Income and Capital Appreciation Strategy

My third active investment strategy is called Income Growth Capital Appreciation, as the goal of the strategy is to invest in high quality businesses and assets that increase their earnings and dividend payouts, but also continue to increase their value. Of course, these must be bought at attractive valuations, perhaps when they’re out of favor for various reasons. Peter Lynch in his book One Up on Wallstreet called these “growth bonds”.

If you hold a bond until maturity, the only return you’ll get is the Yield to Maturity. The return is fixed and limited. However, if you buy securities with growing dividends, the income on the security can increase over time. Additionally, if you buy them right, you can also earn price appreciation on the investment.

My Chief Investment Consultant, Michael Nowacki, has shared with me his reasons for why I have performed so well in the past: I am selective, opportunistic, flexible, and open-minded. Investment managers are often given a lump sum to invest and are fully invested 100 percent of the time—to buy something, they must sell something else. By contrast, having an income stream that one can reinvest when the market is in a correction allows the individual to take advantage of the low prices the market is offering. When you have cash to invest, lower prices are better and therefore volatility can be your friend.

We focus on several areas for Income Growth Capital Appreciation. One is that we buy high quality, mature companies that are undervalued. An example is Broadcom. In 2016 the dividend per share was $2.30 and in 2021 it is $14.40. Earnings Per Share (EPS) also more than doubled over the past 5 years. So long as you don’t overpay, high EPS growth over time tends to result in strong stock performance.

As a rule, we tend to avoid cyclical companies because of low predictability and because they tend to be more volatile. We like companies with consistency. The one area of cyclicals that we do like, however, are banks. I have over 30 years’ experience investing in banks, and I feel comfortable identifying good bank investments. Throughout the last 30 years I’ve used the volatility of the market to take advantage, buying good banks when they were significantly punished for various reasons. Today we invest in both public and private high-quality banks, below their intrinsic transactional value that are very desirable to other banks. We like to buy these at attract valuations that have earning momentum growth, alignment of interest of all parties, inside ownership, and outstanding bank models with excellent management where there are a concentration of successful bank investors.

Real Estate Investment Trusts (REITs) and real assets are another area we invest into. Many REITs do not create much value over time because they pay out 90% of their income in the form of dividends, so there is little left over to invest into growth. Therefore, REITs issue shares to fund expansion of their property portfolio. REIT dividend yields can be counter intuitive: a high dividend could be a negative for a REIT because it makes the cost of capital high, while a low dividend makes the cost of capital less expensive. Therefore, the most expensive REITs can also create the most value due to the low cost of capital. We like to invest in REITs that are high quality properties bought at very attractive valuations, where management knows how to increase their revenue, FFO and net income; and where they add value to create value much in the way good private operators know how to do.

An example is Brookfield Infrastructure Partners (BIP), which owns utilities, railroads, toll roads, midstream, and data centers around the world. We initiated a position in this in Nov 2017 and added in 2018 and 2020. Our average purchase price was $35 and today it is $58, which is appreciation of 66%. We also received dividends of $1.69, $1.81, $1.94, and $2.02 from 2018 – 2021, which is another 21% return on our purchase price. We also bought Brookfield Energy Partners, which has done even better.

The one thing to certainly try to avoid are poor quality REITs, which sometimes lure investors in with very high yields. These are a form of value trap. The yield may look attractive, but in reality, the REIT likely is going to have trouble maintaining that dividend in the future, which is why the market is not giving it a higher price and lower yield. High yields can often mean potentially higher risk.

I am also a passive investor in private real estate, though I do that with people I feel have extremely high integrity and have significantly outperformed in their given area of expertise. I consider real estate investing part of income growth capital appreciation, be it public or private.

Although income growth capital appreciation does not seem to be as exciting as investing in dynamic high growth companies, it does provide a steady stream of income growth and capital appreciation.