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. These must be bought at attractive valuations, such as when they’re out of favor for various reasons. Peter Lynch, in his book “One Up on Wall Street,” called these growth bonds.
If you hold a bond until maturity, the only return 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 his reasons for why I have performed so well: 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 cheap 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. We buy high-quality, mature companies that are undervalued and predictable. We tend to avoid cyclical companies because of low predictability and because they tend to be more volatile.
The one area of cyclicals we do like, however, are banks. I have over 30 years of experience investing in banks. I’ve used the volatility of the market to buy good banks when they were significantly punished for various reasons. Today we invest in both public and private banks, below their intrinsic transactional value to other banks. We buy these at attractive valuations when they have earnings growth, alignment of interest of all parties, insider ownership, a concentration of successful bank investors and outstanding bank models with excellent management.
Real Estate Investment Trusts (REITs) is another area we invest into. Many REITs do not create much value over time because they pay out 90 percent of their income in the form of dividends, so there is little left to invest into growth. Therefore, REITs issue shares to fund expansion of their portfolio. REIT dividend yields can be counterintuitive; 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 lower. Therefore, the most expensive REITs can also create the most value due to the low cost of capital. We invest in REITs that own high-quality properties bought at attractive valuations, where management knows how to increase revenue and free cash flow.
The one thing to avoid is poor-quality REITs, which lure investors in with very high yields. These are a form of a value trap. The yield may look attractive, but the REIT is likely is going to have trouble maintaining that dividend, 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, with people I feel have 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 is not as exciting as investing in dynamic high-growth companies, it provides a steady stream of income and capital appreciation.
Umberto P. Fedeli is CEO of The Fedeli Group