Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. The more different you are from the person that defined a rule the less you should follow the rule. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.

A controversial income pick 

"For the great enemy of truth is very often not the lie--deliberate, contrived and dishonest--but the myth--persistent, persuasive, and unrealistic. Too often we hold fast to the cliches of our forebears. We subject all facts to a prefabricated set of interpretations. We enjoy the comfort of opinion without the discomfort of thought." 

- John F Kennedy

I became an income investor in my early 20s. This is far from a conventional path. Over the years I’ve been constantly reminded of just how unconventional my approach is. The fact that the questions have died down recently is more a product of my advancing age than a changing convention.

Calling me an income investor doesn’t paint an accurate picture. I’m a dividend growth investor. Adding the word ‘growth’ makes a big difference. It also leads to some people questioning some of the shares I buy.

I recently published the quarterly update of my 12 picks for income investors. When I first came out with the list my inclusion of CSL CSL was questioned. CSL does not fit the conventional view of an income share given the current dividend yield of 1.45%.

We live in the age of blanket statements and feel more comfortable when we can classify people and things in easy-to-understand buckets. This extends to investing where we tend to classify investments as income or growth based on the preconceived and uninterrogated stereotypes of each investing approach.

The misconception is that growth investing is exciting and is synonymous with investing success. Growth investors are young risk takers who will strike it rich by investing in companies in up-and-coming industries with rapid growth while deftly navigating changing market conditions.   

It is worthwhile comparing that perception of success with income investing. The stereotype is that companies that pay dividends are boring and by extension the people who invest in them are boring. Many people view the stereotypical income investor as a miserly old person counting pennies.

I see things differently. I think people would benefit from carefully thinking about the problems they are trying to solve with their portfolios and the best way to solve those problems. The problem I am trying to solve in my own life is that I want to do more things I love, those things cost money, and the costs go up over time. In my case those things I love include traveling and having new experiences.

This is not some academic exercise. My returns are not some scoreboards to boost my sense of self-worth or further my career. I want a growing stream of passive income so my portfolio can contribute to my life. I just want to spend the income so I can maintain the principal so I can spend it later. That is it. And that is the lens I used for my 12 picks for income investors. Specifically, I wanted to achieve average income growth of 10% per year. That should comfortably outpace inflation which means the purchasing power of the portfolio will grow over time.

How CSL fits into my strategy

I think some income investors focus too much on the current yield and too little on income growth. Taking more of an income growth approach provides a different lens to evaluate CSL. The following chart shows dividends by calendar year and the growth over the previous year.

CSL

The average dividend growth rate over this period is over 10% a year. This includes both the outlier 30% growth year in 2018 and the COVID year where there was no growth. This growth matters.

An investor who purchased $10,000 in CSL on the 31st of December 2014 would have received $479.10 in dividends in 2024. While the yield was low in 2014 the yield on the $10,000 originally invested is now 4.79%. This doesn’t include the opportunity of reinvesting the $3,218 in dividends received in the decade since the original purchase.

We can compare CSL with Telstra TLS which is a more traditional income share. At the end of 2014 Telstra had a 5.27% yield. This likely would have attracted the attention of income investors. The following charts shows how an investor in CSL and Telstra would have faired since the end of 2014.  

CSL two

CSL is the clear leader in two categories. The investment in CSL would generate more current income and the yield at the original $10,000 cost would be higher. A Telstra investor would have made marginally more in total dividends over the 10 years.  

The outlook for CSL

What matters is the prospects for CSL going forward. One of the things that I’ve often found is overlooked by income investing sceptics is that what matters over the long-term is earnings growth. Earning growth funds dividend increases. Incidentally, earnings growth also leads to gains in share prices.

In the case of CSL our analyst Shane Ponraj is forecasting compound annual earnings growth of 12.50% for the next five years. The expectation is that this growth will be driven by revenue growth of 8% with the remainder made up of margin improvements. Given our expectations that the dividend payout ratio will remain the same we are also forecasting similar rates of dividend growth.

Business risk: A share is an investment in a company. And companies have different levels of business risk. I want low business risk in my portfolio because it makes it easier to predict what the future holds. That makes it easier to predict dividends going forward.

This isn’t true for all companies. Some nascent industries with emerging technology have lots of players competing for market share. It is unclear who the ultimate winners will be because the technology is unproven and nobody knows what attributes of the good or service will ultimately resonate with consumers. Contrast that with mature industries with a few established players who have captured significant market share. The range of outcomes is far wider in the nascent industry. Lots of companies will fail. Some will succeed spectacularly.

That is just one example of business risk. Highly leveraged companies are riskier than companies in sound financial shape. Cyclical industries are riskier than non-cyclical industries because economic conditions will have a bigger influence on the outcomes on the former. A company selling multiple products into multiple markets is less risky than a company producing a single product that is sold in a single market. There are multiple measures of business risk. It is captured in the Uncertainty Rating that our analysts assign to each company they cover.

CSL’s Uncertainty Rating is medium which is our second lowest rating. It operates in an oligopoly with two other competitors who have collectively captured 80% of the market and have cost advantages over any emerging threats. Barriers to entry are high given the institutional intellectual capital inherent in creating plasma-based treatments. The company is vertically integrated meaning they control sourcing of the plasma used to create the treatments. Healthcare is non-cyclical as people prioritise treatment in any economic environment.

There is always a risk that alternate treatments will develop for haemophilia, immune deficiencies and for influenza vaccines. There is little risk the diseases will go away. Every business has risk. I believe the business risk of CSL is at the lower end of the spectrum.

Low debt: The company receives an Exemplary Capital Allocation from Ponraj which takes the balance sheet into account. He believes the financial risk is low and debt levels are reasonable. Debt is another variable that can impact dividend payments. Low debt lowers the risk that CSL will have to reduce a dividend because of financial difficulties.  

Sustainable competitive advantage: CSL receives a narrow moat rating which indicates Ponraj’s belief that a competitive advantage can be maintained for at least 10 years. The source of the moat is cost advantage and intangible benefits. And the impact of the moat can be seen in the financial statements. The return on invested capital (“ROIC”) has been over 19% for the last 8 years. That means that the company is earning high returns on investments in the business. That is a good sign the business can keep profitably growing and puts the low dividend in perspective. Without a moat those returns would be eroded over time as the impact of competition takes hold.

I want companies with moats because competition can force companies to lower prices or invest more in marketing and product development. Both lower earnings and dividends.

Valuation: There are lots of things to like about CSL but i don’ t think you can credibly argue that the shares are cheap. However, the shares are trading at the lower end of the trading range they’ve been stuck in for the last 5 years. In 2019 CSL was trading at around 46 times earnings. Currently the shares are trading at around 32 times earnings. Our fair value is $310. I’m comfortable at this level as a dividend growth investor given the yield and the growth prospects. I’ve recently added to my position.

Final thoughts

I’m not suggesting that every share in a dividend growth portfolio should be like CSL. At a certain point you need a bit of yield too. However, the point of a portfolio is to create a mix of holdings that in aggregate are aligned to the problem you are trying to solve. In my 12 picks for income investors, I combined some shares and ETFs with high growth and lower yields and some with lower growth and higher yields. I do the same thing in my own portfolio.

We all succumb to stereotypes at our peril. Spend some time thinking about the problem you are trying to solve with your portfolio. And remember a problem won’t be solved by being ‘rich’ and it won’t be solved by amassing a certain amount of money. A problem is something that you want from life that you don’t have now. That could be more time doing what you love or more time with your family. Once you’ve identified the actual problem you may be surprised at how much easier it is to find a solution.

Please share any thoughts or topic suggestions with me at [email protected]  

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What I've been eating

One of the problems I’m trying to solve is how to be in Hong Kong more. I lived in Hong Kong for 5 years when I was younger, and it is still one of my favourite places. I know it is strange to visit a city with amazing Cantonese food only to eat Chicken Tikka Masala and Beef Tartare. I also don’t care. A martini at the Captains Bar and dinner at the Chinnery is a pretty nice way to spend an evening.  

Tikka