of the business are considered at the outset instead of cracks being papered over just because they are income or growth stocks that inherently come with certain weaknesses.

For instance investment should not be made in a company merely because it pays an above average dividend or because its return on equity is sky high. These are positives, but high dividend payers may offer poor returns on equity meaning there is little scope for an increase in intrinsic value. Similarly an increasing return on equity may be a result of high gearing which can cause problems further down the line.

More than just growth... or income

So, how much weight should smart investors give to income and to growth potential when analysing possible additions to their portfolio?

Smart investors should firstly realise that during their long-term investment horizon there will be years when the economy struggles and falls into recession; this is simply a part of the economic cycle. It is during these years that an income is of greatest importance, for it has the endearing quality of helping investors to stay sane when share prices are plummeting.

However as the recent recession showed, dividends are not guaranteed and can be cut or even cancelled at relatively short notice. Therefore attention should be focused on growth and a generous income viewed as a bonus that is nice to have, but is not a prerequisite or standalone reason to invest.

Of course when focusing on growth, the smart investor must be clear that it relates to a growth in the intrinsic value of the company. This does not require a growing return on equity nor significant profit growth, but it does require the purchase to be made when the shares are carrying a minimal amount of goodwill. In other words when net asset value makes up a fair chunk of the share price. That way too high a price will not be paid for shares in a sound business with the potential to grow.

Prepare for the unknown

Furthermore it should be accepted that future performance is unknown and unforeseen events can occur to reduce the profitability of any company, a notable example being BP. Therefore smart investors should not rely on increasing profitability or optimistic forecasts as an indicator of potential future growth. Rather they should focus on allowing themselves a margin of safety when assessing potential future profitability.