What Are Income Stocks?

By Damian Davila on 20 October 2016 0 comments

You may think that investing in stocks is all about share price increases over time. In reality, you may be surprised to find out that the price of some stocks can vary little over time and still provide an ever-increasing stream of income. These types of securities are known as income stocks.

Let's review the seven things you need to know about income stocks and their ability to provide a high payout to investors.

1. They Pay a Dividend

The defining feature of an income stock is that it pays a regular and predictable dividend, which often increases over time. For example, Caterpillar Inc. [NYSE: CAT], a leading manufacturer of construction, mining, and transportation equipment, has paid a dividend to its stockholders every quarter since 1933. For the last 22 years, Caterpillar's cash dividend has consistently increased and it stands at $0.77 per share of common stock — up from $0.35 in 1996, and without adjusting for the two-for-one stock splits of 1997 and 2005.

A predictable, steady, and ever-increasing stream of income makes income stocks attractive to those retirement savers who're close to retirement age.

2. They Are Often Large Companies

While income stocks can be found in many industries, they are most often part of the real estate, energy, utility, natural resource, and finance industries. One example of an income stock in the energy sector is Phillips 66 [NYSE: PSX], which has been in the news due to its spinoff from ConocoPhillips back in 2012. It doubled its stock price in the first year after the spinoff, and attracted Warren Buffett's investment (a 15.2% share of the company as of late August 2016). (See also: The 5 Best Pieces of Financial Wisdom From Warren Buffett)

The Houston-based multinational energy company generated $161.2 billion in revenue in 2014, a figure that is bigger than the GDP of some nations around the world. Since its 2012 spinoff, Phillips 66 has been consistently paying a quarterly dividend that started at $0.20 per share of common stock and stands now at $0.63 per share of common stock.

3. They Have Been in Business for a Long Time

Generally speaking, the less established a company, the more likely that company can experience extraordinary growth per quarter. Think of 12-year-old Facebook or 13-year-old Tesla, whose current stock prices are seven and 10 times, respectively, their original prices after going public. Both Facebook and Tesla would be considered growth stocks. On the other hand, income stocks are those of companies with a long history. Caterpillar and Phillips 66 were originally founded back in 1925 and 1917, respectively. (See also: What Are Growth Stocks?)

4. They Are an Alternative to Fixed-Income Securities

If you have a 401K, chances are that you have a target-date fund. In 2014, 48% of 401K plan holders had target-date funds, which gradually lowers exposure to risk as you get closer to retirement age and helps maintain a steady stream of income during your retirement years. However, dialing back your risk doesn't necessarily mean that you will stick to municipal bonds and money market accounts from now on.

Legendary investor Peter Lynch said it best: "Gentlemen who prefer bonds don't know what they're missing." The appeal of income stocks is that they provide a steady stream of income while providing some exposure to corporate profit growth. Many investors use the yield of a 10-year treasury bond rate as a benchmark to grade the performance of income stocks. As of October 10, 2016, the yield of a 10-year treasury bond was 1.77% and those from Phillips 66 and Caterpillar were 3.13% and 3.48%, respectively.

5. They Have Modest Annual Profit Growth

That being said, don't expect companies behind income stocks to have ambitious goals of profit growth. Due to its long business history, some income stocks may have limited future growth options and provide only a moderate annual profit growth. However, this is the main reason why these companies are able to pay a dividend in the first place. Since there may be no need to aggressively reinvest in new infrastructure, research, or development, then the company can afford to issue a dividend every quarter to its shareholders.

6. They Have Low Stock Price Volatility

Among the many statistics that analysts report on stock tables, beta is one of the most relevant ones, besides dividend and yield, to incomes stocks. (See also: Beginner's Guide to Reading a Stock Table)

Since the beta of the market as a whole is 1.0, a stock with a beta below 1.0 would move less than the market, and a stock with a beta above 1.0 would deviate more than the market. Often, income stocks have betas below 1.0. For example, machinery manufacturer Deere & Company [NYSE: DE] has a beta of 0.63, and retailer Wal-Mart Stores Inc. [NYSE: WMT] has one of 0.09.

7. They Are Available in Mutual Funds and Index Funds

Even though throughout this article we have only focused on individual companies, you can still buy a basket of several income stocks at the same time. You can do this through either a mutual fund or a low-cost index fund. One example of the second category is the Vanguard High Dividend Yield Index Fund Investor Shares [Nasdaq: VHDYX], which holds many income stocks, such as Microsoft, Exxon, Johnson & Johnson, and General Electric.

Two advantages of using index funds to include income stocks in your portfolio are diversification (e.g. 420 holdings in the mentioned index fund from Vanguard) and low cost (e.g. 0.16% annual expense ratio for the same index fund).

The Bottom Line

Before buying an income stock, make sure to evaluate it using your current investment strategy. While an income stock can offer you a way to get higher yields than those of treasury securities or certificates of deposit, you may be so far away from retirement age that you could afford a higher exposure to risk through value or growth stocks. Consult with your financial adviser to discuss more about your investment objectives and the appropriate ways to achieve those financial goals.

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