The Income Investor: improving financial outlook is attractive

Income investors may feel as though they are currently in a quandary. While interest rate cuts have commenced in the UK, US and the Eurozone, with further monetary policy easing on the near-term horizon, the presence of time lags means it will take many months for companies to feel the benefits of lower borrowing costs. It could take even longer for them to pass higher profits onto investors in the form of rising dividends.

At the same time, the near-term outlook for the world economy is extremely opaque. Economic risks are still present as inflation across some developed economies remains above central bank targets and recent data has been mixed.

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Geopolitical risks are also currently elevated. Domestically, the looming Budget is creating uncertainty for investors and businesses as the new government remains tight-lipped on which taxes will rise. In the US, the upcoming presidential election could mean major changes to the country’s trading relationship with China. And with conflict in Europe and the Middle East showing little sign of abating, income investors may naturally feel somewhat overwhelmed.

A lack of investment appeal

All of the above could cause income seekers to sell shares and instead focus on other mainstream assets. They may, for example, decide to hold cash ahead of what could prove to be a very volatile period for the stock market. Although it is currently possible to obtain an income return of around 5% from savings accounts, their appeal is likely to rapidly decline. After all, interest rates that are due to fall to around 3.8% over the next two years means income investors will almost certainly experience a decline in their purchasing power from holding cash.

Similarly, bonds may not be the ‘silver bullet’ that income seekers are looking for. Certainly, the yield on 10-year gilts has risen rapidly over recent months to a relatively appealing 4.2%. But with the UK being at least partly reliant on lending from international investors, a misstep in the upcoming Budget could prompt heightened volatility in gilt prices. And with bonds inherently providing zero income growth, investors will inevitably face a decline in their purchasing power – even with inflation expected to move just 50 basis points above the Bank of England’s 2% target over the coming months.

Long-term potential

Of course, shares are by no means the perfect investment at present. The stock market is, as ever, highly susceptible to a bout of sudden, elevated volatility that could be caused by any deterioration in the economy’s outlook or heightened investor concerns regarding geopolitical developments. However, on a long-term view, shares offer a far superior income investing outlook than bonds or cash.

The main reason for this is the prospect of dividend growth. Ultimately, a fall in interest rates is highly likely to have a positive impact on employment levels, wage growth and economic activity that equates to better operating conditions for businesses. Given the scale of interest rate cuts now expected in the UK, US and the Eurozone, as well as inflation being forecast to remain close to central bank targets, this should mean that dividend growth easily outpaces inflation over the coming years.

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Furthermore, shares offer significant capital growth potential as lower interest rates and an improving economic outlook prompt an increasingly risk-on attitude among investors. This should lead to upward reratings, especially among cyclical stocks. And while the income return offered by shares at present may not be any higher than that of cash or fixed-income assets, the prospect of brisk dividend growth means that long-term investors are likely to benefit to a greater extent from holding a diverse range of income stocks.

Managing risk

Although interest rates are set to fall, income investors should still avoid companies with high debts. Highly-leveraged firms could be among those hardest hit by an economic slowdown in the short run as investors flock to financially sound businesses. Similarly, buying stocks that have strong competitive positions can further lower risk while providing greater scope for dividend growth and capital gains, as they are better able to capitalise on improving operating conditions over the long run.

Clearly, many income investors could be dissuaded from buying shares by the prospect of heightened market volatility. But it is worth remembering that short-term share price fluctuations which are largely prompted by changing investor sentiment do not equate to a higher risk of permanent capital loss. Nor do they reflect a worsening outlook for a company’s dividends, which are not linked to temporary changes in its market value.

Continued income appeal

FTSE 100 member Sainsbury (J) (LSE:SBRY) continues to offer long-term income investing appeal. The retailer’s shares have risen by a rather disappointing 3.5% since they were last featured in this column during November last year. As a result, the stock’s dividend yield is little changed at 4.8%.

In its latest financial year, the company maintained dividends per share at the same level as in the previous year. While this is somewhat disappointing, given that it equates to a loss of purchasing power for investors amid positive inflation, it is perhaps to be expected due to the company’s 3.9% decline in annual profits. The retailer continued to face a challenging set of operating conditions, with the cost-of-living crisis prompting consumers to remain relatively price conscious.

An improving outlook

Now, though, an improving trading environment is beginning to take hold. An era of more modest inflation and rate cuts is set to prompt improved purchasing power among consumers. This should make them less focused on price and more interested in product quality, service and convenience, thereby providing scope for profit margin growth.

A stronger economic outlook should have a disproportionately positive impact on Sainsbury’s financial performance due to it being a mid-tier operator, with customers who have previously traded down to no-frills options likely to return.

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Indeed, the company’s latest trading update showed that it is delivering an improving financial performance. Like-for-like sales in the first quarter of the year amounted to 3%. In addition, the company remains on track to grow its operating profits by 5-10% in the full year. Given that shareholder payouts were covered a healthy 1.7 times by net profits in the previous financial year, the firm’s improving prospects bode well for dividend growth. Further information on this and other areas will be included in half-year results that are due to be released in early November.

A margin of safety

Clearly, the path to improved retail trading conditions may not be particularly smooth. Interest rate cuts will take time to have their desired impact on consumer spending. The firm’s solid financial position, though, suggests it is well placed to overcome near-term economic uncertainty. This is evidenced in a net debt-to-equity ratio of 66%, while net interest payments were covered 3.4 times by operating profits in its latest financial year.

Following recent share price volatility that was prompted by the Qatar Investment Authority (QIA), the company’s largest shareholder reducing its stake, Sainsbury’s now trades on a price/earnings ratio of 12.4. This suggests that it offers a margin of safety that could prove to be a useful ally for investors should economic or geopolitical risks prompt a near-term decline in the wider stock market. And while elevated share price volatility could persist in the short run, the company’s long-term prospects remain sound.

Indeed, the firm’s valuation indicates that there is capital growth potential on offer as falling interest rates prompt improved investor sentiment towards businesses that are relatively dependent on the economy’s performance. When combined with the company’s attractive dividend yield, its potential to raise shareholder payouts and solid fundamentals, this suggests it continues to offer long-term income investing appeal.

Robert Stephens is a freelance contributor and not a direct employee of interactive investor.