When it comes to equity investing, there are 3 general categories companies can fall in. You should think of these categories like a Venn Diagram. A company can belong to more than one sphere and the sphere(s) it belongs to can change over time. The three categories are Income, Growth, and Value. My main focus, as the name of this blog would imply, is income, though if I had to label myself I would say I am a value/income investor.
What are some examples of each category? Income stocks would be generally qualified as any stock that pays a dividend. There are multiple sub-categories of Income stocks, with high yield and dividend growth being the most prevalent. Examples of high yield would be companies like AT&T (6.7% yield), British Petroleum (6.4% yield), and most REITs. The defining characteristic of these stocks is they pay a significant portion of their earnings out in dividends – in the case of REITs it is 90% of their taxable income by law – and generally have lower growth rates. Dividend growth stocks are more likely to give you a combination of increasing income and higher stock price as they will generally be able to increase their earnings more than high yielders as they have pay a lower percentage of their earnings in dividends so have more cash available to reinvest in the business or buy back shares. Coca-Cola (3.3% – 56 years of consecutive increases), Johnson and Johnson (2.8% – 56 years of consecutive increases) and Exxon-Mobil (3.3% – 36 years of consecutive increases) are examples of dividend growth stocks. (Statistics from dripinvesting.org)
Value stocks are stocks that are trading for less than they are inherently worth. It can sometimes be difficult to identify value stocks, as just because something is trading below its historical valuation does not make it a value stock. It is always important to be aware of the dreaded value-trap, where a company is mired in annual earnings decreases or has serious debt concerns that will prevent it from growing even if everything goes right. However finding value stocks can be one of the best ways to creating long-term wealth. If you are able to identify a solid company that is going through a short-term hardship that is affecting it’s stock price, not only will you lock in the future earnings growth of the company, you also have a built in buoy that is the eventual regression to the mean for valuation. Finding the combination of those two things is one of the rare scenarios where you are actually able to earn more than the earnings growth of the companies you invest in over the longer term.
Growth stocks are generally the highest gainers (or losers) percentage-wise in the stock market. A loose definition would be any company increasing revenue or earnings 20% or more per year. I include revenue along with earnings because many times growth stocks are early in the stages of the business model and aren’t necessarily profitable yet. The majority of small and micro cap stocks are growth stocks. Amazon is one of the few mega cap growth stocks. The reason for that is once you reach a certain size the laws of economics come into play. Going from $100 million to $200 million in sales is a lot easier than going from $100 billion to 200 billion. At a certain point your market becomes saturated and growth becomes limited unless you can open up new markets or go into new ones. Amazon happens to be one of the few companies that has successfully been able to do both.
So why do I prefer income and value investing to growth investing, if that’s where the big bucks are? Predictability. I am not a market timer nor a psychic. It turns out its much harder to predict what will drive growth and for how long. A tech company can come out with a great new gadget or radical software that drives awesome growth for a few years. But growth will always attract competition, and I am not smart enough to say how long that gadget or that software will keep its top spot. Income (and to a lesser extent value) is much easier to predict. I can look back and see that Exxon-Mobil has raised its dividend for 36 years in a row (and for much longer before that as Standard Oil) at an average rate of 8.4% over the last 10. That time frame includes many recessions and multiple oil price booms and busts. It is because of that track record I’m able to comfortably predict that 20 years from now, they will be able to continue paying out ever-increasing dividends. The same goes for Coca-Cola and Johnson & Johnson. I may be missing out on the big % gainers, but I’m also missing out of the big losers as well. I’ll leave you with a quote from Warren Buffett:
Rule #1: Never lose money
Rule #2: Don’t forget rule number 1
-Warren Buffett