What's best? Income or growth - or both

Two investment options compete. But there is a middle way, says Jenne Mannion

The recovery in the UK stock market seems to be firmly entrenched. This week, the FTSE 100 index crashed through the 4,900 barrier to it highest point in 31 months. The FTSE 250 index of smaller companies has been registering all-time highs.

This brighter picture has enticed some investors back into the market, but one perennial and crucial question is whether the best returns can now be achieved by investing in growth- or income-generating companies.

Investment professionals say that growth companies can deliver excitement but are generally more risky, while income offers more stability. But the divisions between the two are becoming increasingly blurred, and there's a place for both within an investment portfolio.

Figures from the Investment Management Association, released last week, show that income investing is the most popular, with investors still cautious after the collapse in equity markets at the start of the new millennium. In each of the past seven months, equity income funds have been the best selling funds to private investors.

Growth investing tends to focus on newer, more exciting companies with good prospects. Most of the profits generated by these companies are reinvested, rather than being paid out to shareholders as dividends.

John Hatherly, the head of global analysis at M&G, says: "Fund managers and investors who use this style are very specific about the types of stocks they want, and look for companies that they consider undervalued. It is about identifying themes and opportunities."

Income investing tends to focus on older, more established companies that are highly cash-generative. Hatherly says that this is more of a discipline, with investors seeking stocks with a dividend that is higher than the market average (the FTSE All Share currently yields 3 per cent). But that is not all there is to it; income-focused fund managers also look for companies with good business models, and which have the ability to maintain and grow their dividends.

Hatherly says that, typically, income investors adopt a contrarian approach. This is because if a company is maintaining its dividend, but the yield is rising, it is because the share price has fallen, indicating that the company has fallen out of favour with investors. Therefore, to buy such companies generally means taking an approach that differs from the mainstream view.

Jason Britton, a fund-of-funds manager at T Bailey, based in Nottingham, says that income investing is considered the more defensive strategy, as a dividend provides some form of return, regardless of share-price performance.

Mark Lyttleton, manager of Merrill Lynch's UK Dynamic Fund, says that in a period of low inflation the UK market is widely expected to deliver annual returns of 6 to 8 per cent over coming years, of which 3 to 4 per cent will come from dividends. Reinvestment of dividends contributed one-third of the total return to FTSE 100 investors in 2004. While the index rose 7.54 per cent last year, the reinvestment of income took the total return to 11.25 per cent.

Dividends have also proven important over the longer term. The Barclays "Capital Equity Gilt Study 2004" shows that, from 1990 to 2003, annualised total returns from equities were 9.3 per cent. This figure represents inflation of 4.2 per cent and capital gains of 0.5 per cent, with dividends accounting for 4.6 per cent of the return.

Investment experts anticipate that dividends will form an increasingly important part of the total return. Tineke Frikkee, manager of the Newton Higher Income fund, expects that over the next decade, total returns from equities are likely to be 5.7 per cent. Breaking this down, she expects that this would be 2 per cent inflation, 3.2 per cent dividends and capital gains of just 0.5 per cent.

While capital growth is expected to become increasingly difficult to come across, there is better news on the dividend front in the UK market. Dividends from UK stocks are now growing strongly. Research from Fidelity shows that three-quarters of Britain's 100 largest companies raised their dividends by more than the rate of inflation in 2004. On average, blue- chip companies increased dividends by 11.4 per pent, more than three times the headline rate of inflation.

At the top of the list of increases were Vodafone, which doubled its payout, and BSkyB, which reintroduced its dividend in 2004. Close behind was Centrica, with 62.6 per cent increase in its dividend. Frikkee believes that strong dividend growth is set to continue. It is forecast that dividend growth in 2005 will be 9 per cent; this is compared with the annual 3.5 per cent dividend growth over the past year.

Investment professionals say that there's a place for both styles in an investment portfolio, and this is reflected in their own portfolios. Many managers who have funds in the equity income sector will hold some traditional growth stocks, while those in the growth sector will hold income companies if they find them attractive.

Britton says: "We believe investors should have a blend of UK equity income funds and UK growth funds. Income stocks will deliver a yield, which forms part of the total return. Meanwhile, investing for growth in this climate requires good out-and-out stock-pickers - managers who only allocate their assets to their very best ideas rather than seeking to follow the indices. There's certainly a place for both."

Mitch Hopkinson, an adviser at M2 Financial, says a diversified UK equity portfolio ideally includes both types of fund, but for an investor starting out, an income portfolio is a good first port of call. He says: "I expect that equity income funds will remain in vogue for many years to come." Hopkinson rates Invesco Perpetual Income as a consistent performer. The manager, Neil Woodford, he says, is not afraid to take strong views on stocks and the market. Alternatively, Credit Suisse Income has had weaker performance recently, but Hopkinson expects that it will be a good performer over the longer term.

For a faster-footed fund, Jason Britton at T Bailey, suggests Standard UK Equity Higher Income. At pounds 50m, the fund is small, so the manager Karen Robertson can be nimble in her stock selection. Hopkinson also endorses this fund.

In the past three years, the average income fund has performed better than the average growth fund: 17.3 per cent and 8.3 per cent respectively. But if the bull market continues, this trend could easily swing in favour of growth funds. And if that comes to pass, the experts have some favourites that they think will do well.

Britton tips Rensburg UK Growth Fund, where the manager Mark Hall's skill using a high quality threshold before parting with his investors' monies has caused him to avoid many nasty shocks. He also likes Old Mutual UK Select Mid Cap Fund. This focuses on companies in the FTSE 250 index and Britton says that the manager Ashton Bradbury has proven competent at picking winners.

Mark Dampier, an adviser at Hargreaves Lansdown, favours Framlington UK Select Opportunities. He says the manager Nigel Thomas has a proven ability in choosing companies over the long term. He also likes Jupiter Undervalued Assets: Managed by Edward Bonham Carter, who looks for companies that are out of favour. Mr Dampier says this has been a strong long term performer.

In recent years, though the distinction between growth and income companies has blurred. Mr Lyttleton cites Imperial Tobacco (now yielding 4 per pent) as an example. "This is what has been traditionally known as a value or income company, but it has managed to grow its earnings by 10 per cent a year over the past five years," he says.

Companies can swing from being growth to income and vice versa. In the late 1990s media and healthcare were cited as big growth sectors, but following poor performance, they tend to be regarded more as income plays. The happiest investors are, of course, those who manage to spot a strong growth stock that evolves into a strong income provider.