The case for industrial shares

The first question most people ask about investing in industrial shares is: why limit yourself to industrial shares in a country like Australia, one of the world’s great resource producers? The answer is simple – industrial shares may provide higher levels of income, strong capital appreciation and lower volatility.

INDUSTRIALS VS RESOURCES

The choice between resources and industrials will depend upon your individual circumstances, goals, income needs,  and so on. Generally, resources can suit investors looking for higher growth exposure. Over the past decade, resource shares have exhibited more of what fund managers call ‘growth characteristics’ – simply put, the rise in their share price has been greater than that for industrials. However, those higher returns have come at the expense of increased volatility. In fact, over the past 20 years, resources experienced volatility of 22% per annum1 compared to 13% per annum2 for industrials. Industrial shares have historically generated more consistent growth in capital and income.

If you are looking at industrial shares as an investment option, consider the following these four main factors:

1. Capital growth

Capital growth occurs when the value of an investment increases over time. Under normal conditions, movements in a company’s share price should reflect changing expectations of its profits. When you invest in shares with growth characteristics you may be better able to protect the value of your capital.

The tendency of industrial shares to grow in value over time is one of their key attractions. Over the past 20 years, industrial shares returned 5.0 per cent per annum in capital growth alone (excluding dividend payments). The ability of industrial shares to grow their share price is linked to the successful growth strategies they pursue within their business – new product development, international expansion, entrance to new markets, and so on. These strategies underpin the sustainable capital growth of successful industrial companies.

2. Investing for income

The income you receive from direct shares is in the form of dividends. Dividends are paid out of a company’s earnings.  Dividends generally increase as a company grows.

Industrial companies have historically paid strong dividends, with a sector average yield of 5.1 per cent per annum. As industrials tend to operate in more predictable business sectors – banking, retail, manufacturing, etc. – their earnings are less cyclical and operations more flexible. This means they can prudently pay out a large portion of their earnings as dividends – particularly in comparison to resources. Resource companies typically have very high capital expenses, such as equipment and machinery, and their profitability relies heavily upon the changing market price of the commodities they sell or use. As a result they are required to retain a large portion of earnings to provide a cushion against volatile market conditions. This naturally means they have less cash to pay out to shareholders.

3.Tax-effective income

Not only are industrial shares a good source of income, they can also be very tax effective. This is because Australian share income is taxed favourably through what is called ‘dividend imputation’, also known as ‘franking credits’. This means that if the company has already paid tax on its income, you may be eligible to receive a tax benefit for dividends received from that company. This is so tax isn’t paid twice on the same income.

4. Protection against inflation

Inflation erodes your purchasing power and diminishes your real investment returns. So it’s important that your investments provide protection against inflation. Over the past 20 years, industrial shares have consistently generated both income and capital growth above the rate of inflation. This protection against inflation is one of the reasons industrial shares are often highly valuable to long-term investors – including those looking to fund their retirement.

Case Study 1 – ARB Corporation

ARB Corporation is Australia’s largest manufacturer and distributor of 4x4 accessories. Having grown from a family garage in Melbourne, the company now has a large international presence and distributes its products to more than 100 countries around the globe. Management’s unwavering focus on quality, product innovation and cost control has allowed the business to continually expand at a steady pace over time, maintaining consistently strong profit margins, earnings and cash flow.

Case Study 2 – Reece Australia

Harold Reece opened the first Reece plumbing hardware store in 1920. Today, the company has over 570 branches throughout Australia and New Zealand and has become a household name in bathroom supplies. The company has a long history of successful store roll-outs and expansion into new product lines.

Supported by a strong brand name and a reputation for quality, Reece have built a dominant position in their market.  As evidence of this, Reece has delivered earnings growth of 15 per cent per annum since 1996. This earnings growth is reflected in the long-term rise in its share price, as reflected in the chart below.

How does an industrial share fund fit into a balanced portfolio?

Over the past 20 years, Australian industrial shares have delivered income and capital growth at levels that have comfortably beat inflation at a level of volatility or risk that is lower than both resource shares and the overall Australian market. Every investor has different needs for income and growth, a unique tax situation, and a personal risk tolerance. When making investment decisions, these factors need to be considered.

To find out more about the benefits that industrial share funds can offer, talk to Wynyard Park Private Wealth.

1 Annualised volatility of historical monthly returns of the S&P/ASX 300 Resources Price Index from 30 June 1996 to 30 June 2016.

2 Annualised volatility of historical monthly returns of the S&P/ASX 300 Industrials Price Index from 30 June 1996 to 30 June 2016.

3 Annualised return of the S&P/ASX 300 Industrials Price Index from 30 June 1996 to 30 June 2016.

4 Average dividend yield of S&P/ASX 300 Industrials Accumulation Index from June 2001 to June 2016.

Source: Perpetual