Income investing versus growth investing

Many investors, especially the professionals running funds and trusts, fall into two camps, the income investors versus the growth investors. The real world is more complex than that and many private investors have the luxury of choosing to invest wherever they see the best returns, without having to meet any criteria or justify their decisions to a boss.

What is the difference between income and growth?

At its simplest income investing is about building a portfolio that has a focus towards dividends. They will be a major consideration, likely because of the benefits of compounding. This is where dividends accumulate into ever larger amounts of passive income year after year. The trick is to build a portfolio of equities and other investments, which may include bonds as the most obvious example, to increase the dividend you receive.

You’ll want if possible though to do this without eroding your capital, for example by investing in shares which go down in price. This can be a difficult balance to achieve.

Whereas growth investing is a focus on share price appreciation. The dividend is less important of a consideration when it comes to growth investing. It’s about the future potential of a company, usually operating within a growth industry. It often, but not always means investing in smaller companies as the UK’s FTSE 100 is dominated by companies in the more established industries such as banking, oil and mining.

This is in contrast to the US where the top companies tend to be globally recognised tech companies with huge scalability. The trick with this type of investing is to buy shares at the right time and not overpay or get attracted to something just because others are excited by it.

It’s hard to boil down into a simple explanation, and growth investing will mean different things to different people. Growth investors are by no means always interested in micro and small caps, it’s just that that happens to be where the biggest growth opportunities often lie, because elephants don’t gallop. Smaller companies can more easily double their market capitalisation than big companies.

Making income investing work for you and avoid the pitfalls

If we take a more in-depth look at income investing then we must consider dividend growth and cover, as well as dividend yield. Yield is only a part of what an income investor should look at when picking shares. If the dividend yield is too high it may indicate the company has big problems, or that the dividend isn’t sustainable and is at greater risk of being cut.

That’s why dividend growth is important. If a company has a history of steady and consistent growth in the dividend, alongside earnings growth then the risk of a dividend cut in the future must be lower. Especially if the company operates in a sector where demand remains stable no matter what the economy is doing. Examples of this might include utilities and supermarket companies.

Dividend cover is also an important consideration when it comes to income investing. If the cover is low – often considered to be below 2x earnings – or is falling year on year then again there may be problems down the road for management. This will also may be an early warning that the dividend could come under pressure.

If you want to create a flow of dividends that rises each year and which can be taken as passive income or as cash to reinvest in more shares (ie compound), then you need to consider more than just the yield. You should look at the industry the company is in, what its competitors offer, and look at the dividend growth over time and what’s happening with the dividend cover.

Making the most of investing for growth

When it comes to growth investing one of the first things an investor might want to consider is what are the growth prospects for an industry? This fundamental question allows you to filter down the pool of possible companies. The industry needs strong growth predictions to create opportunities and allow innovative companies to prosper.

Next up on a company level, you want to be checking on the price-to-earnings (P/E) ratio,, especially versus competitors. A high P/E isn’t necessarily bad if earnings can rapidly accelerate but you need to have confidence this will happen. A further step is to check the price to earnings growth ratio (PEG). Ideally, that would be under 0.7.

Other important metrics would be earnings growth and margin growth – both need to be moving up. In the case of earnings ideally by quite a bit. Again with these metrics, it pays to compare how a company you might like the look of compares to its competitors.

Another important consideration, especially when investing in micro cap shares, is to consider the holdings of management. The larger their holdings, the more aligned their incentives should be with those of shareholders. It’s best to be wary of companies that make big promises but where management doesn’t back up that confidence with much of their own money.

The perks of being a private investor

For private investors, there’s every opportunity to combine the two worlds. Generating income so that you have money to invest in more shares while also looking to create higher returns through shares which can appreciate in value. Doing this consistently over the long term provides the opportunity for investors to make money on the stock market.

If you like this article please follow my blog for the latest posts and you can read my most recent post on buying shares in Aston Martin and M&S here.

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